How to Read a Financial Statement

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Learning how to read a financial statement is one of the most important aspects in running your business. Imagine playing a basketball game without watching the scoreboard; if you don't know you're trailing, failing to adapt and modify your techniques will cause your team to lose. It's important that you understand small business accounting so you'll know your company scoreboard (i.e. your company's performance in financial figures). Learning how to read a financial statement will get you a big leg up on your competitors.

The Basics

Accounting contains three financial statements: Balance Sheet The Balance Sheet shows a snapshot of your company right now--how it is doing financially at the present time. Income Statement The Income Statement is the camcorder that records a period of time; in accounting terms, it's to see how you received the earnings (i.e. net profits) between your beginning balance sheet to the ending balance sheet for a certain period. Cashflow Statement The Cashflow Statement keeps track of your company's cash as it flow in and out during a time period.

Balance Sheet

The Balance Sheet is divided into two financially equal sides, so they can "balance."

Assets reside on the left column, and Liabilities + Owner's equity reside on the right (i.e. Assets = Liabilities + Owner's Equity).

The key component for the balance sheet is to connect the things (left side) to the people who own these things (right side).

Assets (i.e. "What we have") are organized on the balance sheet in descending order of liquidity (i.e. how easy it is to covert an asset into cash).

The following represents the order on the Balance Sheet:

  • Cash - readily available funds you can use now 
  • Accounts Receivable - money owed to you (e.g. for items you sold on store credit but haven't received money) 
  • Inventory - all available materials that will be sold; includes raw materials (lemon, sugar, water) and finished goods (lemonade) 
  • Prepaid Expense - expense you paid beforehand, to be used in the future 
  • Fixed Asssets -- items you use over and over, and aren't normally for sale

Liabilities + Owner's Equity (i.e. "Who owns it") are organized into the following: 

  • Accounts Payable (Liability) - the value of the inventory you borrowed & now owe; usually have to be paid back in 30 daysNotes Payable (L) - the loan amount in money you borrowed and must owe; payable over long-termTax Liability (L) - taxes you owe the government Original Investment (Owner's Equity) - your personal money invested in your business Retained Earnings (O) - earnings from past accounting periods; shows retained "net profit" 
  • Earnings [Week, Month, Year] to Date (O) - earnings from present accounting period; shows period's "net profit" (i.e. bottom line)

Income Statement

The Income Statement acts as the camcorder that illustrates how the Net Profit was gained between the beginning balance sheet and the ending balance sheet. It shows if your business was profitable in a certain period. To get Net Profit, use:

  • Earnings = Sales - (Costs of Goods Sold + Expenses)Gross Profit = Sales - Cost of Goods Sold Net Profit = Gross profit - Expenses Note: We haven't deducted taxes, and dividends paid. These will subtract the earnings (i.e. Net Profit).

Cashflow Statement

When learning how to read a financial statement, remember this: The Cashflow Statement is probably the most important sheet in your small business accounting papers, as it keeps track of your cash.

Remember that you can be profitable, but without necessary cash, your business is in serious trouble. You can't spend your earnings, otherwise known as "paper profits"; you can only spend cash to fund your operating capital (e.g. fixed costs).

Good cashflow management means delaying your payables as long as you can, while speeding up your collection of accounts receivable money owed to you.

The cashflow statement accounts for collections, inventory paid, fixed asset investment, and expenses paid.

Learning how to read a financial statement is not that difficult. Most people avoid it because of this reason.

Once you understand the basic concepts on how to read a financial statement, you'll be on track to building a great company.

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Posted on February 18

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