Financial Statements: What You Need to Know

A business’s ability to generate earnings consistently over time is a major driver for investors and a key for the business’s financial management to understand the past, current and on-going financial position. Financial statements can greatly aid in determining profitability, ability to pay back debts, and how to plan for the future.  There are three financial statements that businesses need for this purpose: the profit and loss statement (P&L statement), balance sheet, and the cash flow statement.

The P&L Statement

The P&L statement is commonly known as the income statement.  It shows the changes in the business’s profitability over time.  The P&L can be reported on either the cash or accrual methods.

The P&L statement reports all of the income the business receives through its normal course of business.  This is often referred to as the “top line.”

The P&L also reports the costs associated with doing business.  These costs include Costs of Goods Sold (“COGS”) for product related businesses and ordinary operating expenses for other businesses.  Once these costs are subtracted, you get to “net income” or the “bottom line.” This is the profit or earnings of the business.

The P&L statement helps the business keep track of net income and spending to ensure that it is profitable and on track to meet its financial goals. The business can use the P&L statement to check the business’s financial health.  This is often done by analyzing ratios using the P&L statement data, such as the gross profit margin, product profit margin, operating profit margin, net profit margin, and operating ratios.

  1. Operating margin measures how much a business makes on each dollar of sales after paying for the variable costs of production (raw materials and labor), but not the operating costs, interest or taxes associated with the products.
  2. The net profit margin is the percentage of revenue remaining after all operating expenses have been deducted from the business’s total revenue.
  3. The operating ratio shows the business’s overall efficiency by comparing the total operating expenses to net sales.

These ratios vary from one business industry and cycle to another.  By tracking them over time, the business can identify trends. The trends can show whether the business is improving, struggling, or declining.  

The Cash Flow Statement

The cash flow statement is similar to the P&L statement. It shows the business’s income and expenses on the cash method.

The cash flow statement is broken down into three parts:

  1. cash flow from operations,
  2. cash flow from investing, and
  3. cash flow from financing.

Cash flow from operations includes transaction from all operational business activity. This begins with net income, derived from revenue less expenses, and then reconciles all noncash items to cash items involving operational activities. This includes accounts receivable (reduced from revenue as cash is not yet received), accounts payable, depreciation, amortization and prepaid items (reduced from expenses as they are not yet paid).

The cash flow from investing includes cash spent on property, equipment or other capital expenditures. As these appear on the balance sheet, they are not part of the net profit figure but need to be accounted for in the cash outlay.

Cash flow from financing provides an overview of cash used in the business’s financing to determine how much money the business has paid out in dividends and buybacks. This covers any cash obtained and paid back from fundraising efforts or loans.

As previously noted, thae cash flow statement is used to show the business’s income and expenses in the cash method. There are two types of accounting methods utilized by companies to track and report their net profit or loss. One is accrual, meaning that the transactions are recognized by economic events rather than the timing of when they occur, and one is cash. If the business reports in an accrual method, the cash flow statement is an important item to review to see the state of the business in real time, or the cash position.

The Balance Sheet

The balance sheet reports the business’s assets and liabilities on a specific date.

The accounts listed on the balance sheet will vary widely by entity and industry, but most balance sheets will include the following asset accounts:

  1. cash (bank) and cash equivalents (brokerage),
  2. accounts receivable (invoices to customers),
  3. inventory (product not yet purchased),
  4. prepaid expenses, and
  5. fixed assets (land, buildings, machinery, equipment).

The liabilities generally consist of:

  1. accounts payable (vendor bills),
  2. rent and operating costs payable,
  3. customer prepayments,
  4. wages and payroll taxes,
  5. short term debt (credit cards, short term loans),
  6. long term debt, and
  7. pension/retirement fund payables.

The balance sheet is used to show:

  1. What the business has as its resources and
  2. What the business owes at any given time.
  3. What the business’s owners or investors have put into the business.

A healthy business will typically have more assets than liabilities reported on the balance sheet.  This means that the owners would be able to recoup their investment should the business close. The ratio of assets to liabilities and equity is important track over time.

As the balance sheet is a snapshot in time, it cannot be used to identify business trends.  It can be used to evaluate the business’s current overall health. For example, it is useful in determining the business’s debt-to-equity (“D/E”) ratio. The D/E is calculated by dividing a business’s total liabilities by its owner equity. This is used to determine the business’s financial leverage or how much of the business’s operations are being financed through debt rather than income.

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