Financial Statements: The Guide to Understanding Your Business

This is an Alignable guest contributor post by Michael Fahmy , Principle Accountant at Fahmia, Inc.

Most businesses fail. This truth may be a tough pill to swallow for aspiring entrepreneurs and existing business owners.

A majority of businesses willfully ignore the wealth of information that can be drawn from financial statements. Often times, this is because business owners are too preoccupied with keeping up with their operations that they neglect maintaining their books. Another common reason is that although many businesses outsource their bookkeeping to an accounting professional, they don't dedicate enough time analyzing their financial statements on a quarterly or annual basis. Nonetheless, the importance of financial statements in relation to business success has never been more pronounced in today's competitive environment.

Where to Start

Being able to effectively analyze financial statements to make informed decisions is going to depend on the quality and accuracy of accounting information used to prepare them and the basis of accounting. The most commonly used bases for accounting are cash, modified cash, accrual, and income tax. Consulting with a business accountant will help determine the most advantageous choice that will suit your business situation.

What To Look At

The three most important financial statements every business owner should become familiar with are the balance sheet, income statement (commonly known as the "P&L Statement"), and statement of cash flows

The balance sheet paints a "big picture" image of a business at a single point in time. Put simply, this document lists all assets, liabilities, and equity items encompassing a business and puts into place the simple equation: Assets = Liabilities + Owner's Equity. This practical equation states that all of a business' assets come from either creditors or owners. If the asset comes from a creditor, it must be paid back. In the event of a bankruptcy, creditors have a higher liquidation priority than owners.

Assets are resources belonging to a business that have some future economic value1. An asset is said to be current if it will be converted into cash within 1 year, otherwise it is classified as a long term asset. Liabilities are generally balances owed to creditors and suppliers. Liabilities are classified as current if they will be paid within 1 year, otherwise they are classified as long term liabilities. Owner's equity, as you may have already guessed, is simply whatever amount of assets are left after all liabilities have been paid off. Put another way, this amount represents how much of the assets are owned by the business owners.

Looking at the balance sheet from time to time, business owners will be able to determine the assets available to carry operations, make investments, and survive. More importantly, owners will be able to evaluate their liquidity to determine if they can meet their debt obligations and major goals and act accordingly in decisions relating to expansion or down-sizing, investments, mergers and acquisitions, and debt/equity financing considerations.

The income statement shows a company's different types of revenues and expenses over a fixed period of time. From this financial statement, owners can form effective budgets and projections in conjunction with the balance sheet, understand how different marketing strategies have affected revenues, perform a cost analysis to see if expenses can be reduced to improve profits, and determine the extent of profits to be allocated to investment and expansion considerations. The income statement has also been a very useful tool in evaluating employee performance from time to time and promoting desirable results by influencing bonuses and incentivized compensation packages. At the end of each year, the net income is closed out to "retained earnings" in the owner's equity section of the balance sheet.

The statement of cash flows makes clear where cash in a business is coming from and what it is being spent on. The three main categories of cash inflows and cash outflows are operating activities, investing activities, and financing activities. The operating activities section will generally show cash flow related to the main business operations such as buying and selling merchandise and services, paying employees, and covering rent and utilities. The investing activities section will cover monetary gains and losses from financial instruments and capital assets such as stocks, bonds, buildings, and equipment. Finally, the financing section states cash flow activities related to financing operations of a business such as taking out debt, paying interest and dividends, or issuing stock.

Breaking up cash flows into these three sections analyzes cash requirements of a business and provides a means to analyze a business' liquidity. Often times, businesses will show great profits, however their allocation of cash may still lead to short term financial troubles. At the end of each year, the cash balance at the beginning of the year is added to any net changes throughout the year covered in the statement of cash flows, and is summarized under "cash and cash equivalents" in the current assets section of the balance sheet.

The balance sheet, income statement, and statement of cash flows are three powerful tools that, with due care, can propel business owners to make the most informed decisions. Failure to scrutinize any of them will result in operational inefficiency, poor managerial decision making, and a dysfunctional organization.