The financial statements allow a business to stop in time and take a snapshot of how well the company’s performing. These reports of a company’s performance are usually completed within a few days after the end of each month. Each financial report shows different aspects of the company’s operations. Together, these three important statements help the entrepreneur make important decisions for the financial health of the business.
The Balance Sheet and Net Worth
The balance sheet is the financial statement that reports the company’s net worth or owner’s equity. For larger public companies it also shows stockholder equity. The balance sheet is divided into two sections and each section must balance. The first section shows the business assets and the second section shows the liabilities and owner’s equity. The following formula is a simplistic example of what makes up the balance sheet.
Assets – Liabilities = Owner’s Equity
As assets increase, owner’s equity increases. If liabilities increase, owner’s equity will naturally decrease. If liabilities were incurred for the purchase of assets, then owner’s equity is not affected. When a business is first created, the amount of the owner’s personal investment is listed as equal monetary portions for assets and owner’ s equity. The investment of assets can vary depending on the business. Some asset examples might include:
The Income Statement and Profitability
The income statement, also known as the profit and loss statement (P & L), is a report that shows the company’s profitability. The P & L statement is an accumulation of the general ledger (GL) accounts that affect profitability. The income statement is divided into two sections. The first sections shows gross profit (sales – cost of goods sold) and other incomes. The second section shows expenses. Expenses are then deducted from gross profits (income), along with other incomes to get net profit before taxes. If the total expenses exceed total income, then the end result would be a net loss.
Since the income statement is an important business management tool, expenses are usually separated by variable expense and fixed expense. Variable expenses usually fluctuate from month to month whereas fixed expenses tend to remain constant. Therefore it’s much easier to make changes to reduce variable expense.
The Statement of Cash Flows – Cash Flow vs. Profits
The statement of cash flows, also known as the cash flow statement, reports the company’s ability to generate cash. The income statement might show that a company’s profitable, however profitability and cash flow don’t always coincide. For example if a business has a large portion of its revenues in accounts receivables with a slow turnover rate, it could have a detrimental effect on cash.
Another example of cash flow deficiency is when cash is used for the purpose of purchasing assets. Buying too much inventory is a good example of negative cash flow practices. Since cash and inventory is an asset, neither shows up on the income statement. Yet trading cash for inventory will naturally decrease the cash account but will not have an affect on profits.
To get a true picture of a company’s financial performance and stability, it’s important to analyze all three financial statements. If looking to purchase a business, it would be a mistake to look at profits alone. Net worth and cash flow strength are equally important attributes to the financial stability of a business.