Most small business owners and startup entrepreneurs never had a formal course in business finance, and earned their “MBA” at the School of Hard Knocks. If that’s you, here’s a “cheat sheet” to understanding three basic financial statement flavors: Balance sheets, income statements and cash flow statements.
I agree – it’s not a sexy topic like social media. But if you ever seek bank financing, angel investors, venture capital or a loan from friends and family, these are things you need to know.
Your balance sheet shows what your business owns and what it owes at a fixed point in time, and provides details about your assets, liabilities and owners’ equity. It does not show money that flows in and out of the accounts during that period (we’ll get to that shortly).
- Assets are things your business owns that have value and could be sold, including tangible assets such as vehicles, equipment, inventory and cash, plus intellectual assets such as trademarks and patents.
- Liabilities are amounts your business owes to others, including loans, rent, vendor accounts, payroll and taxes, as well as obligations to provide goods or services to customers in the future.
- Owners’ (or shareholders’) equity is your capital or net worth. It’s the amount that would be left if the business sold all assets and paid off all liabilities. This leftover money belongs to the owners.
An income statement shows revenues over a specific time period – i.e. a month, quarter or year – and shows what you spent to generate that revenue. The literal “bottom line” of an income statement shows what the business earned or lost over that period.
Think of an income statement as a stairway. You start at the top with total sales, and then go down one step at a time. At each step, you make a deduction for costs or other operating expenses that were necessary to earn the revenue. At the bottom of the stairs, after deducting all of the expenses, you learn how much the business earned or lost.
A Cash flow statement shows inflows and outflows of cash over a fixed period. This is critical because any business needs cash to cover ongoing costs. While an income statement (above) shows profit or loss, a cash flow statement merely indicates if the business generated cash. You should also know that a cash flow statement shows changes over time, not absolute dollar amounts at a given point. The bottom line of the cash flow statement shows how much it went up or down for the period. Generally, cash flow statements review the cash flow from three key activities: operating, investing (back into the business) and financing.
4 Key Terms and Ratios to Know
Here’s a mini glossary of four key financial statement terms and ratios you’ll also want to know:
- The Debt-to-equity ratio compares total debt to owners’ equity. Both numbers come from your balance sheet. To calculate a debt-to-equity ratio, divide total liabilities by owners’ equity. If a business has a debt-to-equity ratio of 2-to-1, for example, it means that it is taking on debt at twice the rate that its owners are investing in the company.
- Inventory turnover ratio compares a company’s cost of sales on its income statement with its average inventory balance for the period. To calculate this ratio, divide cost of sales by average inventory for the period. A 2-to-1 ratio means the company’s inventory turned over twice in the reporting period.
- Operating margin shows percentage of profit for each dollar of sales. It compares operating income to net revenues. Both numbers come from the income statement. To calculate operating margin, divide income from operations (before interest and income tax expenses) by net revenues. Operating margin is usually expressed as a percentage.
- Working capital is the money leftover if the business paid its current liabilities (debts due within one-year) out of its current assets.
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