Understanding Financial Statements: Business Owner’s Guide
- ReInvestWealth
- Sep 14, 2022
- 7 min read
Updated: Apr 22
Updated June 2024
“Accounting is the language of business, and you have to be as comfortable with that as you are with your own native language to really evaluate businesses.”
This quote from investor titan Warren Buffet highlights how crucial it is for a Canadian entrepreneur to have a solid understanding of financial statements. However, like Warren Buffet said, it can truly feel like another language.
We know that it can be scary to scroll through documents full of terms you don’t know. So this article keeps it simple; we’ll explain the essentials on how to analyze financial statements to help you understand their relevance to your business.
After reading this article, you should have a clear understanding of the basics of the three main types of financial statements (income statement, balance sheet, and cash flow statement).
Table of Contents
The Purpose of Financial Statements
Financial statements are more than just for preparing yearly tax filings -- they are a key to the success of any business. If you have a solid understanding of how to analyze financial statements, then you have a clear picture of how well your business is doing, what resources are available, and where they should be allocated.
Keeping your statements accurate and updated helps with both long-term and short-term planning. This is why financial statements are useful for startups, because you can easily see the flaws in your business and what steps need to be taken to succeed. Dealing with investors and bankers also requires financial statements which they use to evaluate your company’s performance.
What is an Income Statement?
Also known as the profit and loss (P&L) statement, the income statement is where your company’s revenues and expenses are recorded.
Here are the common items you’ll see on an income statement:
Sales - The amount received by the company for selling its goods or services. “Revenue” is often used interchangeably with sales.
Cost of Goods Sold (COGS) - The total costs directly tied to producing the goods or delivering the services your company sells. This includes materials, labor, and directly attributable overhead costs. Subtracting COGS from sales gives you the gross profit.
Operating expense - The ongoing costs of running your business. Examples include salaries for sales and administrative staff, rent, marketing materials, and utilities.
Operating income - Profit from core operations after subtracting COGS and operating expenses. It's also sometimes called earnings before interest and taxes (EBIT).
Income before taxes - This takes operating income and adds any other income or subtracts any other expenses not directly related to your core business operations.
Income tax expense - The amount of income tax your company owes on its profits.
Net income - Your company's profit after all expenses, including taxes, have been subtracted from revenue. Net income is also referred to as the "bottom line" while Sales/Revenue is the “top line” of the income statement.
While the income statement provides a basic overview of your company's financial performance, financial ratios help you analyze that data further.
Ratios like customer acquisition cost (CAC) and monthly recurring revenue (MRR) can reveal trends, identify areas for improvement, and benchmark your performance against industry averages. Learn how to calculate ratios using data from financial statements with our financial ratios cheat sheet.
What is a Balance Sheet?
The balance sheet is a financial statement that has two main parts - one part will describe all the different assets that your company has, while the other describes your company’s liabilities and shareholders’ equity.
The balance sheet is given this name because the two parts of the balance sheet must equal each other - the value of your assets is the same as the sum of your liabilities and shareholders’ equity. The two parts must balance.
Most Canadian small businesses will have both current and long-term assets as well as current and long-term liabilities. The shareholders’ equity section will contain your company’s retained earnings from another financial statement called the statement of equity, but we won’t go through the details of that in this article.
Essentially, what you need to know is that your shareholders’ equity section will mainly contain your retained earnings (previous profits that are going back into the business). The Shareholder Equity section will also include common shares, which just refers to money received from stakeholders who invested in your company.
The information from your balance sheet will allow you to calculate working capital, runway, and debt to equity which are important financial ratios to consider, particularly for startups seeking investments. We discuss how these can help you make informed business decisions in our guide to financial ratios.
What is a Cash Flow Statement?
The cash flow statement explains what happened to a company’s cash during a period of time. It’s a record of both cash receipts and cash payments. Through this detailed statement, it’s easy to see exactly why your company is experiencing a positive or negative cash flow, painting a picture of how well a company is doing currently, and in the future.
There are three parts of the cash flow statement - operating cash flows, financing cash flows, and investing cash flows. The three parts are extremely useful tools for entrepreneurs as it gives a clear view of how cash changes due to each activity.
Operating Cash Flows
This part of the cash flow statement details the cash increases and decreases from day-to-day operations (providing goods or services). It contains revenues and expenses and how both play a role in your net operating cash flow.
This may sound similar to the income statement, but there are differences. Operating cash flow differs from the income statement – the operating cash flow statement is like a mirror, while the income statement is like a camera with a filter on it.
The cash flow statement cannot be artificially pumped with payables and receivables. It shows the real cash movement and can quickly tell an investor or business owner if the business is doing a good job collecting money from customers and paying expenses on time.
Financing Cash Flows
Financing cash flows refers to money that comes from debt and equity financing. Explained simply, this section of the cash flow statement relates to things such as what happens with your company’s shares, dividends, and from funding or repaying debt.
For instance, if your company issues shares, pays dividends and gets funding from issuing long-term debt like receiving a bank loan, these are all activities that would fall under financing cash flows.
Example - In the case of an online IT consulting business, let’s say that they had the following financing activities:
ー Took out a bank loan +$100,000
ー Paid off previous debt -$10,000
ー Issued shares of +$6,000
ー Paid dividends -$30,000
In the end, their financing cash flow would be $66,000, as you simply sum up all of the above. The overall financing cash flow plus a look into the different financing activities tells us how the company received funding and gives money it owes to investors.
Investing Cash Flows
The last section of the cash flow statement is investing cash flows, which usually includes transactions where a company buys or sells assets.
Examples of cash inflows within this section of the cash flow statement would be if you sold company equipment or other bigger assets like buildings. Cash outflows can arise from buying property such as company cars or investments such as stocks.
Example - For the IT consulting business mentioned above, perhaps they had the following investing activities:
ー Bought the land for their new office -$100,000
ー Bought new company equipment -$10,000
ー Sold previous equipment +$5,000
This would leave the company with a negative investing cash flow of $105,000 after summing up the above.
As an investor looking into this company or if you were the owner of a company with the cash flow above, it may be scary to see a negative cash flow of $105,000. However, this section of the cash flow statement will illustrate what caused the negative cash flow. In this case, seeing that most of the negative cash flow came from the big investment of buying land, this will bring some ease to a potential investor.
Difference Between Profitability vs. Positive Cash Flow
Through your time and effort to learn about the cash flow statement and monitor it, your company is now experiencing a positive cash flow. Yay! That’s good right? It may be a fair assumption to make that if your company has a positive cash flow, that also means that it is profitable.
This is an honest mistake that most who are new to accounting and finance make, but it’s important to know the differences between profitability and positive cash flow or else you’ll run into some problems when you face expenses or loans you have to pay off.
When we talk about cash flow, we are referring to the movement of cash. On the other hand, profitability is determined on an accrual basis which is different from the movement of cash.
This becomes an issue when we mistake profitability for positive cash flow. A simple way to understand this is to remember that in accounting, we must record things as they happen.
If we were to take on the job of painting a building and finish painting it at the end of the year of 2022, the job is considered finished and revenue is to be recorded in the year of 2022. However, even though it looks like we made a profit this year, we may not actually receive the cash until the next year.
If the client is unable to pay after the job is completed, we may find ourselves short of cash and unable to pay bills or loans when they are due. In this example, the company is profitable but may experience negative cash flow.
How Accounting Software Can Help With Financial Statements
We can’t stress enough that entrepreneurs need to have a solid understanding of financial statements. Think of this knowledge as the blueprint for an empire that you are building; without the blueprint and a solid foundation, you will never be able to create something that is successful and long-lasting. Like they say, accounting is the language of business.
However, manually managing accounts takes valuable time away from strategic analysis. As a business owner, you could be spending more time on growing your business instead of spending time doing bookkeeping.
That’s where accounting software comes in. Cloud accounting software, like ReInvestWealth, allows you to connect your company’s bank accounts and automatically record transactions for you. This makes it easier to build financial statements.
Whether your company resides in Quebec, Ontario, Alberta or another Canadian province, ReInvestWealth’s accounting software meets government regulations across Canada and prioritizes security by encrypting your data and credentials.
Knowledge is power, but it must be applied. Now that you understand financial statements, you have this blueprint of knowledge that you can use to build something truly meaningful.
