The 3 Financial Statements Every Business Owner Should Understand
As a small business owner, having a solid grasp of financial statements is crucial for making informed decisions. To illustrate this importance, let's draw an analogy to sports. Imagine being a head coach of a baseball team without any player statistics or scouting reports. Even with years of coaching experience, it would be challenging to form strategies or set lineups effectively. Similarly, running a business without accurate financial statements is like navigating blindfolded. Clear visibility into financials allows you to make informed decisions, identify competitive advantages, and uncover areas for improvement. In this article, we will explore the three fundamental financial statements that every business owner should be familiar with.
Profit & Loss Statement:
Also known as the Income Statement or P&L, this statement summarizes revenues and expenses over a specific period. The P&L starts by listing all revenues, followed by all expenses. It's beneficial to set up your bookkeeping in a manner that produces separate lines for different sources of revenue. This will facilitate the tracking of each revenue stream and how much they contribute. Similarly, the expenses on your P&L should be detailed and separated as much as possible, to enable cost-cutting opportunities to be identified. The bottom line of the P&L is the Net Income, representing the business's profit for the period. Net Income is the most important metric for every business since it shows if a business is profitable or not. Setting goals related to your Net Income and comparing them to actual results helps owners understand where the areas of opportunity are in their business.
Balance Sheet:
The balance sheet provides insights into a company's assets, liabilities, and owner's equity. To better understand the balance sheet, it’s important to understand this formula: Assets = Liabilities + Stockholder’s Equity. This equation means that all the company’s assets were funded through one of two sources: either by borrowing money (increases liabilities) or by an owner’s contribution (increases stockholder’s equity). If an owner contributed $10,000 cash to start the company, that would increase assets and stockholder’s equity by $10,000.
The asset section of the Balance Sheet is split into two parts: current assets (expected to be turned into cash within a year) and non-current assets (equipment, long-term investments). Similarly, liabilities are classified as current (debt due within a year) or long-term. Finally, the stockholder's equity section includes the amount of common and preferred stock outstanding, and retained earnings, which are the cumulative profits of the business over its lifetime. Understanding the balance sheet allows business owners to gauge financial worth and funding sources.
Cash Flow Statement:
This statement presents the inflow and outflow of cash in a given period. It’s categorized into three sections: operating activities (daily operations), investing activities (buying/selling assets), and financing activities (issuing or acquiring long-term debt/obligations). The Cash Flow Statement is very important for every size business because it highlights the difference between Net Income and the ending cash balance for the period. Net Income and cash differ due to transactions that affect Net Income but don’t affect cash (like asset depreciation). Vice versa, some transactions in your business might affect cash, but not your Net Income (like proceeds from issuing debt).
By becoming familiar with the Profit & Loss statement, Balance Sheet, and Cash Flow Statement, small business owners gain a comprehensive understanding of the financial health of their business. These statements provide invaluable insights into revenue sources, expenses, assets, liabilities, equity, and cash flow dynamics. Armed with this knowledge, business owners can make informed decisions, develop effective strategies, and navigate their financial journey with confidence.