A Basic Primer to Small Business Financial Statements and their Importance to Business Plans
- Balance Sheet
- Profit and Loss Statement
- Cash Flow Statement
- Financial Ratios
We’ll discuss them here generally, and why they’re essential to business planning. Each type of statement has an important role in the mix of business financial plans, telling you and those who need to know important facts or possibilities about your business.
Let’s start with the…
The balance sheet simply lists the assets, liabilities and equity of a business. Its primary function is to show you the net worth of the company. It’s called a balance sheet because the total value of assets must always equal the total value of liabilities and equity.
Assets = Liability + Equity
On the assets side of the balance sheet, which is the left side, you will find current assets listed separately from long-term assets. Current assets include, for example, cash, accounts receivable and inventory, while long-term assets include items such as land, buildings, and other fixed assets.
The same is true of current and long-term liabilities. Examples of current liabilities include accounts payable and short-term loans, while long-term liabilities would include items such as long-term loans and mortgages.
Equity is the value of your business, or in other words: Assets – Liability. Equity is shown on the bottom right side of the balance sheet, below the liabilities.
A balance sheet is important for assessing the worth of the company as of a specific date.
Profit and Loss Statement
A profit and loss statement, otherwise known as an income statement, has a very different role than the balance sheet. Its primary purpose is to see whether a business is making a profit or loss as at a specific date. It has two main sections:
Unlike the balance sheet, which separates its three sections side-by-side, the profit and loss statement stacks the income section above the expense section.
What you and anyone who is interested in your business is looking for, is the difference between Income and Expenses: Profit/Loss.
Net Profit/Loss = Income – Expenses
Profit and loss statements also let you see what percent of your income each expense represents. For example, your office rent may represent 20% of your gross income. Similarly, your gross margin. In other words…
Gross Profit = Gross Income – Cost of Goods Sold
It’s common to compare financial statements from period to period, such as from last month to this month, or last year to this year.
The profit and loss statement is directly connected to the balance sheet in that income and expenses affect assets and liabilities. For example, a sale would result in either increased cash or account receivable, whereas a loan repayment would result in a decreased loan payable in the liabilities column.
Both the balance sheet and profit and loss statement are also connected to the cash flow statement. So we’ll discuss that statement next and see the connection between these small business financial statements.
Cash Flow Statement
The cash flow statement shows the movement of cash within your business for a specific time. Essentially, it lets you see the inflow and outflow of cash.
In many ways, the cash flow statement is the most important of all small business financial statements, because…
Money is end result of every business!
After all, it’s great if your business regularly earns a profit but if it can’t produce a positive cash flow, you could go out of business really fast. And that’s what happens to a lot of profitable businesses.
Similar to the profit and loss statement, where you’re looking at the net of income and expenses to see whether your business is profiting or losing money, the cash flow statement lets you see whether you have a positive or negative cash flow. You can express this as a formula:
Net Cash Flow = Total Cash Inflow – Total Cash Outflow
You have two goals when it comes to cash in your business:
- Consistent Positive Cash Flow
- Always Positive Cash Balance
A consistent positive cash flow is necessary for your business’ survival, but it’s normal to have negative cash flow from time to time. Sometimes, your business needs to make a large payments or investments in a particular month.
Especially if you business is a start-up, it’s very normal to have a negative cash flow, or more money going out than coming in, because your sales will often be minimal in the early stages of your business.
However, it’s absolutely necessary that you always have a positive cash balance. In other words, you need to have money in the bank. A low or negative cash balance is a clear sign of a business going under.
So how does the cash flow statement relate to the balance sheet and profit and loss statement? I think you can already start to see the connections between these small business financial statements!
When your business makes a sale or receives payment for a sale on credit, that is an inflow. A sale shows up as income on your profit and loss statement and as an inflow on your cash flow statement. It also shows up either as cash or accounts receivable on your balance sheet.
Also, how quickly you can collect on accounts receivable will play a big role in your cash flow.
Conversely, when your business spends money, it shows up as an expense in your profit and loss statement and as an outflow on your cash flow statement. It also shows up on your balance sheet as a decrease in cash, or an increase or decrease in liabilities, depending on what the expense represents.
Cash flow is the king of small business financial statements.
Because small business financial statements take time to evaluate, and because sometimes you need to evaluate the performance of your business in more mathematical ways, financial ratios are important to measure a company’s performance and financial situation.
We won’t go into each type of ratio here, because there are too many to cover. For now, just know that there are five categories of ratios which are used to evaluate a company’s financials:
- Liquidity Ratios: tell you how easy it is to liquidate your business in the short-term
- Asset Turnover Ratios: tell you how efficient your business manages its assets
- Financial Leverage Ratios: tell you how solvent your business is over the long-term
- Profitability Ratios: tell you how well your business is at generating profits
- Dividend Policy Ratios: tell investors about the dividend policy of your business and the propensity for future growth
It’s important to note that you should use ratios in context of the business itself. You should compare them historically if possible, and assess them together rather than as separate indicators for a business.
How Small Business Financial Statements are Relevant to Business Plans
Small business financial statements can be used in many ways, but in a general sense, they can be used to examine a company’s past or a company’s future.
When we explore a company’s historical financials, we are looking at factual data. The financial statements portray the company’s actual financial performance and position. They allow you to gain a perspective of the company’s history and trends.
We look at the future, we are really projecting how we think the company will perform financially. If we are talking about an existing business, projections will be based on historical financial trends and any factors that may affect the future, such as a weakened economy.
If the business is a start-up, any projections will be made largely on assumptions and market research, as well as factors included in your business plan, such as the strength of your management team.
Either way, projected business financial statements are not factual, of course. They are predictions.
Still, they are important to investors, lenders, suppliers and you as an owner to determine the feasibility of your business.
Ultimately, small business financial statements are similar to any size of business financial statements.
- The Four Financial Statements You Must Know
- What are the Most Important Types of Financial Statements?
- Financial Statement Ratios