Benefits of Understanding Financial Statements
Understanding financial statements is something that many small business owners think is of less value. Many who run small businesses do not take the time to understand financial statements. But as you do, you miss out on important aspects of your business. Examples of the things you miss out on include how much each of your services or products is making you and how much it is costing you to do so. Such information leads to many benefits, some of which we will discuss in this article.
What are the benefits of understanding your financial statements?
Financial statements consist of three individual statements that a business produces for each quarter or financial year. These are the Income Statement, Balance Sheet, and Statement of Cash Flows or simply the Cash Flow Statement. I will be using these three to describe the benefits of understanding your company’s financial statement.
Why understand a company’s income statement?
An income statement, in summary, asks you this simple question: Is your business profitable? It asks you if you have profited in any given period, which could be a quarter, six months, or a full financial year. You may be wondering how an income statement does this. Well, it takes your revenue for the period and subtracts expenses for the same period. Here is the formula below.
Revenue – Expenses = Profits.
Profit is also called net profit, net income, or the bottom line. So, when you hear financial industry experts talking about these terms, they simply mean profit.
So, how does understanding this statement help you? We already mentioned the net profit as the last line on the financial statement. Well, arriving at this takes a few steps – these steps are the ones that reveal some crucial details about your business. For example, at the top of your financial statement is your gross revenue for the period. This figure could really be exciting. But when you eventually arrive at the last line – the net income, you may find that you actually made losses. How? This is when the entire statement comes in.
By investigating other steps, such as subtracting operating costs and the costs you incurred to sell your products – such as transportation and storage – you will find your problems. It could not be only the cost of goods sold killing your profits because below them, you will also find operating costs such as rentals and payrolls as well as interest costs and taxes. They also affect your revenue. So, by studying all these line items, you will find your biggest culprit that needs adjustments. By doing so, you increase your profits without creating a new line of products.
Why understand a company’s balance sheet?
Balance is an English word that is straightforward. If someone asks you, are you balanced? They probably want to know if you will not fall when they throw extra weight on you. In the same manner, our businesses go through various stresses each period. A balance sheet indicates whether the business will keep standing after going through various shocks. In a nutshell, it asks if your business is healthy or has enough financial strength and muscle to fight off economic pressures or headwinds. For example, during a recession, and many customers just stopped buying your product or service, will your business have enough financial resources to keep financing itself during the entire recession?
So, if you do not know about this, your business might go under, just as what happened to many small businesses during the COVID-19 pandemic.
The balance sheet helps you see your company’s financial strength through your assets, the money you owe (liabilities), and how much your company is worth on paper (equity). If your assets are lower than the total liabilities you owe, it means your company already has less financial muscle. Therefore, you will need to conjure a plan to lessen borrowing, pay off what you already owe, and grow your assets.
Assets you can own include cash in the bank, the money that customers owe you (accounts receivables), products you have but not yet sold (inventory), and assets such as buildings or equipment and vehicles your company owns as well as intangible assets such as software licenses. All this information is important. It is what banks use to determine whether they should give you a loan or not. Remember, when you get a loan, it becomes an obligation to pay up installments as soon as next month. Therefore, the balance sheet will also show you whether you can meet your business’ short-term obligations or not.
Why understand a company’s statement of cash flows?
A cash flow statement reveals how money has been spent over a certain period. It also shows you the total cash you have or had at the end of the same period. This is done through the following formula.
Net Increase/Decrease of cash during period + Cash at the beginning of period = Cash at the end of the period.
Your net increase or decrease is valued using these three factors:
- Operating activities – how much cash did you receive from sales versus money paid to make the sales?
- Investing activities – how much went into buying new equipment or selling any?
- Financing activities – did you pay out any debt or receive capital? How much was it?
The above becomes a basis for measuring or comparing whether you neglected your operations by funding them less, or whether all your income is going towards debt payments. Such information helps you to realign your business and start making meaningful profits.
Conclusion
You cannot understand financial statements unless you have them. The role of accounting in your business is fulfilled when you actually have the accounting. And the important role that accounting plays in a business is a reason for every business owner and sole proprietor to start taking it seriously. So, do you already prepare financial reports for your business? If not, you need an accountant ASAP. Contact me now for your accounting services. I will take care of your business. Go to my Link Tree and click, “Want me to be your accountant?”
Frequently Asked Questions
- What are the advantages of understanding financial statements?
Financial statements help you understand how your business makes money and where you are spending it.
- What is the most important financial statement?
All financial statements are essential. That is why every business has a statement of financial position, a balance sheet, and a cash flow statement. They all work together.
- What are the three main financial statements?
The three main financial statements are the statement of financial position, a balance sheet, and a cash flow statement.
- Why is it important to understand basic financial statements?
Every business owner must understand the basics of financial statements so that they plan and implement informed business decisions.
- How do you prepare financial statements?
Preparing financial statements begins with bookkeeping, where all receipts and payments are accurately recorded. However, other processes leading to financial statements are long, and their sequence depends on the accountant preparing the statements as well as the nature of the business. But generally, all receipts and invoices are verified, wages (unpaid) are also accrued while cash in the banks is verified, together with the dollar amount of inventories. All this is done up to a certain period; hence, accountants preparing the statements will close accounts of the business for the period being reported and open them for the next season.
