Here's How Your Financial Statements Tell the Story of Your Business
The language of Business is numbers and accounting
The first time you lay your eyes on your business’s financial statements, it might be hard to see past the wall of numbers as anything but cold hard data. But within these numbers is the story of your business. You just need to understand the language in which the story is being told.
Accounting is a process used to analyze financial data, from how much money you earned to how much you for various taxes. We look at the data through standard financial reports, also called financial statements.
These statements are produced through the bookkeeping process. Bookkeeping is the part of the accounting process where financial transactions are recorded into bookkeeping software — the books.
The three main reports are the income statement (also called the profit and loss statement or P&L), the balance sheet, and the statement of cash flows (also called the cash flow statement).
These are the three main reports that your bookkeeper (who may or may not also be your accountant) will typically send to you each month so you can see how your business is doing month over month.
The reports are important because they’re used for your tax filings, but they also tell the story of how the business is doing. They’ll tell you if the business growing, remaining sustainable, or shrinking. They’ll also reflect the impact of any recent changes or decisions you’ve made within your business. Anyone who has a vested interest in the business’s success will want to make sure to understand how to read the story of the business’s financials.
Now that we know why financial statements matter, let’s unpack how to use them to tell the story of how your business is doing.
The Income Statement
Revenue - Expenses
All financial statements and reports are standardized. In the same way stories in other mediums typically have a standardized format of three acts, all financial statements are standardized. All income statements will show a business’s income minus its expenses over a period of time. For example, revenue and expenses over the previous month or previous year.
Revenue is the income the business receives from selling products or services.
Expenses are what it costs to manufacture products or provide services (cost of goods sold) and to run your business in general (overhead expenses).
The cost of goods sold can also be called direct costs, which are costs a business has that are directly related to producing the product they sell or the service they provide. For example, if you run a production company, the art department costs and labor required to produce each campaign are costs of goods sold or direct costs. But the lawyer you pay to draft your terms and conditions and the bookkeeper you pay each month are the second category of expenses, overhead costs.
Costs can also be fixed or variable. For example, your labor cost goes up with each commercial you shoot, but the rent you pay on your studio is fixed no matter how many jobs you have that year. Generally, businesses want to minimize fixed costs and control their variable costs because lower costs mean you spend less of what you earn. This is profit, hence the name profit and loss.
Here is the story your income statement tells
It reflects how efficiently your business operates . You’ll also be able to see what costs you need to keep a close watch on, so your business remains sustainable. It’ll help you figure out the difference between what it costs to produce your product or provide your service compared to what you make/charge the customer. In other words, it will help you understand if your business is profitable and how efficiently it operates.
Understanding your income statement’s story can help you make better decisions when it comes to how much you’re spending and how much you need to be earning.
Balance Sheet
Liabilities + Equity = Assets
Remember, all of the financial statements and reports are standardized. When it comes to the balance sheet, the standard report will tell you what your business has (cash and assets) and what it owes (liabilities) so you know what it’s worth (equity) on any given day. It’s like a photograph of assets, liabilities, and equities on a single day of your business, so for example, December 31.
Your assets are everything your business owns. This includes cash, inventory, and even fixed assets, like equipment and buildings.
Your liabilities are what you owe. They’re the balances for debt your business owes like loans and credit cards. They’re also other expenses that you need to pay*, but haven’t yet, income taxes you need to pay (tax payables) or upcoming bills.
*In accounting, payables are liabilities. When you pay payables, they become expenses. It’s a bit like a tadpole becoming a frog. [ILLUSTRATION PAYABLE TO EXPENSE]
Lastly, your equity is what you're worth. If you sold your assets and paid off your liabilities, your equity is what’s left. In accounting terms, equity is money put into the business (shares or ownership), profits paid out of the business (dividends), and earnings retained in the business (retained earnings).
Here is the story your balance sheet tells
The balance sheet tells you whether your business is healthy in terms of what it has and what it owes. It’ll show you how much cash the business has on hand. Which can help you answer some bigger questions, like do you have enough cash to pay your bills? How much debt do you have in total? Can the company meet its debt obligations each month? Can your assets cover liabilities? And what is the debt-to-equity ratio (how much debt your company has compared to what it’s worth)? And is your company solvent (this means your assets can be used to reduce your liabilities to $0)?
Once you understand the story your balance sheet is telling, you’ll have another dimension to understand the financial health of your company. Instead of just looking at income and expenses, you’re looking at what you have and what you owe. You’ll know how much the company is actually worth, which is important to think about if you ever want to sell your business or ask a partner to come on and buy into the business. If you want to take on a loan to expand, you’ll want to know the story your balance sheet tells you.
Statement of Cash Flows
Opening cash + Net increase or decrease of cash during the period = Ending cash
As its name suggests, the statement of cash flows helps you understand how cash flows into and out of the company. Cash is vital for a business. It’s like oxygen. And just like oxygen, it’s constantly moving in and out.
There are three main ways to look at how cash flows through your company.
There is cash going in and flowing out through normal operations. This is what we saw on the profit and loss statement.
Then there is how cash flows through your company via financing. Financing is borrowing money through loans. Remember that this was a perspective we saw by looking at the balance sheet.
The third way we saw cash moving through the company is through investments. One example is if you have investors that put money into your company or if, you, business owner, invests money into your company or pays dividends as a return on your investment.
Here is the story your cash flow statement tells
Your Statement of Cash Flows provides insight into how much money you received or used for financing, operations and investments during a particular time period. This financial statement will help you determine if your cash flow is positive or negative and how well your operations are without financing or investments.
Keeping an eye on your Statement of Cash Flow monthly or quarterly will provide an overview of your financial health. It helps you understand if your company is able to survive from operations or if investors or loan money is what has been propping it up. If the only thing holding you above water are investors and loans, the cash flow statement will make this clear. Then you can start to determine what changes you need to make to succeed.
Each financial report helps tell the story of how your business is doing
Together all three of your financial statements help tell you the story of your business in a holistic and multidimensional way.
They provide fruitful insight into your cash flow, your costs, your assets, and liabilities. With this information, you can then start to look toward the future potential of your company. Understanding the story of your financials may help you catch problems before they impact your bottom line and will help investors understand how profitable you are.
Every detail, every number, and statement you look at is your story.
Learning how to understand accounting doesn't need to be scary. Just by taking the time to learn how to understand these three financial statements, you'll improve your ability to navigate business decisions big and small.