How To Read The Big 3 Financial Statements
There are 3 financial statements small business owners need clarity when reading. In this article I will break into each one and help demystify some of the confusion when looking at them. The big 3 are the Income Statement (P&L), Balance Sheet, and the Statement of Cash Flows. All three tell a different story about the business and when all three are read together you can start to put together the numbers in a way that makes sense. This will just be an introduction, entire articles could be written about each statement.
Lets start with the Income Statement (IS) since most are familiar with it. The main point of the Income Statement is to show if a business was profitable over a period of time. The format of a traditional IS makes it easy to read top to bottom. The top is reserved for revenue to the business. Following this is the Expense section. In here at the top sometimes you will see the Cost of Goods GOCS section. This is expenses that were directly connected to the business receiving revenue, think direct materials used in production. After the COGS, the gross margin will appear. This the Revenue divided by the COGS. Gross Margin can be a great Key Performance Indicator (KPI) of a company. The rest of the expenses should be straight forward. Before the “Bottom Line” you may see a section called Other Income/Other Expenses. This may include interest earned on bank balances and other line items that are not directly connected to the operations of the business. The last line should be the Net Income of the business.
Next lets talk about the Balance Sheet. This one shows the position of the business at A MOMENT IN TIME. This is the big lesson. The Balance Sheet is a snapshot of the different accounts related to the business at a given time, not over a period. The accounting formula used in this is Assets = Liabilities + Equity. The equation operates as a double entry system. If one transaction is entered, it will need to balance somewhere else. The asset and liabilities sections are broken down to current and long term. Generally current is going to be moved around in under a year. The equity section shows the residual interest the owner has after assets and liabilities are subtracted. This section will show common stock, retained earnings, treasury stock, and other accounts.
Lastly lets discuss the Statement of Cash Flows. This financial statement is probably the most overlooked of the Big 3 and might be one that us all need to keep an eye on. The statement tells the story of how cash moved in and out of the business over a period of time. One of the main reasons this needs attention is because if you are only looking at profit in the Income Statement but not realizing it is all tied up in accounts receivable and not being collected on you could soon run out of cash to operate. Big lesson is that profit does not equal cash. The Statement is broken down into 3 sections. First you will find the operating, this will be the core of the cash movement (generally). Transactions such as cash from customers, rent, cash paid to vendors, and payroll fall into this category. The second section is investing. Transactions such as purchasing and selling equipment fall into this category. The third section is financing. In this section transactions such as owner distributions, loan proceeds, and loan repayments will be found.
I will sum it up with a short description of how these interplay with each other. This is just an overview and is not meant to describe all the different subtleties involved.
Income statement creates profit → profit updates equity on the balance sheet → cash flow statement explains how profit turned into actual cash. Knowing how these work and how to read them with confidence will allow you to make confident decisions.
Keep it reconciled,
-Justin Oliveri