As an entrepreneur it is important you understand financial statements. Numbers paint a picture of what is going on in your business: You cannot truly attain financial freedom from your business if you do not understand your numbers. This is true if you choose to keep your business as part of your investment portfolio. It becomes easier for your staff to run down your business because you fail to see the warning signs in your financials.

There are three statements you need to understand to make sense of your business namely: the balance sheet statement, the income statement and the cash flow statement. As a business owner, you need to keep track of cash, assets, liabilities and equity in your business. Thereby, the need for these three statements.

Moreover, understanding financial statements is the first step to positioning for growth. You have to understand you are in business to build assets and you do that by earning income.

Income Statement

The income statement tells how much you have made versus how much you have spent. The difference between the two, is what you get to keep. At the end of the day, what really matters is how much you get to keep.

The 3 things you need to know about an income statement are:

• How much you make
  
• How much you spend
  
• How much you keep
  

How much you make

Income in your business comes from your customers. This is also called total income or top line revenue. Top line income can also be broken down into the types of income you bring into your business as shown below:

How much you spend

The income keeps track of cash you spend in keeping the lights on in your business. How much you spend is also called expenses. Expenses are categorized into similar types and entered as line items in the income statement. For example, everytime you spend money on advertising, it will be entered in your financial statement as an advertising expense line item.

When keeping track of expenses, it is important to have a line item that keeps track of the cost of producing / acquiring the goods you are selling. For example, if you are in re-sale, you will want to keep track of the cost of the goods your purchase for resale. This is called the cost of goods sold.

The cost of goods sold appears higher up (before other expenses) on the income statement. The difference between the income and the direct cost is called gross profit. See sample below:

After the gross profit has been established, other expenses are listed as follows:

How much you keep

Your net profit is the bottom line. It is how much you get to keep after all expenses have been paid.

The bottom line is what matters because it is this amount that creates the extra capacity we need to reinvest and to reward ourselves from all our hard work.

Balance sheet statement

If a business was a student in a classroom, the balance sheet statement will be the grade book. The balance sheet measures how good a job you have done in building the assets of your business. It keeps track of:

• Every cash you spent in your business that still has future benefit (assets like computer)
  
• Money, you received less what you have paid on your debt
  
• All the money you have made to date less what you have spent (retained earnings)
  

The balance sheet tells you what your business is worth.

The balance sheet statement expresses the very fundamentals of any business transaction which is: assets has to equal liabilities plus equity as shown below:

Assets = Liabilities + Equity

Relationship between the profit and loss statement and balance sheet

Income from the profit and loss becomes part of the retained earnings in the balance sheet statement. This keeps the balance sheet balanced. In other words, your retained earnings are the total earnings in your business since you opened it less any distributions (amounts you have withdrawn from your business) you have taken.

Every transaction must flow through the balance sheet as shown in the expanded equation below:

Expansion of accounting equation

Assets = Liabilities +Equity

Assets = liabilities + capital contribution + retained earnings* – distributions

Assets = liabilities + capital contribution + prior earnings +revenue – expenses

*Remember – retained earnings is the accumulation of prior earnings retained in the business.

Example

Your cousin Lucy, was downsized from her business and so decided to start a consulting business. She took $2,000 from her savings to buy a computer. After the first month she had one client who paid $1,000. She paid $200 for wages to a high school student who worked with her.

Before starting her business, Lucy acquired $2,000 capital from her savings. When this happens, her asset cash increases and her equity $2,000 increases. This is represented in the accounting equation as follows:

Assets = Liabilities +Equity

2000 (cash) = 0 + 2000 (capital contribution)

Next, she uses $2,000 to buy a computer (asset). The asset account, computer, increases by $2,000 and cash another asset declines by $2,000. This is represented as follows:

Assets = Liabilities +Equity

-2000 (cash) + 2000 (computer) –no change in liabilities or equity

Next, she makes $1,000 in the first month. This event increases her cash account (an asset) and her revenue account (equity). The accounting equation is affected as follows:

Assets = Liabilities +Equity

Assets = liabilities + capital contribution + retained earnings – distributions

Assets = liabilities + capital contribution + prior earnings +revenue – expenses

1000 (cash) = 1000 (revenue) – all other accounts are 0

Lastly, she spends $200. This decreases her cash account and increases her expense account as follows:

Assets = Liabilities +Equity

Assets = liabilities + capital contribution + retained earnings – distributions

Assets = liabilities + capital contribution + prior earnings +revenue – expenses

-200 (cash) = -200 (expense) – all other accounts are 0

As a result of these transactions, Lucy’s profit and loss statement and balance sheet look like this:

Profit and loss statement

Balance sheet statement

The profit and loss show the wealth generated during the period. The revenue and expense elements of the financial statement are represented in the profit and loss statement while the assets, liabilities and equity are represented in the balance sheet. Lucy’s net worth is equal to her equity balance which is $800.

The statement of cash flow

The cash flow statement is interested in cash received and spent in business. It does not care about cousin Lia who used your services and promised to pay you next month when she gets paid. Cash is the lifeblood of any business.

Cash flow statement is not only interested in the cash that flows through a business but also explains the source of the cash. There are 3 main areas a business obtains or spends cash namely:

1. Operations
   
2. Investing
   
3. Financing
   

Operations

This is cash received from or used in the business main operations. It is the major source of cash for most well-run businesses. When a business obtains cash from customers or pays cash to vendors, the purpose of the cash flow is for operations.

The main questions to ask to determine if a transaction affects the cash flow from operations is:

• Did the cash flow result from business operations?
  
• Did or will the transaction affect the income statement?
  

Investments

Cash flow to or from investments is mainly used to ensure that the required assets needed to support efficient operation are acquired and maintained. Business buy and sell assets to stay competitive. The cash flow from the sale of a business asset is a cash inflow from investing activity. The cash from the purchase of capital assets are cash outflows from investing.

Moreover, if a business has excessive cash it could decide to invest by purchasing securities or acquiring other businesses. The cash outflow from purchasing securities are cash flow from investing activities.

Financing

Businesses often use debt or money from other investors to purchase business assets. Companies can finance operations by issuing stock, using personal funds, borrowing money, etc. These activities are to finance the business operations and are classified as income from financing activities on the cash flow statement.

Now let us construct a cash flow statement using our previous example:

Your cousin Lucy, was downsized from her business and so decided to start a consulting business. She took $2,000 from her savings to buy a computer. After the first month she had one client who paid $1,000. She paid $200 for wages to a high school student who worked with her.

Previously, we constructed the profit and loss and balance sheet statement as follows:

Profit and loss statement

Balance sheet statement

Now using the same information, we will construct the cash flow statement.

*Note 1 – Since all income and expenses were cash based, the cash flow from operations matches the net profit

*Note 2 – Net change in cash = net cash flow from operating activities + net cash flow from investing activities + net cash flow from financing activities

*Note 3 – Ending cash balance equals the cash account in the balance sheet

This article discusses the base line to understanding financial statements. Be sure to log into your financial software and practice reading your number using these basic concepts.

For more details on how to analyze the numbers be sure to take a look at Retire from My Business: Module 2.