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When running a business, one of the most important things to know is how to read financial statements. Without this, you might produce reports but not know what they mean.
Even if you use the services of a bookkeeper or accountant, it is helpful to understand the information they are giving you and know the company’s financial health.
In this post, we will explain the basics of financial statements, how to read them and give examples of each, and useful templates for free download.
Table of Contents
What are the Financial Statements?
Financial Statements are documents containing summarised data that describe an organisation’s financial activities, such as income, expenses, assets, liabilities, net worth, etc.
The three main types of financial statements are the balance sheet, income statement and cash flow statements. They provide different information about your business and are essential for various decision-making processes.
How are Financial Statements Produced?
There are several ways you can produce financial statements, including:
Excel Spreadsheets
If you are a small business or charity, Excel spreadsheets might be the ideal solution, especially for self-assessment. If you are looking at Excel bookkeeping, we will provide our free templates below.
Accounting Software
One of the easiest ways is to use accounting software. This is particularly useful if you have many transactions or employees to manage. Professional accounting software such as Xero and QuickBooks can help you produce accurate financial statements quickly.
Bookkeeper/Accountant
You can also hire a bookkeeper or accountant to produce your financial statements. This might be more expensive, but it will usually guarantee accuracy. If you are a Limited company hiring the services of an accountant is important to produce the financial statements in the correct format for Companies House and follow the generally accepted accounting principles.
We will now look in detail at each of the financial statements.
How to Read the Balance Sheet
A balance sheet is a fundamental financial statement that provides a snapshot of a company’s financial health at a specific point in time. It is called a balance sheet because it adheres to the basic accounting equation: Assets = Liabilities + Equity. This equation ensures that both sides of the balance sheet always balance out.
Company’s Assets
Assets are resources owned by the company which have future economic value. They can be tangible, like machinery, buildings, or cash, or intangible, like patents and trademarks. Assets are classified into two categories:
Current Assets:
These are assets that can be converted into cash within one year, such as cash itself, accounts receivable, and inventory.
Non-Current Assets:
These are long-term assets that cannot be readily converted into cash, like property, plant and equipment (PPE), and long-term investments.
Liabilities
Liabilities represent what the company owes to others. Like assets, liabilities are divided into two categories:
Current Liabilities:
These obligations need to be paid within one year like accounts payable, accrued expenses, and short-term debt.
Long-Term Liabilities:
These are obligations due beyond one year, like long-term loans and deferred tax liabilities.
Equity
Equity, also known as shareholder’s equity or net assets, represents the residual interest in the assets of an entity after deducting liabilities. In simpler terms, equity is what’s left over for the owners (shareholders) of the company after all the debts (liabilities) are paid off. It typically includes common stock, retained earnings, and other comprehensive income.
Each of our examples of financial statements is taken from Xero, although other software will have very similar reports.
Below is an example balance sheet; it shows the date of the balance sheet, the company it is for, and the individual sections that make up the report.
The balance sheet is critical in understanding a company’s financial position. It allows stakeholders – from investors to creditors – to assess the company’s liquidity, solvency, and investment potential. By comparing balance sheets over different periods, one can track changes in assets, liabilities, and equity to gain insights into a company’s growth, profitability, and risk profile.
How to Read the Profit and Loss Account or Income Statement
The income statement, also known as the profit and loss statement (P&L), earnings statement, or statement of operations, is one of the three core financial statements businesses and investors use. This statement provides a detailed summary of a company’s revenues, costs, and expenses over a specific accounting period – typically a fiscal quarter or year.
The income statement essentially shows you how much money a company has received (its revenues), how much it has spent (its expenses), and the difference between the two (its profit or loss) over a certain period of time.
Here are some key components you’ll typically find on an income statement:
Revenues/Sales:
This is the money earned from the business’s primary activities, such as selling goods or providing services. It’s often presented at the top of the income statement, hence the phrase “top-line” revenue.
Cost of Goods Sold (COGS):
These are the direct costs incurred in producing the goods or services sold by a company. It includes raw materials and labour costs directly tied to the production process.
Gross Profit:
This is calculated by subtracting the COGS from the Revenues. It represents a company’s profit after deducting the costs associated with making and selling its products or providing its services.
Operating Expenses:
These are the costs associated with running the business that are not directly tied to producing goods or services. They include salaries, rent, utilities, depreciation, and marketing expenses.
Operating Income:
Also known as operating profit or operating earnings, this is calculated by subtracting operating expenses from gross profit. It represents a company’s profit from its core business operations before interest and taxes.
Net Profit:
This is the bottom line of the income statement. It’s what remains after all costs, expenses, interest, and taxes have been deducted from the revenues. If the result is positive, the company has made a profit. If it’s negative, the company has suffered a loss.
Understanding an income statement or profit and Loss can help managers and business owners make numerous financial decisions. For instance, managers can use income statements to identify areas to cut costs or boost revenue.
Below is an example of the Income statement:
How to read The Cash Flow Statement
The cash flow statement, also known as the statement of cash flows, is one of the three essential financial statements that reports the cash generated and spent during a specific period. It covers activities in three areas: operating, investing, and financing.
The cash flow statement complements the balance sheet and income statement by showing how changes in balance sheet accounts and income affect a company’s cash and cash equivalents and breaks down to provide an analysis of the firm’s operating, investing, and financing activities.
Ideally, the business will show a positive cash flow rather than a negative one; this shows that the business is generating enough cash from its operations to fund growth and pay off debt.
Here’s a brief overview of each section:
Operating Activities:
This section reports the cash effects of transactions that create revenues and expenses, thus affecting net income.
Investing Activities:
This section reports changes in cash resulting from activities that often involve long-term assets, investments and property. It includes making and collecting loans, acquiring and disposing of investments and productive long-lived assets.
Financing Activities:
This section reports cash changes resulting from transactions with lenders and owners. Examples include obtaining cash from issuing debt, repaying the amounts borrowed and receiving cash from or distributing cash to owners.
Understanding a cash flow statement is critical to assessing a company’s liquidity, flexibility, and overall financial performance. Investors can use it to understand how a company’s operations are running, where its money is coming from, and how it is being spent.
How to Read Financial Statements – Financial Ratios?
Financial ratios are mathematical comparisons of financial statement accounts or categories. These relationships between the financial statement accounts help investors, creditors, and internal company management understand how well a business performs and areas of improvement.
Financial ratios are most useful when they compare a company’s financial performance against its industry peers or historical performance. They are also valuable tools that can help stakeholders decide about investing, lending, and other business strategies.
Here are some key types of financial ratios:
Liquidity Ratios:
These measure a company’s ability to pay off its short-term debts as they are due. Examples include the current ratio and the quick ratio.
Profitability Ratios:
These measure a company’s ability to generate earnings relative to sales, assets and equity. Examples include the gross profit margin (gross profit divided by net sales), operating profit margin (operating income divided by net sales), and return on equity (net income divided by shareholder’s equity).
Debt Ratios:
These measure the firm’s ability to repay long-term debt. Examples include the debt ratio (total debt divided by total assets) and the debt-to-equity ratio (total debt divided by total equity).
Efficiency Ratios:
These measure how effectively a company uses its assets and liabilities internally. Examples include the asset turnover ratio (net sales divided by total assets) and inventory turnover ratio (cost of goods sold divided by average inventory).
Understanding and using financial ratios effectively requires knowing which data from the balance sheet, income statement, and cash flow statement to obtain the needed information. By studying these ratios over time, you can track trends in a company’s financial performance and identify potential problems or areas of strength.
Free Financial Statements Templates
At Business Accounting Basics, we offer many free Excel bookkeeping templates. These templates include the following financial statements:
Cash Book – This is an easy-to-use spreadsheet to record the bank transactions of a small business. Once all the transactions are posted, the totals page will show the profit and loss account for the year.
Balance Sheet – A simple balance sheet for small business
Cash Flow Statement – An Excel template to produce a cash flow statement for small businesses.
How to Read Financial Statements Conclusion
Financial statements are an essential tool for companies to keep track of their financial health and performance.
By understanding and knowing how to read financial statements and the different components of a balance sheet, income statement, cash flow statement, and financial ratios, investors can make better decisions about whether or not to invest in a company.
These documents provide valuable insight into how well a business manages its finances and operations, which helps creditors evaluate creditworthiness. With this knowledge, you can assess any potential investments or expenditures confidently!
