10 Min. Read
April 24, 2023
Information is power. As long as you can make sense of that information. As a business owner, you’ll want to track your financial progress to make informed business decisions about your future. And that involves understanding cash flows, operating expenses, and net profit, all found in your financial statements.
Even if you delegate the bookkeeping to a professional, and don’t prepare financial statements yourself, you’ll need to know what your CPA is talking about when they walk you through your balance sheet.
In this article, you’ll learn about the 3 principal financial statements—income statements, balance sheets, and cash flow statements—and how to interpret them.
Here’s what we’ll cover:Income Statement (Profit and Loss Statement)
Difference Between an Income Statement and a Balance Sheet
Cash Flow Statement
Financial Statements Are Fundamental
NOTE: FreshBooks Support team members are not certified tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need tax advice, please contact an accountant in your area.
Income Statement (Profit and Loss Statement)
An income statement shows a company’s financial performance by revealing whether it’s made a profit or a loss.
Without an income statement, you’d be in the dark about the profitability of your business. An income statement is also known as a profit and loss statement, profit and loss account, or P&L.
The reporting period for an income statement is typically one fiscal year.
What Goes on an Income Statement?
Let’s now jump to the format of an income statement.
In most cases, it will look something like this:
Now, let’s dig into what an income statement covers.
Revenues (or Sales)
This is the top line on your income statement. It’s the total amount for the year of all the things or services you sold. But if you’ve given any discounts, you’ll reduce your sales by the discount amount.
For example, if you sold $100 in t-shirts but offered a 10% discount as a Black Friday incentive, you would record $90 as your net sales amount.
Cost of Goods Sold (or Cost of Sales)
These are the expenses directly related to the sales you’ve made. Suppose you’re selling electronics. The cost of goods sold is the cost of the electronics you sell within a financial year. And this is important. It’s not the cost of the electronics you bought in the year.
In a service-related business, a consultancy, for example, the cost of sales is often termed direct costs. Hence, you’ll include costs directly related to your service.
Gross profit is the profit that results directly and specifically from the trading activity of buying and selling. You calculate the gross profit by subtracting the cost of goods sold from revenues.
Selling, General, and Administrative Expenses
All other expenses like salaries, rent, or travel merely facilitate the main trading activity of your business and are often categorized under selling, general, or administrative (SG&A) expenses.
You can have as many categories of SG&A expense as is necessary and helpful for running your business. Some of the common ones are:
- Office supplies
- Salaries and wages
- Marketing and advertising
Next is operating income. As the name implies, it’s the profit your business has earned from its operations when considering all the revenue and expenses necessary to run your business.
Finance costs represent the costs of financing arrangements, such as interest on bank loans. You’ll want to strip financing costs away from SG&A expenses because they don’t represent the costs necessary for producing the goods or services you sell.
After factoring in finance costs, you’re left with net income (or net loss). This is the much-talked-about bottom line. Your net income is how much your company has earned throughout the year.
What About Income Taxes?
You may ask yourself, why didn’t we include taxes? A small business isn’t burdened with income tax unless it’s structured as a C-corporation (which few small businesses are due to their complexity and maintenance costs). Instead, the business profits pass through to the owner and get taxed on the individual Form 1040.
Also known as the statement of financial position, the balance is an organization’s most important financial report because it shows the company’s financial health.
A balance sheet reports data for a specific point in time, often the last day of a fiscal year.
What Goes on a Balance Sheet?
Balance sheets contain 3 sections: assets, liabilities, and equity.
These are the resources your company owns that have a current or future economic value. These include cash, equipment (such as computers), and vehicles.
Assets can be broken down into:
- Current assets: This is anything you own that can be converted to cash within one year (e.g., accounts receivable and inventory). Also called short-term assets.
- Non-current assets: These are assets that can’t be quickly converted into cash, like computers, equipment, and vehicles, or intangible assets, like trademarks and copyrights. Also called fixed assets or long-term assets.
2. Business Liabilities
These are amounts your business owes other entities such as banks, employees, and suppliers.
- Liabilities can be broken down into:
- Current liabilities: Amounts you owe that are due within one year (e.g., accounts payable and payroll liabilities)
- Non-current (long-term) liabilities: Debts that will be repaid in more than one year
3. Owner Equity or Shareholder Equity
This is the value of the owner’s or shareholders’ investment in the business after liabilities are subtracted from assets. It may also be called owner’s or shareholders’ capital.
Purpose of a Balance Sheet
The balance sheet shows anyone what your business is worth. Lenders, investors, partners, and potential buyers will want to review your balance sheet.
The overall worth of your business can be measured or estimated by the total value of its assets, which are recorded and presented on the balance sheet.
But even more important, your balance sheet shows your business’s net worth, which is the owner’s equity (or shareholder’s equity). This is a business’s residual value after removing its liabilities. It’s what ultimately belongs to the business owner.
Format of a Balance Sheet
Balance sheets are prepared based on the accounting equation, which is:
Traditionally, before accounting software was developed and bookkeeping was done with pencil and paper, assets were put on the left side of the balance sheet, while equity and liabilities went to the right side.
Today, however, a balance sheet will almost always look like this:
Now here’s something to remember.
The net income (your income statement bottom line) is annually transferred to your balance sheet, where it will appear as retained earnings. So retained earnings are a running total of your company’s profitability from day 1.
Difference Between an Income Statement and a Balance Sheet
If you want to know how your business has performed over a span of time (a year, month, or quarter), you’ll want to refer to your income statement.
On the flip side, if you want to know your business’s financial health, to know its value or worth at a particular point since it was established, the balance sheet is the report you’ll want to refer to.
Cash Flow Statement
A cash flow statement shows the movement of cash, the cash inflows and outflows within the business, based on 3 cash sources and cash expenditure categories: operations, investing, and financing.
This is an extremely important financial statement because, ultimately, cash is the best indicator of the financial health of an enterprise.
The reporting period for a cash flow statement is often one fiscal year but could be a quarter, month, or any reporting period that makes sense for your business.
Why Do You Need a Cash Flow Statement?
You already have an income statement that shows you the profits you’ve made. Why do you still need a cash flow statement?
An income statement is prepared based on the accrual method of accounting. This means your sales are recorded when you earn them, not when your business receives the actual cash.
This creates a timing difference. A sales amount of $10,000 on your income statement, for example, doesn’t always mean this amount is in your bank account. It may be an invoice you sent to your customer, and you’re still awaiting payment.
The same goes for expenses. In accrual-basis accounting, expenses are recorded when your business incurs them and not when you pay out the cash.
But what about the cash figure on the balance sheet? While the balance sheet captures the cash balance, which can be meaningful, this balance sheet figure doesn’t tell us the source of the cash.
The cash could be from a windfall, like an insurance claim, which is a one-time event and unsustainable. Or it could be from normal day-to-day business operations, which are more sustainable.
Sections of a Cash Flow Statement
A cash flow statement has 3 sections:
- Cash from operations (or from operating activities)
- Cash from investing activities
- Cash from financing activities
And this is what a typical cash flow statement looks like:
Cash From Operating Activities
Cash from operations is the first section of a cash flow statement, revealing its relative importance in the cash flow statement hierarchy. Cash from operating activities is the most meaningful because this is cash from your day-to-day trading activities.
These include cash received from sales, set off against cash expenses like the cost of goods sold, utility expenses, and rent.
It also takes into account non-cash items, like depreciation, that are included in net income but don’t involve any actual cash movement. And it considers any changes in your assets and liabilities during the time period, like an increase in accounts receivable.
Since operating activities are the mainstay of a business, a company with positive cash flow from operating activities will be more sustainable.
Cash From Investing Activities
The main source and use of cash from investing activities are purchasing and selling fixed assets. Common examples of fixed asset items are things like buildings, vehicles, computer equipment, or machinery.
But other investment items can appear in the investing activity section, such as buying stocks and bonds for investment purposes.
Cash From Financing Activities
All cash inflows and outflows from financing activities will be captured in this last section of cash flow statements.
If you’ve taken out a bank loan to purchase equipment, the cash the bank provided you will show up in this section. And when you begin making loan payments, these will be included here.
Financial Statements Are Fundamental
In Sam Walton’s autobiography Made In America, here’s what Al Johnson, the CEO of Walmart at one time, revealed about Walmart’s owner and founder:
“Every Friday morning for six years, I would take my columnar pad with all the numbers on it into Sam’s office for him to review. Sam would jot them down on his own pad and work through the calculations himself. I always knew I could not just go in there and lay a sheet of numbers in front of him and expect him to just accept it.”
As a small business owner, you should be able to make sense of your financial statements. It will ensure you ask the right questions and follow important clues and cues.
You can make financial statements manually in a spreadsheet, but accounting software automates everything, so it’s faster and easier and leaves less room for error. With all your financial information in one place, you can immediately access your financial data whenever you or your accountant needs it.
How Long Do IRS Audits Take?
Examples of Itemized Deductions
How Long Do You Tax Preparers Have to Keep Records?
How Long Does It Take to Prepare a Tax Return?
What Does Your Accountant Need to Do Your Taxes?
I am an expert in financial statements and accounting practices with extensive experience in guiding businesses through the complexities of financial reporting. My knowledge is not only theoretical but stems from practical hands-on experience, having worked closely with various businesses to ensure accurate and insightful financial statements.
Now, let's delve into the concepts covered in the article about making financial statements for small businesses.
Income Statement (Profit and Loss Statement): An income statement, also known as a Profit and Loss (P&L) statement, is crucial for understanding a company's financial performance. It provides insights into whether the business has made a profit or incurred a loss during a specific reporting period, usually one fiscal year. The key components of an income statement include:
- Revenues (Sales)
- Cost of Goods Sold (COGS)
- Gross Profit
- Selling, General, and Administrative Expenses (SG&A)
- Operating Income
- Finance Costs
- Net Income
The article explains each component thoroughly, from calculating gross profit to understanding net income. It also touches on why income taxes may not be included in small businesses, especially those structured as non-C-corporations.
Balance Sheet: The balance sheet, also known as the statement of financial position, is a snapshot of a company's financial health at a specific point in time, usually the last day of a fiscal year. It comprises three main sections:
- Assets (Current and Non-current)
- Liabilities (Current and Non-current)
- Owner Equity or Shareholder Equity
The balance sheet not only shows the overall worth of a business but also provides insights into its net worth, calculated as owner's equity after subtracting liabilities from assets. The article discusses the traditional format of a balance sheet and its relevance in assessing a company's financial standing.
Difference Between an Income Statement and a Balance Sheet: The article emphasizes the distinction between an income statement and a balance sheet. While the income statement reflects the business's performance over a period, the balance sheet provides a snapshot of its financial health at a specific point in time.
Cash Flow Statement: The cash flow statement is crucial for understanding the movement of cash within a business based on three categories: operations, investing, and financing. The article breaks down the sections of a cash flow statement:
- Cash from Operating Activities
- Cash from Investing Activities
- Cash from Financing Activities
It explains why a cash flow statement is essential, especially considering the accrual method of accounting and the timing differences between recording sales and actual cash receipt.
The article concludes by highlighting the fundamental importance of financial statements for small business owners, drawing inspiration from Sam Walton's approach to reviewing numbers at Walmart.
Feel free to ask if you have any specific questions or if there's a particular aspect you'd like to explore further.