Understanding Financial Statements:
A Complete Guide for Small Business Owners

Staying fully informed about the financial standing of your small business is a challenge while managing demanding day-to-day operations and business growth. Financial statements help small business owners assess their organization’s financial health, make informed decisions, and effectively prepare for quarterly and year-end reviews. In this guide, we’ll explore the three main financial statements – income statements, balance sheets, and cash flow statements – and demonstrate how they can be leveraged to help your business improve operations, track financial performance, and avoid tax, cash flow, and investment-related issues.

What Are Financial Statements? 

Financial statements are an essential tool small businesses can use to view a clear and objective summary of their financial activities. In addition to ensuring financial transparency, financial statements increase accountability across a wide range of business operations and empower small business owners to make strategic changes that improve the long-term financial health of their organization. 

Whether it’s analyzing shifting expenses on your income statement, examining borrowing patterns on your cash flow statement, or assessing liabilities and assets on your balance sheet, your business’ financial statements can offer insights that lead to better financial decision-making, increased profitability, and streamlined day-to-day operations.

The Three Main Financial Statements

To gauge your business’ financial well-being, it’s best to rely on three main financial statements as sources of reliable data: an income statement, balance sheet, and cash flow statement. 

Income Statement Basics

An income statement includes three key components: revenue, expenses, and net income. Income statements help businesses identify financial trends and track profitability (or losses) over a given period – whether it’s one business quarter or an entire fiscal year. Let’s explore each element of the income statement.

• • • Revenue – This represents the total income your business has generated over a set time period, and helps you distinguish and analyze income/performance from multiple revenue streams. 
    • Expenses – This represents the total costs connected to operating your business, ranging from wages & salaries to utilities, rent, transportation, and materials. By examining your expenses, you can make more informed decisions to reduce costs or make improved investments. 
    • Net Income – Your “bottom line” net income demonstrates the profits or losses of your business during a set period. Negative net income reveals that you’ve lost income during a given period, while a positive net income shows overall profitability.

Balance Sheet Explained

A balance sheet also includes three key components: assets, liabilities, and equity, which help to provide an accurate picture of a business’ financial health at a specific point in time. The balance sheet helps businesses assess solvency and liquidity, which we’ll discuss more here and in a later section: “How to Analyze Financial Statements.”

• • • Assets – Assets include every item of value your business outright owns, including equipment, inventory, accounts receivable, and cash. 
    • Liabilities – Your business’ liabilities could include loans, accounts payable, unpaid bills, or any other outstanding debts, financial obligations, or borrowed funds from creditors. 
    • Owner’s Equity – This is the portion of business assets that you (the owner) directly own. Equity represents the remaining interest in your business once liabilities are deducted from assets.

In basic terms, liability + equity = assets, since assets are funded by either an owner’s contributions, earnings retained by the business, or from borrowed funds. Liabilities and equity demonstrate how assets were funded. When analyzed carefully, your business’ balance sheet should offer important insights about your business’ liquidity, its readiness to fulfill future financial obligations, and its overall financial stability.

Cash Flow Statement Guide

A cash flow statement is a critical tool for managing cash flow, surpluses, and planning for your business’ long-term growth. Using three categories – operating, investing, and financing activities – it helps you identify how cash moves in and out of your business during a given period.

• • • Operating Activities – This section of the cash flow statement shows all of the cash that is either generated or spent during daily operations, including cash from sales, payments to vendors/suppliers, or routine operating expenses. Increases or decreases in cash flow caused by accounts receivable/payable transactions or inventory changes can be identified in this section and affect net income adjustments. 
    • Investing Activities – To help your business evaluate its capital expenditure choices, the investing activities section records all cash spent or gained from buying or selling long-term assets including but not limited to property, stocks, or equipment. When assets have increased, it usually leads to a cash outflow. 
    • Financing Activities – The financing activities section helps you track all cash activities connected to dividends payments, raising capital, or borrowing & repaying debt. It can help you improve your understanding of how effectively your business is managing funding and utilizing equity or debt.

Why Financial Statements Are Crucial for Year-End Reviews 

Conducting a year-end financial review is crucial for any small business. Fortunately, financial statements can help your organization – before the start of the new year – identify trends in revenue and expenses, prepare for tax filing & audits, or plan for the upcoming fiscal year with accurate data.

Offering an objective and accurate picture of your business’ financial standing, financial reviews can provide all of the following insights during your year-end review process.

• • • Overall Profitability – Among other benefits, financial statements allow you to accurately track profits and losses over set time periods. 
    • Debt Assessment – Financial statements give you a clearer sense of your business’ debt levels and how prepared you are to repay them on time and in full. 
    • Investment Strategy – If you have any concerns about the investment strategy you’re implementing to maintain or grow your business, financial statements provide the information you need to make informed changes. 
    • Optimizing Operations – Gaining a clear sense of how your business’ generated revenue stacks up against operational expenses can empower you to cut unnecessary costs or make other needed adjustments. 
    • Short- or Long-Term Trends – Financial statements also help your business assess increases or decreases in profits as compared to past financial periods (quarterly, yearly, or otherwise).

How to Analyze Financial Statements

Understanding financial statements and responding constructively to them can be a challenge for any small business. Key first steps like comparing year-over-year data, examining financial ratios, and detecting red flags like cash shortages or declining margins can help your business analyze financial statements and leverage the data to make productive financial decisions moving forward.

Comparing Year-Over-Year Data

Examining year-over-year data allows you to isolate and analyze two or more measurable events and determine whether your business’ financial health is static, improving, or moving in a negative direction on a consistent basis. For instance, you might identify that revenues consistently decrease in the second quarter on a year-over-year basis over a three-year period, and take measures to improve your business practices to alter that trend in the coming year.

Using Profitability, Liquidity, and Debt-to-Equity Ratios

Different financial metrics like profitability, liquidity, and debt-to-equity ratios also help your business measure past financial performance and current financial standing to make informed decisions for the future.

• • • • Profitability Ratio – This ratio gauges your business’ capacity to generate profit/income relative to revenue, operating costs, equity, and balance sheet assets over a set period of time. 
      • Liquidity Ratio – Liquidity demonstrates how readily your business can transform company assets into cash to fulfill any short-term financial obligations. Analysts generally use the working capital ratio and quick ratio to measure liquidity and determine a business’ ability to pay current liabilities using current assets. If analysis shows that a business’ quick ratio is less than 1%, it typically means that liquid assets are lacking to cover short-term liabilities and it may be necessary to raise more capital for the business. More specifically, cash liquidity is a critical ratio/factor in determining a small business’ financial well-being, with a recent JPMorgan Chase Institute study showing that 50% of small businesses operate with less than 15 cash buffer days and only 40% have over three weeks cash buffer.

• • • • Debt–to-Equity Ratio – The D/E ratio measures the amount of borrowed money that is used to fund business operations and demonstrates how readily shareholder equity can cover debts. Your business’ debt-to-equity ratio is determined using the following formula: Total liabilities ÷ Total Shareholders’ Equity = Debt-to-Equity Ratio. If your business has a low or modest ratio (of 0.25, for example), investors are more likely to view your business as a relatively safe or low-risk investment target. 

Identifying Red Flags like Cash Shortages or Declining Margins

Analyzing financial statements also helps your business identify potential red flags like cash shortages or declining margins. Cash shortages or irregular cash flow may occur for a variety of reasons: unanticipated expenses, accounts receivable mismanagement, or high tax bills that could be reduced with professional tax and accounting support. It’s important to work with a qualified accounting professional to investigate cash shortage issues and determine whether they are a result of a short-term change in circumstances or a more recurring and long-term financial problem.

Similarly, it’s essential to identify and analyze your business’ gross profit margin, especially if it has decreased. Your gross profit margin indicates your business’ profits once the cost of goods (production costs, operating expenses, etc.) has been subtracted from total sales. If your gross profit margin is decreasing, you should enlist the help of accounting professionals to address the situation and avoid future financial risks.

Common Mistakes and How to Avoid Them 

Beyond the red flags we’ve already explored, there are a number of common mistakes business owners should strive to avoid when generating, analyzing, and responding to financial statements.

Neglecting Cash Flow

If your business fails to verify transactions against bank records, it can overestimate how much cash it has available and make compromising and costly financial decisions. Often cash flow mismanagement is due to issues with reconciling bank statements, which we’ll explore next.

Ignoring Reconciliations

When your business utilizes bank reconciliations, it not only supports improved cash flow management, but also protects your business against fraud, including internal fraud, external fraud, or duplicate transactions. This is particularly important as recent data from the Fraud Examiner’s Occupational Fraud Report shows that small businesses have the highest median losses due to fraud (over medium-sized and large businesses). When you reconcile your business’ bank statements and enlist professional assistance with regular reviews & monitoring, you can quickly identify unusual activity and avoid serious financial consequences.

Misclassifying Expenses

Misclassifying expenses is another common error that can cause businesses to lose on deductions or even attract an IRS audit. Whether it’s missing a valid/qualifying tax deduction, or labeling a personal expense a business one, support from a professional tax & accounting firm can help you maximize deductions, avoid penalties, and avoid financial mismanagement related to expenses reporting.

Empower Your Business with Professional Financial Guidance 

Creating, evaluating, and constructively responding to financial statements is a demanding and multifaceted process for small business owners focused on day-to-day operations and business growth. Even so, incorporating financial statements into quarterly evaluations and year-end processes is crucial to ensure your business is making responsible and informed financial decisions.

That’s why Accounting Freedom offers comprehensive accounting and tax services that can simplify financial management for your business, improving accuracy and supporting increased profits. We provide all of the following services for small businesses seeking support with financial management:

• • • Bank Account Reconciliation
    • Creating a Balance Sheet, Income Sheet, & Other Financial Statements
    • Organizing General Ledger & Related Bookkeeping Services
    • Ongoing Business Consulting
    • Tax Planning & Tax Preparation

All of our services are customizable to meet the specific needs and aspirations of your business, and we offer related small business payroll and HR services to support an integrated approach to managing your business’ finances and long-term financial strategy.

Ready to leverage accounting & tax support to improve your business’ financial health? Contact us today to start the process.