As a business owner, you know how crucial it is to accurately track your financial activities. Monthly cash flow, money owed, net profits—you need all this financial data to gauge performance and make wise budgeting decisions.
What is a financial statement?
Having the ability to understand your company’s financial condition means that you can identify relevant business opportunities while also mitigating costly mistakes.
That’s where financial statements come in. These important documents help investors, managers, and business owners better understand the financial stability of a company, as well as:
- Determine a company’s ability to generate cash and identify cash sources
- Examine and detect ahead of time any possible profitability challenges
- Track financial results as per the business needs
- Determine a company’s ability to pay back debts
- Track a company’s financial performance
With the proper expense and budgeting software solution, you can spot opportunities while improving your company’s strategic standing in both the short term and long term.
Let’s take a closer look at the financial statements your company may need and the best way to record all of this essential information.
Exploring the three main financial statements for your business
When you’re a relatively young small business, figuring out what kinds of documents and reports you need to keep track of the money coming in and going out can be challenging
But no matter the size, there are three primary financial statement documents that you or your accounting team need to accurately record, track, and analyze your business’s financial health for month-end or any timely reporting. These key financial documents are balance sheets, income statements, and cash flow statements.
#1: Balance sheet
A balance sheet holds information about a company’s assets, liabilities, and the owner’s or shareholders’ equity during a specific accounting period.
Balance sheets are necessary because they provide a look into a company’s current value. What this type of financial statement does is it shows what a business owns and owes.
However, balance sheets alone don’t reveal information on past trends or predictions, which is why you should always use them in tandem with other financial statements.
Balance sheet calculations are about finding the value of a company’s assets, which is determined by adding liabilities and owners’ equity totals:
Total Assets = Total Liabilities + Total Equity
Need a breakdown? Assets are anything a company owns. Liabilities are any amount of money a company owes to a debtor. The owner’s equity is the company’s net worth, the amount of money if all assets were sold and all liabilities were paid.
#2: Income statement
An income statement (also called a profit and loss statement or P&L) focuses on a company’s income and expenses during a specified accounting period.
The company’s income statement shows financial trends in business activities. This document lets you compare various periods, which is important for understanding financial performance.
Ultimately, the income statement asks whether the company is profitable and measures how much money is spent to produce its products or services.
Total net income is determined by subtracting the total expenses and losses from the total revenue and gains:
Net Income = (Total Revenue + Gains) – (Total Expenses + Losses)
Need a breakdown? Revenue is the amount of money a business makes. Gains are considered “other income.” They indicate net money from other activities. Total expenses is the total amount of money spent on running the business. Losses are any excess of expenses over revenues.
#3: Cash flow statement
Cash flow statements provide a more detailed picture of the business’s cash inflow and outflow during a specified accounting period. Measuring the influx of cash can help shareholders, investors, other business leaders, and employees understand how the company will operate in the short term or long term.
It’s important to understand that cash flow is not the same as a company’s profit. Cash flow is the money that comes in and goes out of a company, while profits refer to what’s left after you deduct all expenses.
For the company’s cash flow formula, you have to add or subtract all the cash from operating activities, investing activities, and financing activities. Then add the result to the beginning cash balance:
Cash Flow = Cash from Operating Activities +(-) Cash from Investing Activities +(-) Cash from Financing Activities + Beginning Cash Balance
As you can see, cash flow is broken down into three sections: operating, investing, and financing activities. If you need a breakdown, here’s the difference between the three:
- Operating activities are cash flows used for daily business operations, including cash payments, revenues, and expenses.
- Investing activities refer to the cash spent on business investments, like purchasing or selling assets, including physical property (like real estate or vehicles) and intangible property (like patents or bond certificates).
- Financing activities are the cash flows from debt and equity financing, like business loans and capital contributions.
Two common methods for calculating financial statements
The most common way to calculate financial statements is by using ratios. In business and finance, ratios allow business leaders to observe and understand the relationships between items.
For example, you might want to compare your business to a competitor’s. The proper ratio will help you better understand your profitability and performance so you can always remain one step ahead.
Here are two of the most common ratios used for financial statements.
Inventory turnover ratio
The inventory turnover ratio measures the rate at which inventory is sold, used, and replaced. It helps leaders understand how well their company manages its inventory and the supply versus demand ratio.
While high turnover isn’t desirable when talking about your employees, in this case, higher turnover rates are actually a good thing. High inventory turnover means storage needs are reduced, which allows room for new products.
The inventory turnover ratio is calculated by dividing the cost of goods (COGs) sold by the average inventory for a specific accounting period:
Inventory Turnover = COGs Sold ÷ Average Inventory
The inventory turnover ratio is a well-known and well-used formula because it’s one of the easiest ways to measure a company’s efficiency. This ratio helps businesses better manage inventory so there’s not too much overhead or too little supply.
However, since managers want a high turnover rate—and it’s easy to manipulate the numbers—your ratio might not reflect the actual ratio.
Also, without deeper analysis, focusing on the inventory turnover ratio puts business leaders at risk of accidentally brushing over slow-moving items. This is because the ratio only measures the average figures.
Operating profit margin (also called the return on sales, or RoS) is a profitability ratio that measures the overall financial health of a company by determining how much profit a company makes after paying operating and non-operating expenses.
For example, the operating margin in a manufacturing facility could measure the profit after paying for the costs of production, like raw materials.
Before you use the formula, first calculate the operating income by subtracting COGs from revenue. With the operating income in hand, you’ll use this formula to find the operating margin:
Operating Margin = Operating Income ÷ Revenue
Say that a company has a revenue of $1,000,000, COGs sold of $50,000, and administrative expenses of $400,000. Its operating income would be $450,000, which brings us to the equation above.
Now, divide the operating income of $450,000 by the original revenue of $1,000,000, which equates to .45, or 45%. The higher the operating margin, the more money a company makes. So 45% is an excellent margin (although admittedly a rare one since anything above 15% is considered great!).
A better understanding of your company’s financial position
Measuring your company’s financial health through financial statement analysis is critical to determining both current and future business activities—but you need a tool that can bring all your financial data together in one place.