Financial statements serve several purposes for small businesses. While there is more than one financial statement, you may not know which is most appropriate to use for your specific financial calculation. There are also a few limitations to be aware of as well.
Here’s an overview of financial statements and the types of financial statements used by small businesses.
What are Financial Statements?
Financial statements provide an overview of the financial status of small businesses. These statements are helpful because they each illustrate a different measure of the financial position of a small business.
What are the 3 Main Types of Financial Statements?
There are three main types of financial statements:
- Balance sheets
- Income statements
- Cash flow statements
An explanation of each financial statement is below.
Balance sheets provide an illustration that shows the financial position of a business. Balance sheets allow potential shareholders to see the net worth of your business.
A balance sheet contains three accounts in the general ledger: assets, liabilities, and equity.
There are two categories of assets: liquid assets and non-liquid assets. Liquid assets are cash or assets that you can convert into cash.
- Accounts receivable
- Cash and cash equivalents
Assets can also be non-liquid. These are assets you can’t convert into cash quickly. Non-liquid assets include:
- Franchise agreement
- Intangible assets
Liabilities consist of what you owe and can be current liabilities or long-term liabilities.
- Debt including long-term debt
- Dividends payable
- Wages payable
Current liabilities are liabilities due within one year and includes:
- Accounts payable
- Building and equipment rents
- Sales tax
Long-term liabilities are liabilities due over one year. Long-term liabilities include:
- Deferred tax liabilities
- Long-term debt, including interest and principal on bonds
- Pension fund liabilities
Shareholders’ equity is what remains after you deduct assets from liabilities. The second category of shareholders’ equity is retained earnings. This is what the corporation, or small business, will keep.
How to Use a Balance Sheet
Using a balance sheet is a simple process. On a sheet of paper (or document), you’ll first list your company name and balance sheet information (including the date).
Next, you’ll list assets in the upper left portion. Beneath assets, you’ll list your current assets, along with a total. Beneath your current assets total, you’ll list your fixed assets with their sum. Finally, at the bottom left portion, you’ll calculate your total assets.
You’ll do the same process with your liabilities and equity. First, you’ll list liabilities, including current liabilities, along with a total. Beneath your current liabilities total, you’ll list your long-term liabilities with their sum. Then you’ll calculate your liabilities.
Next, you’ll list your equity and total it. Your liabilities and equity combined should equal your assets.
Income statements are another financial statement you can use. Income statements are also known as profit-and-loss statements.
Income statements provide a glimpse into a company’s performance over a particular duration. This statement tracks:
Gross profits are what remains after you deduct revenue from the cost of goods sold or COGS. Costs of goods sold don’t include indirect expenses. Instead, COGS includes:
- Direct labor
- Direct materials or Raw materials
- Manufacturing overhead
Gross profits differ from net profits because gross profit doesn’t include debt, taxes, or other business expenses.
Net profit is the total income after deducting costs, expenses, and revenue. On an income statement, the net profit is written last. It’s what the income statement seeks to find as an answer.
Net profits are also known as net income.
How to Use Income Statements
Income statements provide a calculation of your small business’s net income. This calculation is the total of your revenue plus your gains, minus your expenses plus your losses.
First, you’ll list your revenue amounts. Next, you’ll list your expense amounts. Third, you’ll record any gains, and finally, you’ll list any losses. Using the above formula, you’ll determine your business’ net income.
Cash Flow Statements
Cash flow statements are the third main financial statement. This statement provides information regarding how your small business makes its money, spends its money, and how it operates.
You’ll use cash flow statements to determine a longer duration of finances, typically a fiscal year.
How to Use a Cash Flow Statement
While the balance sheet and income statement provide a short-term overview of your small business finances, a cash flow statement has essential uses for future opportunities.
Three are four sections for a cash flow statement:
- Cash Flow from Operations
- Cash Flow from Investing
- Cash Flow from Financing
In each section, you’ll list the amount, including cash-ins (when capital is raised) or cash-outs (when dividends are paid). The total will be the cash flow for a period.
Financial Statement Ratios or Calculations
There are six financial statement ratios, with different ways to calculate the value of your company:
- Working Capital Ratio
- Quick Ratio
- Earnings per Share (EPS)
- Price-Earnings (P/E) Ratio
- Debt-Equity Ratio
- Return on Equity
The working capital ratio is the ratio between the current assets and current liabilities of a small business. To determine the working capital ratio, you’ll divide your current assets by current liabilities.
The quick ratio calculates how current liabilities can be paid for by cash or items with a cash value. You’ll evaluate a quick ratio by subtracting inventories from current liabilities first. Then, you’ll divide that amount into liabilities.
Earnings per share, or EPS, is a measure of net income earned on a business’ common stock. To determine this amount, you’ll divide the company’s income by the weighted average number of outstanding common shares throughout the year.
Price-Earnings (P/E) ratio is a ratio that reflects an investor’s assessment of future earnings. To calculate this ratio, you’ll figure out the share price of a company’s stock. Then, you’ll divide the amount by the EPS to determine the P/E ratio.
The debt-equity (D/E) ratio is another financial ratio you can use. You’ll calculate this ratio by adding any outstanding long-term and short-term debt. Then, you’ll divide it by the book value of shareholders’ equity.
Finally, you’ll use the return on equity (ROE) ratio to figure out how profitable shareholders’ capital is in a small business.
You’ll determine this amount by listing net earnings after taxes, subtracting the net earnings from preferred dividends. Then, you’ll divide this amount by the common equity dollars in your business.
While financial statement ratios or calculations can help you, there are significant limitations you should know.
While the working capital ratio is suitable for establishing your assets and liabilities, it can be challenging to know which to use from your balance sheet.
A second limitation for both EPS and P/E is that negative earnings will make both ratios ineffective by leading to not applicable (N/A) results.
How to Use Financial Statements in Business
Financial statements are essential for organizational purposes, but they are also valuable for business opportunities.
Investors will need to examine your financial statements if you ever seek external investments. These investors will look at your statements to see how you’ve allocated money to see if your small business is worth investing in.
Second, financial statements are also useful for loan opportunities. Banks, credit unions, and other financial institutions will need to see your financial statements for potential loan opportunities.
A third way you can use your financial statements for business purposes is for taxes. By having your financial statements organized, you’ll have an easier experience with filing or paying taxes.
Work with an Accountant
Financial statements are extremely important when considering the past, current, and future stages of your small business. However, help with each statement will ensure that you don’t have a stressful time while you could attend to other matters.
When you need help figuring out what to do with your financial statements, work with an accountant. Work with the accountants at 1-800Accountant for your financial statement and small business needs.