Judging how well (or poorly) a business is doing requires a robust understanding of the business’s financials. In a previous post we looked at the three different types of financial statements. In this post we’re going to show you what to look for in your financial statements to know if your business is successful or at risk.
Learn more about how to read and understand financial statements in How to Read Financial Statements: A Guide for Business Owners.
1. Balance Sheet
A balance sheet is essentially a snapshot of a business’s financial situation at a specific point in time. It shows assets, liabilities, and owner equity as they currently stand.
From these figures, you can determine whether a business owns or owes more. Although a single balance sheet provides an accounting at only one moment in time, the financial direction of a business becomes evident if you compare balance sheets across months, quarters, or years.
To see how solvent a business currently is, check its most recent balance sheets’ listed assets and liabilities. The business has positive equity if the assets are greater than the liabilities and has a negative balance if the liabilities are greater. (Owner equity should also be checked but is less commonly an issue.)
You can also see whether current assets (e.g., cash) are sufficient to cover current liabilities (usually due within one year). If they aren’t, the business could have cash flow issues in the coming months.
To see how a business is trending, compare its balance sheet to a previous one (e.g., a quarter or year ago). Asset growth shows that a business is either growing or investing in growth. You likewise can see whether liabilities are declining or increasing.
2. Profit & Loss Statement
An income statement (or profit and loss statement (P&L)) summarizes revenues and expenses over a period of time, usually a month, quarter, or year. Revenues are tabulated and expenses deducted, and the resulting balance reveals whether a business made or lost money during the period.
In the reporting, revenues and expenses are typically broken down into categories. Listing separate categories makes it easier to assess where a business has growth opportunities and/or is spending most of its money. Categories could include online sales, brick and mortar sales, types of products/services, facility costs, wages, inventory costs, and anything else that’s also relevant.
First, look at the overall P&L to assess a business’s general performance. For decision-making, however, check the revenues and expenses of specific categories. You can see whether they’re declining, stable or growing, and you can also see correlations between certain ones. For example, a growth in sales might necessitate higher employee compensation to meet the increased volume.
3. Cash Flow Statement
A cash flow statement converts the profit shown on the P&L to the actual cash generated (or used) from operations. It also shows the cash provided for or used from investing and financing activities.
For example, your P&L may include $100,000 in invoices not collected yet, including in accounts receivable. On the Cash Flow Statement, this will be adjusted as a reduction of $100,000 from the profit shown on the P&L to reflect the actual cash earned.
Cross-reference the cash flow statement with the P&L. The trends of the P&L should continue on a cash flow statement, or there should be a good reason for a difference.
Assess a Business’s Financials
With these three reports, you can accurately assess a business’s financial situation. Compile the reports to check how your own business is doing, or request them as you evaluate one that you’re considering investing in.
It’s also important to be aware that these reports are only useful if all accounts are reconciled and they have been properly prepared considering accruals like revenue and A/P, and non-cash adjustments like amortization and tax expenses.
If you want help examining your financial statements, book a free consultation and we’d be happy to show you what your financial statements are telling you about your business.
Disclaimer: Avisar Chartered Professional Accountant’s blog deals with a number of complex issues in a concise manner; it is recommended that accounting, legal or other appropriate professional advice should be sought before acting upon any of the information contained therein. Although every reasonable effort has been made to ensure the accuracy of the information contained in this post, no individual or organization involved in either the preparation or distribution of this post accepts any contractual, tortious, or any other form of liability for its contents or for any consequences arising from its use.