Guide to reading Financial Statements

Financial statements are more like your business synopsis, giving you an insight into the flow of your money (in or out) and how much do you hold to sustain a business.  They are the type of reports necessary for you to make wise financial decisions for your business and absolutely inevitable when you need loans or funding to expand.

This article is important, especially for all the newbies out there who have ventured on a business saga but do have concerns of how to read their business finances to be in control.  In this write up we shall visit the important parts of any financial statement and how can one interpret them.

So, what are financial statements actually?

Financial statements are the type of reports that encapsulate all your business financial transactions and related information into certain parts.  There are primarily three aspects of every financial statement – Balance Sheet, Income Statement (or Profit and Loss Statement), and Cash Flow Statement.  Combined, these three provide you and any external players e.g., lenders or investors, a picture of your business’s financial health.  So, lets understand each of these important financial statements.

A.   Balance Sheet

The balance sheet is a summary of your business as it currently stands.  It is always reported as of a particular date, e.g., 31^st December or 31^st March or 30^th June etc.  It displays the assets your business owns and the liabilities or debts that it owes on that date.  The frequency at which your balance sheet is prepared will be depending upon the nature of your business.  Some businesses warrant daily or monthly financials, whereas some prepare them quarterly and annually alone.  Banks typically have large activity volumes and require a daily balance sheet.  Traditionally, businesses in the modern era prefer having monthly financial statements prepared for complying with various statutory norms.

A balance sheet comprises three important segments, Assets, Liabilities and Equity.  This is how typically a conventional balance sheet would look like:

Assets

Assets refer to anything valuable that your business owns.  It comprises of your fixed assets such as plant and machinery, land and building, furniture and fixtures, Motor vehicle, Computers, intangibles such as patents, goodwill etc.  Additionally, it also comprises your current assets like cash and bank, debtors or receivables, inventory or stocks, prepaid expenses etc.

Liabilities

These generally include the long term or short term debts or loans your business owes to others e.g., secured bank mortgage loans (be it a term loan or working capital loan), other unsecured loans from other parties etc.  These also include current debts or liabilities such as Creditors or Payables for goods or services, credit cards payable, accrued expenses such as utility bills, taxes or salary and wage owed to the employees, deferred revenue or pre-received incomes etc.

Equity

Equity is the remainder value of the business after deducting the business liabilities from its assets.  It would also encompass all the retained earnings of the business that it has earned till date.  The retained earning is nothing but the cumulated profits or losses as generated by your business year on year since inception.  Equity also reflects the total of capital raised by a business (either by private or public money) including initial capital as contributed by the founders of any business.  It is important to understand that the Equity reflects only book value of a business and not its market value which requires ascertaining when considering a business sale.  The market value of a business is generally derived after valuing various factors such as its earnings, value of its assets including tangibles and intangibles etc.

The Balance sheet however does not reflect the products or services you sold, the costs you incur in order to make or supply those products or services, nor the profit or loss you made during a year.  These are mainly operational results and get reflected in the income statement (or profit and loss statement).

B.    Income statement

The income statement or popularly also referred to as the profit and loss statement shows the profitability of your business over a specific accounting period.  Always remember that the income statement, unlike a balance sheet which is presented as of a particular date, is summary of operational activities over a range of period, e.g., a month or quarter or a year.  It provides you with the total revenue you earned and total expenses incurred during the period.  This is how an income statement typically looks like:

Let us broadly understand the terms used in the above image.

Revenue/Sales:

This shows how much your business earned from selling its Products and Services during the period.

Cost of Goods Sold (COGS):

This reflects the total amount it cost your business to make or supply a Product or Service.

Gross Profit:

            This is derived by deducting your business COGS from Total Revenue/Sales.

            Operating Expenses:

            The costs incurred in running your business, other than COGS, e.g., salaries,

Advertisement, utilities, rents etc.

Net Profit (EBIT – Earnings before Interest & Taxes):

Net Profit = Gross Profit – Operating Expenses

Gross profit of a business tells you how profitable your products and services are.  This is a useful result to be aware of while doing any business as you want to know how well your products or services are doing.  A higher gross profit always signifies a worthy business usually.  If the gross profit is lower, you certainly need to figure out ways to make it healthier by reducing your COGS without compromising on product or service delivery.

Net Profit on the other hand tells you what your business bottom line is.  Despite a higher Gross profit, you might be having a lesser Net profit assuming you would be burning cash on higher administrative or selling expenses.  Sometimes, it may be necessary to run a business that way, mostly in the early days when you are trying to build a brand, but eventually everyone wants to see a higher Net Profit margin as well.

An income statement is crucial to ascertaining your revenues (its sources, segments etc.) as well as knowing your expenditures.  A proper study and analysis of this enables an entrepreneur to plan the business operations more effectively for the future, by deriving the aspects of revenue and expenditures that need more focus or control.

Most businesses, usually use only a balance sheet and an income statement to review their business positions, but depending on the nature of your business, a third type of report is must, and which gives you a detailed insight into your business liquidity position which is called a Cash Flow statement.

C.    Cash Flow statement

A cash flow statement mainly shows how much cash inflow and outflow your business witnessed over a specific accounting period.  Like an income statement, the cash flow statement is also prepared for a specific range of period, be it a month, quarter or a year.  These are ideally prepared by businesses that apply accrual method of accounting.  Meaning, a business income statement may include sales earned but remaining unrealized or paid for or expenses a business incurred but staying unpaid.  This is how a Cash flow statement typically looks like:

The cash flow statement primarily has three parts:

Cash Flows from Operations:

This reflects your cash flows from your main business activity or operations.

Cash Flow from Investing Activities:

This reflects your cash flows from any investment activities like capital transactions from sale and purchase of major fixed assets like plant & machinery etc.

Cash Flow from Financing Activities:

This reflects cash invested by your business in another business as well as any capital borrowings towards business expansion or repayment of loans etc.

The cash flow statement helps a business owner understand the cash collected and paid during a period.  It helps project the future cash surpluses or shortage based on current trends and aids in planning cash requirements for the short and long term as well.  A balance sheet would show that your business has a receivable for US$ 1,000 and so does your income statement reflect a revenue or sale for US$ 1,000, but if your customers have not paid you yet, that money is not actual cash on hand and hence the cash flow statement corrects the cash position by reducing the US$ 1,000 from the cash on hand reported to reflect the actual effective cash position in your business at the end of the accounting period.

The cash flow statement can be a guiding report in order to plan your future capital purchases of fixed assets that may be necessary in order to expand or smoothen your business, as well as securing a loan where in-house capital is not sufficient, and the lenders want to know whether you’ll be in business long enough to pay off your loans.

Hence, financial statements are invaluable to every business. With properly prepared balance sheets, income statements and cash flow statements, your business is equipped to prove its sustainability—and get hold of the resources it needs to expand.

An experienced accountant like GJM & Co. can do your bookkeeping and prepare financial statements for your business, enabling timely and smart financial decisions.  Additionally, when it comes to filing your business income tax returns, you are assured that the financials are 100% comprehensive and correct and ready for tax reporting. 

We trust this article was helpful to you and provided the necessary basic insight on how to read financial statements.  Should you have any queries or need consultation with your application, Schedule a Call today or write to us at info@gjmco.in.