4 types of financial statements for a small business

Financial management may not be the most thrilling aspect of running a business, but knowing how to read a few accounting statements is vital to your success. These numbers can help you qualify for funding to grow your company. They can also help you make better decisions, resolve problems before they happen and improve your profitability.

You only need to keep your eye on four financial statements to get all these benefits. If you know how to read these documents, they’ll tell you everything you need to know.

The role of small business financial statements

Financial statements give you a snapshot of your business’s financial health at that moment. If you know how to read them, they’ll tell you, your bank and your investors how your company has performed in the past and where you are headed.

For your bank or investors

Sooner or later, most businesses need cash to fund their growth. When you apply for a loan or ask an investor for cash, your financial statements are the most important factor they’ll use to make a decision.

These numbers tell them several things:

• How well you’re managing expenses
• Whether your sales are growing
• If your business is profitable
• How much of your own money you’ve been willing to risk in the business
• How much debt you owe to creditors
• The overall value of your business

For yourself

Financial reports are also an important tool to manage your business. If you learn to interpret the numbers, you can learn:

• Which business activities are the most profitable
• Where you might need to cut costs
• How much your business is worth today
• Which sales are losing money
• Whether your business is in danger or just having a short-term slump

Knowing the answers to these questions will help you make smarter, faster decisions about everything from how to set your prices to whether you should borrow or not.

Patty Black of Dallas Texas is a small business owner who runs an online magazine. “I thought all sales were good,” she says. “But once I looked over my reports with my accountant, I realized that our smaller ad sales were actually losing money. I decided to eliminate some pricing tiers, which meant we lost a few customers. But it freed up my staff to go after bigger clients and we doubled our profits within a year.”

4 types of financial statements

The four most important financial reports for small business owners are the income statement, cash flow statement, balance sheet and statement of owner’s equity. You can print these reports from your accounting software or ask your bookkeeper or accountant to send you them regularly. You might also ask if they’ll meet with you to help you understand the story these documents tell about your business.

Here’s an overview of what each of these statements can do for you and how to interpret them.

Income statement

The income statement (sometimes called a Profit and Loss Statement, or P&L) shows the relationship between revenue and expenses flowing in and out of your business. It’s the most important tool a business owner has for analyzing their sales, costs and profitability.

How to read it

The first half of the statement is your revenue, or income. This document won’t show every dollar that flows into your business; t only shows your business income from selling products and services. That makes the income statement a much more accurate gauge of how you’re doing than your checking account statement.

After that, if you sell products, you’ll see a section for the cost of goods sold. These are the direct costs associated with creating or buying the products that you sell. The total of these costs gets deducted from your income, and so do any refunds you’ve had to pay out.

The second half of the income statement shows expenses that aren’t directly involved in creating products. Things like advertising, salaries, office supplies and utilities will appear here.

On the bottom line, you’ll see the total of your income minus your expenses — your profit (or loss) for that period. This is the most important number of all.

What it can tell you

Studying income statements from different periods side by side can reveal seasonal patterns that will help you plan. Maybe your sales always spike about 20 percent in the summer or fall 30 percent in January.

If you divide your profit by your total sales figure, you will get your profit margin, as a percent. You want to observe whether your profit margin is increasing or decreasing over time. If it’s decreasing, you may need to cut expenses or raise prices.

Your accountant can also show you how to use the data from your income statement to calculate your break-even point, which can help you set goals and pricing.

Balance sheet

The balance sheet tells you what your company has (assets) and what it owes (liabilities) on any given day. It’s useful for ensuring your debts aren’t getting out of control and shows you the value of your ownership, or equity, in the business on any given day.

How to read it

The first half of the balance sheet shows your assets, such as:

• Checking accounts and savings balances
• Investments
• Inventory
• Equipment
• Real estate
• Anything else your company owns that could be sold for cash

Next, you’ll see a listing of your company’s liabilities:

• Bank loans
• Credit card balances
• Customer deposits you’re holding but haven’t earned yet
• Vendor credit balances
• Unpaid bills

The final section of the balance sheet shows the owner’s or investors’ equity in the company. By subtracting debts from assets, you can see the value of the equity.

It’s important to understand that this figure doesn’t reveal what your company would be worth if you sold it. Business pricing is affected by equity, but it also takes into account annual profits, the reputation of the company name and many other factors. However, if you closed your business tomorrow, sold your assets and paid off your debts, this is roughly the amount you’d have left.

What it can tell you

The balance sheet is the best place to keep your eye on your debts. If the total value of your assets isn’t much more than you owe, you don’t want to borrow more money.

You’ll also see your cash at a glance. If you have too much money sitting in checking, you might move some to a high-yield savings account.

Comparing your balance sheets from one period to the next can help you see whether your equity in the company is growing or shrinking over time.

You can calculate your debt-to-equity ratio (D/E) by dividing your liabilities by your equity. This ratio tells you how much of your capital is coming from investors and how much is borrowed. Banks and investors look closely at this number to see if you’re borrowing too much money.

A low D/E ratio can mean that you’re not borrowing as much money as you could to fund your growth. A high D/E ratio could mean you’ve borrowed too much money and your business is at risk. Healthy D/E ratios vary wildly for different kinds of businesses, though. Compare your number to the averages for your industry to see how you’re doing compared to your peers.

Cash flow statement

The cash flow statement tracks cash that moves in and out of your business. That may sound a lot like an income statement — and for some very simple businesses, it is.

But for most businesses, it will be slightly different. For example, you might make a sale and record it as income in August but not receive the payment until November. There could also be a lag of one to three months between the time you buy something and the time you pay for it.

Also, you need enough cash in your accounts to make loan and credit card payments, but those won’t show up on your income statement as expenses in the same month you have to pay them.

Also, if you buy an expensive piece of equipment or property, that’s a capital expense rather than an operating expense, and it won’t show on your income statement.

How to read it

The cash flow statement is one of the easiest for most people to understand because it tracks money in and money out in the same way we track our checkbooks.

You’ll see three sections on your cash flow statement:

• Cash flow from operations (CFO): The money coming in from sales and going out for expenses
• Cash flow from investment (CFI): Any money the owners put into or take out of the bank account, as well as money from buying or selling assets
• Cash flow from financing (CFF): Money that you borrow or pay back

What it can tell you

The cash flow statement can help you see how money is moving through your business each month, so you can gauge the health of your business. A company can be profitable and still suffer from a “cash flow heart attack” if it has to pay bills faster than it collects from customers, or if there isn’t enough cash coming in to make debt payments.

Your accountant or accounting software should also be able to prepare cash flow projections, showing you what you can expect to receive and pay out over the next month, quarter or year so you can identify any problems before they happen.

Statement of owner’s equity

While the balance sheet will show you the value of your equity in the business on any given day, the statement of owner’s equity shows changes to that number over a specific period.

Remember that equity just means the value of the company to its owners if it were to be dissolved today. You might own 100 percent of that equity or share it with partners or investors.

How to read it

All the transactions that impact your equity will be grouped by category on the statement. These are the sections you might see and what each one means.

• Opening balance: Your equity value at the beginning of the period
• Net income: All profits earned during the period, which are added to the opening balance
• Owner withdrawals: Any payments made to shareholders or owners are subtracted
• Owner investments: Money that you or new investors put into the business during the period will be added
• Other income: Gains or losses not included in net income, such as unrealized gains on investments or depreciation in assets
• Closing balance: The final equity value at the end of the period.

If your business is a corporation that sells stock, you’ll see “dividends’ instead of owner withdrawals, and “share issuance” instead of owner investments. Also, any shares the company buys back from investors will be deducted.

What it can tell you

You’ve already learned the value of your equity in the company from looking at the balance sheet, so the closing balance shouldn’t be a surprise. But this simple one-page statement will answer any questions you have about changes in your equity over time.

The bottom line

Keeping up with accounting reports might not be what you pictured when you dreamed of starting your own business. But once you learn how to read the numbers, these four statements will help you make wise business decisions and spot any problems before they happen. Make time to review your statements at the end of each month, and ask your accountant to help with any questions that arise.