Understanding Small Business Financial Statements

If you are like many small businessowners, when you get a copy of your financial statements at the end of the year from your accountant, you flip through them, nod as if you know what they're trying to tell you, and file them away in a drawer, never to see the light of day again.

Knowing how to read your financial statements, however, can help you to understand what happened last year in your business and what's likely to happen this year. Let's have a look at the three major documents in a typical financial statement package.

The Balance Sheet

This is usually the first statement in your package. The purpose of the balance sheet is to give a snapshot of what your business owes and owns at a certain point in time. At the top of the statement will be an "As of..." date. This is the date (usually your business's year end) that the balance sheet reflects.

There are three main sections of your balance sheet. "Assets" (as you might suspect) list the types of assets that your company owns. "Liabilities" show you what your business owes- to the bank, to the government and to others. The last section is called "Equity". This section shows you what your net interest is in the business. You'll notice that the total equity equals the assets minus the liabilities. Another way to view equity is that it is what would be left if you wound up the company and paid out all the liabilities with the assets.

One important note is how your balance sheet is valued. All of your financial statements are (with few exceptions) valued at the cost that you made the original transaction at. For example, if your company purchased the building you operate in for $50,000 ten years ago and it is now worth $150,000, it will appear on your balance sheet at its original $50,000 cost minus depreciation. Your balance sheet is not a good indicator of the value of your business, only the historical transactions. There is great debate in the accounting community about whether historical cost is the correct valuation method (proponents suggest that it is, at least, the most objective method), but for our purposes here, it is sufficient to note that it is historical cost that appears on your financials.

The assets and liabilities on your balance sheet are divided into "Current" and "Long Term". This is an important distinction and one that your banker will look at closely. We'll talk about ratio analysis in future columns but for now, just note that it is important to have at least enough current assets to cover current liabilities.

The Income Statement

The second statement in your package is usually the income statement. At the top of this statement will be wording to the effect of "For the period ended...". Where the balance sheet shows you a point-in-time snapshot, the income statement shows you your business' activities for a period of time, usually a year.

The first line or grouping of lines on the income statement shows you the revenues for the year. They may be called "Revenue" or "Sales" or "Gross Income", depending on the style of your statements. The revenue is the gross amount of income earned from your business activities, less the sales taxes. It is important to note that your sales will appear here even if you haven't collected the money yet. Financial statements are generally prepared using the accrual method, which places revenue and expenses into the period in which they are earned, not collected.

Following the revenue section is a listing of the expenses. You may find this list in alphabetical, size or no particular order. My personal preference is to list them in alphabetical order to make it easier to locate a particular expense, but you may prefer another method, which is just fine.

Your revenue minus your expenses is called the "Net Income". This is the amount that the business will keep and add to the equity. At the bottom of the income statement, you may find a reconciliation of the equity. It will start with the income earned in the current year, add the opening equity, and subtract any dividends paid out to the shareholders in the year. The ending equity will be the same equity number found on your balance sheet.

Cash Flow Statement

This is probably the least understood but most useful of all the financial statements. The purpose of the cash flow statement is to show you where the money went during the year.

There are two main classifications on the cash flow statement; sources of cash and uses of cash. Every transaction the business has entered into in the year has either been a source or use of cash. The main source of cash, of course, is your net income. Other common sources are; collection of accounts receivable, loan proceeds, and incurring payables instead of paying cash. Common uses of cash are; paying payables, paying down debt and buying equipment or inventory.

At the end of your cash flow statement, your current cash balance shows. The statement has reconciled your opening cash to your closing cash.

Many small business owners ask me "Where did all the money go?" This is the statement that shows them.

Getting a deeper understanding of the inner workings of your business is critical to your success and being able to interpret your financial statements is a powerful tool in your knowledge toolkit.