My colleague recently wrote about the importance of closing your business’s books at the end of your fiscal year. A few of you reached out to us after reading her post, asking for more about some of the financial statements that Melissa mentioned.
We’re happy you asked!
Many entrepreneurs are intimidated by their accounting, and chose to hide from it. But when they do this they lose sight of the value and intelligence financial reports add to their small business and to them as a business owner. After all, the idea of inDinero came to our very own fearless leader when she realized how managing the money was the best way to actually make more of it.
No matter how big or small your business is, whether you do your own bookkeeping or you have an entire accounting team, there are three financial reports that all entrepreneurs must know like the back of their hands:
Profit & Loss Statement
The profit & loss (P&L) statement (aka income statement) shows your revenue, costs, and expenses during any given period of time. The P&L is the best view into your bottom line, or net income, which is why it’s typically used to show business lenders and investors whether your company has made or lost money during a given period.
Your business’s net income is also what will be used to determine its taxable income each year. This is calculated by subtracting your business’s expenses from its total revenue, which you can find using your P&L.
If you are familiar with the differences between cash and accrual accounting, you can probably guess that the method you chose can really dictate the figures reported on your P&L. Because each method has its own timing for recognizing revenue (cash requires money to change hands and accrual recognizes income and expense as they are earned in real-time), the P&L for any given period will reflect different transactions or values.
Of the Big Three Financial Statements, the balance sheet is the only one that shows the financial health of a company at a given moment. Instead of listing your business’s income and expenses like the P&L does, the balance sheet is a two-sided chart with three components (Assets on one side and Liabilities and Equity on the other):
One side lists the value of what you owe (your liabilities) and any owner equity (including your retained earnings) while the other lists the value of what you own and who owes you (assets):
The total of each of the two sides of the balance sheet should show the same amount to evaluate whether your balance sheet is properly balanced–accountants LIVE by this formula. To determine the relationship between the three amounts, accountants use a simple equation:
For corporations, the equation looks like this:
Assets = Liabilities + Shareholder’s Equity
And for sole proprietors and partnerships, it looks like this:
Assets = Liabilities + Owner’s Equity
Cash Flow Statement
Your cash flow statement shows each and every one of your company’s incoming and outgoing transactions—how you’re spending your money and how you’re earning your income—over a period of time. The cash flow statement takes your business’s net income (from your P&L, remember?) and takes any non-cash transactions into account from operations, investing or financing activities to give you a picture of exactly what happened to company’s cash during that period.
So, if a company gets $1M in capital, but their P&L shows a net income loss of $50k during the same period, their cash flow statement will show a $950k net increase in cash for that period.
From there, your cash flow statement provides a more comprehensive view of how your business operates, where it’s making money, and how you make choices about expenses. For this reason, investors typically scrutinize the cash flow statement.
A cash flow statement accounts for three types of activities:
- Operations: the business functions you need to operate, including accounts receivable, accounts payable, and inventory.
- Investing: long-term changes to equipment, acquiring or selling assets, etc.
- Financing: acquiring debts, repaying loans, etc. which don’t affect your bottom line, but they do affect the amount of cash in the bank!
How these 3 reports make for 1 financially-savvy business owner
Immersing yourself in your business’s accounting can be eye-opening. It’s the best way to see how money actually flows in and out of your business and gain the context you can use to ask yourself, your employees, and your stakeholders the right questions. Understanding these three financial statements is an important step in becoming a smarter, more data-driven business owner.
From here, you’re on the right track to being able to apply your own financial savvy as a primary decision maker of your business. For 99 more accounting and tax terms that can help drive your business, download our glossary, Accounting Alphabet for Business Owners and CEOs.