Generally decoding everything about financial statements may seem a little difficult at first. However, it is one of the most important aspects to understand for every small business owner.
These financial statements help you keep a track on where your money is coming from, the expenses, and how well your business is doing in terms of profit and loss. And when you know how to read them, as a business owner, you can make better decisions.
To help you understand and decode financial statements with ease, in this blog we will be taking you through everything you need to know, step-by-step!
Table of Contents
- Why Financial Literacy Matters for Small Businesses
- The Income Statement
- The Balance Sheet
- The Cash Flow Statement
- Financial Ratios to Track Business Performance
- Common Red Flags
- Reading Year-over-Year and Month-over-Month Changes
- Understanding Financial Insights to Make Smarter Business Decisions
- DIY vs. Professional Review
- Putting It Into Action
Why Financial Literacy Matters for Small Businesses
A lot of small business owners today focus solely on their product or services related sales, profits, and expenses, often overlooking the full financial document.
And this is exactly where financial literacy comes in.
Being financially literate not only means that you understand the key finance related terms but also means that you understand what the numbers say about your business. Remember that when you have the knowledge and understanding required to read financial documents like the income statements and understand the cash flow reports among several others, you are in full control!
The Income Statement
The income statement also known as the profit and loss statement is one that shows exactly how much profits you made and how much money you spent in a given period of time. In simple terms, it tells you whether your business made profit or loss.
The Balance Sheet
Next, the balance sheet shows how much your business owns and how much it owes in the given period. It is generally divided into 3 main parts that is:
- Assets – what your business owns
- Liabilities – what your business owes
- Equity – what is left for the owner after paying off all the debts
Understanding this will help you see your business’s financial health at its best.
The Cash Flow Statement
The cash flow statement is another financial statement that shows you exactly how much money is coming in and going out of your business. It is completely different from the income statement is it only focuses on actual cash.
Understanding the cash flow statement will not only help you manage your cash wisely but also avoid any financial problems.
Financial Ratios to Track Business Performance
Generally financial ratios make it easier for you to understand your business’s performance. Let’s take a look at some of the most common ratios below:
| Ratio Name | Formula | What It Shows |
| Profit Margin | Net Profit ÷ Sales | How much profit you make |
| Current Ratio | Current Assets ÷ Liabilities | If you can pay short-term bills |
| Debt-to-Equity | Total Debt ÷ Equity | How much you owe vs. what you own |
Common Red Flags
Warning signs also known as the red flags in your financial statement should not be ignored. For instance, if your business’s liabilities are higher than your business’s assets then the finances of your business could be at risk. On the other hand, sudden drops in your cash flow or a sudden rise in your business’s debts can also be some of the warning signs that shouldn’t be ignored at any cost as these issues may further grow into bigger problems.
How to Read Year-over-Year and Month-over-Month Changes
Financial statements can become even more helpful for your business when you compare them on year-over-year changes and month-over-month changes bases. Generally, year-over-year changes show how your business is doing compared to the last year while month-over-month changes show the comparison on a monthly basis. Month-over-month changes can quickly spot sudden changes or trends which further guide you in making quick decisions for your business.
Using Financial Insights to Make Smarter Business Decisions
If you understand how to read your financial statements, you can use them to make smarter business decisions in time. For instance, if your income statement reflects low profit, you will know that it is time to reduce the expenses or even raise prices of your products or services. Another example could be one that if your cash flow is weak, you can delay big business related purchases to balance the flow. With real-time financial insights, you are sure to make smarter business decisions!
DIY vs. Professional Review
A lot of business owners today try to manage their business’s finances on their own to get started with and it is okay if one has to simply manage or track expenses. However, as the business grows and financial statements start to get complex, it is ideal to hire a professional bookkeeping and accounting expert like Orbit Accountants. Their team will not only guide you through your business’s financial statements in detail but also guide you through the entire process. Remember that having an expert by your side to manage your finances can make all the difference in growing your business.
Putting It Into Action
Let us for instance assume that you are running a clothing store. In the month of May, you income statement reflects $20,000 in sales and about $15,000 in expenses which now gives you a decent profit of $5000.
Now, your balance sheet reflects that you have $8,000 in cash, about $3,000 in inventory, and $6,000 that go in unpaid bills. So your equity is $5,000. Your cash flow report shows you received $18,000 in cash and spent $16,000.
This means your cash increased by $2,000.
By understanding all of these reports together, you see that your store is profitable and has decent cash flow.
Understanding financial statements doesn’t have to be hard. With a bit of learning and the right support from an experienced accounting partner like Orbit Accountants, you can use your reports to run your business better. They not only offer the best-in-industry bookkeeping and accounting services in Canada and the US businesses but also take care of the numbers while you focus on growing your business!
