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Understanding Financial Statements – A Guide for Entrepreneurs
As a small or new business owner, it may be overwhelming to learn that you are responsible for maintaining your accounting records in addition to all of the other functions that you must perform to operate your business. Developing and maintaining an accounting system is an on-going process that takes time and commitment to carry out. However, knowing how to read financial statements and understanding what they mean, is a completely different function.
As a business owner, you should become familiar with the three most common and widely used financial statements in the country and be able to understand what each of their functions are.
Why Financial Statements are Important
Financial statements are important because they allow you, the business owner (or the manager) to make informed decisions about your business. These decisions will be based on a variety of factors that may only become apparent to you after reviewing the financial statements. Financial statements are a summary of your business’ activities. They should not only provide a snapshot of your financial position, but they should also provide some indication as to where your business is headed.
Financial statements also allow you to observe any trends and historical financial patterns that may have had an impact on your bottom line. For example, if a restaurant was located near a high school or a college campus, the owner may notice an increase in sales during the basketball and football seasons. This peak in sales could assist him with future planning and decision making. In fact, the owner could analyze his financial statements for the past five years to see what increases were realized on a consistent basis during those peak periods. He could then make estimates and make plans to use the extra income to obtain loans, pay down debt or make large cash purchases. The financial statements from previous years would then justify his financial projections and estimates for the coming years.
Who Uses Financial Statements
Financial statements are also the most requested documents when applying for business loans, gathering information for tax planning and preparation or for obtaining business credit from suppliers. For those reason, it is important to keep accounting records up to date so that they can immediately be made when requested by bankers, private lenders, vendors and suppliers.
Additionally, financial statements also allow you or others reviewing them, to compare your business' performance to other comparable businesses in your industry. This can be done by analyzing your business' key financial indicators.
The Most Widely Used Financial Statements
There are a variety of financial reports that are used by business owners, including customized reports and standard monthly reports. But according to the Generally Accepted Accounting Principles (GAAP,) there are standards and procedures that must be followed when preparing and reporting a company’s financial information. The three most commonly used financial statements that you, the new or small business owner should use and familiarize yourself with, (according to GAAP) are 1) the income statement, which is also referred to as the profit and loss statement, 2) the balance sheet, which is also referred to as the statement of financial position and 3) the statement of cash flows, which is also referred to as the cash flow statement.
1) The Income Statement - The income statement reflects two major functions of the business, the operating functions and the non-operating functions. The non-operating functions are also referred to as the general and administrative functions.
The operating functions consist of income or revenues comprised of cash and / or credit sales and the cost of goods sold, which is comprised of both direct and indirect costs used to generate the sales. The difference between these two areas (revenues minus the cost of goods sold) is the gross profit. The remaining gross profit is what is available to cover the second section of the income statement, or as indicated above, the non-operating section, known as the general and administrative section. Once the administrative expenses have been deducted from the gross profit, (which includes areas such as rent expense, office supplies, telephone expense, insurance expense and other normal business expenses) the remaining amount is the net profit (or loss in some cases) within in a specific period of time. Because losses do occur, it is imperative to have significant cash reserves or access to cash to cover any possible losses.
The income statement is used measure your business’ financial performance within a particular time frame (or accounting period.) with respect to identifying increases and decreases in sales, cost of goods sold, gross and net profit margins, and comparisons from previous periods. In short, it is a snapshot of your company’s total revenues, costs and expenses.
2) The Balance Sheet - The balance sheet is a statement of the business owner’s worth at a specific point in time. It is divided into three sections and maintains a running balance (that displays the current balance or value) of your assets, liabilities and owner’s equity as of a specific date or period of time.
The assets are grouped by long-term assets, short –term assets and other assets. The long-term assets are normally referred to as fixed assets and include items such as vehicles, furniture and equipment. These items lose value over time and are depreciated over the useful life of the asset. Short term assets include cash and cash equivalence, such as securities, accounts receivables or notes receivables, all of which can be easily converted into cash within one year. The last category in the asset section includes other assets, which are comprised of unusual items that don’t fall under the other two categories.
The next section of the balance sheet includes the liabilities section. The liabilities are comprised of both long-term and short-term (or current) liabilities and reflect the long-term and immediate debt at a specific point of time, such as at the end of the month, or at the end of the accounting period. Examples of long-term liabilities include long-term leases, bonds and loans that are due and payable after one year, including auto loans, bank loans and other business loans. Examples of short term-debt would be the same type of loans, but loans that will be paid off within one year. Other examples of short-term debt include wages, unearned revenue and taxes.
The last section of the balance sheet is the owner's equity section. Owner's equity, is the net of the assets minus the liabilities and reflects the overall net worth of the company. Owner’s equity is the term used when there is an individual owner of an unincorporated company, also referred to as the sole proprietor. The term stockholder's equity is used if the company is a corporation that is owned by shareholders. None-the-less, the owner’s equity is reduced when there are payouts or draws made by the owner(s) against the owner’s equity account.
In essence, the balance sheet is used to identify a company’s net worth and whether or not the company has more debt than assets. A favorable balance sheet should have a significant amount of assets that can be easily converted into cash within a year to cover its current debt. So basically, the balance sheet should be an indication of the company’s financial leverage and liquidity by applying the widely used debt-to equity ratio.
3) The Statement of Cash Flows – The statement of cash flows is the third of the three most commonly used financial statements. Also known as the cash flow statement, it provides business owners with information on how their decisions and business activities have a direct effect on cash. Decisions such as allowing customers to make purchases on credit, paying for expenses upon receipt, in full and taking cash payouts are all examples that have a direct effect on the remaining cash position.
The statement of cash flows allows you to identify how well or how poorly you manage cash. Activities that normally affect cash consist of cash inflows such as cash from normal operations, cash from the sale of assets, loans received or investments made to the business. Cash outflows consist of the repayment of loans, the repayment of investments and capital acquisitions, such as the purchase of equipment, vehicles, furniture or office furniture.
Basically, you as a business owner should know what’s happening with your business at all times. You should know the general state of your financial position by analyzing your financial statements. As the business owner, you should be able to comprehend what the numbers that appear on the financial statements are saying. It is also imperative to know what any major changes in the numbers mean. For example if the accounts receivables account continues to show increases on a monthly basis, that's an indication that sales are being made, but cash is not being collected for those sales. Hence, the profit and loss statement will show an increase in sales but there will not be corresponding increases in the cash account. This is just one example of why understanding and knowing how to read and analyze financial statements are of great importance to the business owner. Your numbers are telling the story of your business, they are speaking to you about the financial condition of the company and should be relied upon to guide you during your decision making process.
For more information on understanding and creating financial statements, please visit the Small Business Chron at, http://smallbusiness.chron.com/create-financial-statement-3774.html and the Small Business Administration at http://www.sba.gov/ombudsman/7046.