How to read financial statements
In this article, we'll cover:
The importance of understanding financial statements
The main purpose of knowing how to read financial statements is to give you a clear picture of your company’s financial performance and to help you when it comes to decision-making.
Doing so will provide you with an overview of your company’s financial health, profitability, and potential for growth.
The main components of financial statements are:
- Revenue – how much your business is making.
- Expenses – how much it’s costing you to generate that revenue.
- Net profit – what you’re left with after deducting expenses from your revenue.
- Debts – what liabilities your business has.
- Cash flow – how well your business manages money coming in and money going out.
- Assets – what they are and what their value is.
3 different types of financial statement
There are three financial statements you should understand as a business owner.
- The balance sheet – what your business owns (assets) and owes (liabilities) at a fixed point in time.
- The profit and loss statement – what your business made (revenue) and what it spent (costs) over a period of time.
- The cash flow statement – the money coming into your business versus the amount going out.
How to read a balance sheet
Your balance sheet includes:
- Your business assets.
- Your business liabilities.
- Your equity.
It shows the number of assets your company has (and their value), the debts it may owe, and your level of equity at the end of a specific reporting period.
Understanding your balance sheet
Assets
These are the things your company owns that have value, for example, your tools, equipment, materials, plant, machinery, and vehicles. Cash and investments are also assets.
Assets are typically listed on the left-hand side or at the top of a balance sheet, depending on how it’s laid out.
Current assets are listed first. These are things that your business expects to convert into cash within one year. For example, your stock and materials.
Fixed assets are listed next. These are items that are needed to operate your business, but you don’t intend to sell. For example, your work van.
Liabilities
When it comes to understanding how to read a financial statement, your liabilities are what your company owes to others. For example, your work premises, any business loans, any outstanding debt on a supplier credit account, and any wages or taxes you owe.
Liabilities are listed either on the right-hand side of the balance sheet or underneath the assets.
Typically, liabilities are listed in order of their due dates and split by ‘current liabilities’ and ‘long-term liabilities’.
Current liabilities are those items your business intends to pay off within 12 months. Long-term liabilities are the items due after this time period.
Equity
Depending on the layout of your balance sheet, equity can be found either on the right-hand side or at the bottom, underneath assets and liabilities.
Equity is the amount you would have in your company if you sold all your assets and paid off all your liabilities.
Want an accountant to help with your trade business? Take a look at our post:
How to read a profit and loss statement
If you’re looking for how to read a profit and loss statement (P&L statement) or how to read an income statement, the first point to note is they are one and the same. The terms are used interchangeably.
Your profit and loss statement outlines:
- Your revenue
- Your business costs
- Your net profit or loss
It shows what your business earned (its revenue) and lost (its business costs) to determine whether it made a profit (net profit) or loss (net loss) over a specific time period, e.g. a year.
How to read a P&L statement
- Revenue
Your company’s total sales figure sits at the top of the P&L statement and is called ‘gross revenue’.
- Costs
Working down the P&L statement, you then deduct the various costs you’ve incurred in order to make the revenue outlined above.
Costs include the ‘cost of sales’, which is how much it costs to produce the services you’ve provided, and ‘operating expenses’, which relate to your overheads, wages etc. Income tax is another cost that must be deducted.
- Net profit or losses
Your P&L ‘bottom line’ is your net profit or net losses. i.e. how much your business earned or lost during that particular accounting period.
If your revenue is greater than your costs, your bottom line will show a net profit.
If your revenue is less than your costs, your bottom line will show a net loss.
How to read a cash flow statement
Your cash flow statement shows the money coming into your business and where it’s come from, and how money is being spent. It includes three main areas:
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
Your cash flow statement shows your business’s ability to generate cash to pay its debts (or liabilities), fund its operating expenses (business costs), and fund investments.
Cash flow from operating activities
This is cash from running your business and providing your services, e.g. the receipt of paid invoices, paying wages, making income tax payments, and so on.
Cash flow from investing activities
This is the cash sourced or used to invest in the future of your business, for example, buying a company van, workwear, or tools and equipment.
Cash flow from financing activities
This relates to the sources of cash from investors or banks. For example, paying back a bank loan.
FAQs
How do you read a budget?
Understanding budgets is fairly straightforward. First, decide how often you want to analyse your budget, for example, weekly, monthly, or annually.
Your budget should have four columns: actual, budget, over budget, and % budget.
Input your budget numbers frequently to keep your budget report up to date.
Look for variances in the numbers to see how you’ve faired against your forecast.
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