Why Read Financial Statements and How-To Understand Them

Unfortunately, most business owners give me that look like deer in headlights when I first discuss financial statements because they have no what is detailed on their business’s financial statements. No one has ever taken the time to teach them. In my line of experience as an accountant I have concluded that most accountants are missing out on the opportunity to teach their clients the value of financial statements.

Financial statements provide insight into how their company is performing. It is crucial for a business owner to understand how to read a financial statement. Otherwise, the owner would never know whether the company is managing its money wisely.

I often hear business owners tell me they measure success by having money in their bank account. What!? No! That is not an accurate indicator if your business is succeeding. You could be one payroll away or a big payment from negative cash in the bank account.

An ability to understand the financial health of a company is one of the most vital skills for entrepreneurs to develop. Armed with this knowledge, you can better identify promising opportunities while avoiding undue risk, and professionals of all levels can make more strategic business decisions.

To understand a company’s financial position—both on its own and within its industry—you need to begin by understanding two key financial statements: the profit and loss statement and the balance sheet. The value of these documents lies in the story they tell when reviewed together.

Think of this as Financial Statements 101

Both of these statements report the assets and liabilities of your small business and the amount of profit your business has earned over a set period.

You must know how much money you have and how much money you owe to determine your company’s actual net worth. You must also know your profits and what it costs you to generate those profits to determine whether you’re operating in the black or red. These financial statements work in tandem to provide this information quickly and easily.

Let’s start with How to Read a Profit and Loss Statement

A profit and loss statement (also called an income statement) tells you how much money your business made, and how much it spent, over a particular time period. I usually create these for my clients monthly, quarterly and annually. I also like to create them comparing month over month and year over year to see where they are improving and where they are struggling. 

For example, if we were looking at a March profit and loss statement I would want you to see how March of this year compared to March of last year and previous years. Why? Because looking at how the same month performed year over year can show you financial trends. Maybe there is a holiday during the month that affects sales such as Easter or Spring Break. Sometimes Easter or Spring Break falls in March and other years they fall in April. Do these events effect your income or expenses in a positive or negative way? Knowing that can help you make business decisions such as when to have a sale to increase business or maybe close for a day or two around the holiday.

To dive a little deeper into the profit and loss statement, they typically include the following information:

  • Revenue or Sales: The amount of money a business takes in
  • Expenses: The amount of money a business spends
  • Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever a business sells 
  • Net income: Sales minus Expenses 

Accountants, investors, and other business professionals regularly review profit and loss statements:

  • To understand how well their company is doing: Is it profitable? How much money is spent to produce a product? Is there cash to invest back into the business?
  • They are also helpful for how to determine financial trends: When are costs highest? When are they lowest? You can use this information to know when to save money & when it is ok to spend some extra money.

How to Read a Balance Sheet

The balance sheet tells you what you own, what you owe, and what’s left over. In other words, your company’s balance sheet shows you your current assets, current liabilities, and owner’s equity. That information tells you what your company is worth at a specific point in time.

Assets are anything valuable that your company owns, whether it’s equipment, land, buildings, or inventory.

Your liabilities are any debts your company has, whether it’s bank loans, mortgages or unpaid bills.

Once you’ve figured out how much you have and how much you owe, it’s natural to ask one more question:

“How much is left over?”

That’s what looking at your equity tells you: how much value is left over once you’ve totaled up everything valuable that you have, and subtracted everything you owe to your creditors. For a small business owner, equity is the net worth of your business.

Put another way: when you take all of your assets and subtract all of your liabilities, you get equity.

For a sole proprietorship or partnership, equity is usually called owners equity on the balance sheet. In a corporation, equity is shareholders’ equity.

Alone, the balance sheet doesn’t provide information on trends, which is why you need to examine the profit and loss statement also to fully comprehend a company’s financial position.

So the first step for you, as a business owner, is to figure out what all the numbers on your profit and loss and balance sheet mean. 

Once you understand them, the process of projecting out those numbers for the next year isn’t so daunting. In fact, it becomes tremendously empowering. Picture having a road map for the next year for how your business is going to make money over the next 12 months. That is usually hard to imagine for most business owners.

If you put a good plan together, it is surprising and exciting to achieve the plan and be focused. By understanding the financial statements, as a small business owner, you will begin to take action to make things happen.

Understanding your numbers is a key first step to simplifying that process.

You don’t need to become an accountant to read a financial statement, but you need to know and keep tabs on the numbers to run your company and achieve your goals.