This article explains the basic financial statements and the respective individual reports. At points throughout, this article uses a BLUE word or words to link you to a more detailed article related to that particular subject.
A set of financial statements or what is also called a financial report is comprised of five separate reports as follows:
- Balance Sheet
- Income Statement
- Retained Earnings
- Cash Flows
For any new or beginner in understanding these reports you need to understand that the reports are generally prepared in one of four different basis (economic recording methods) of accounting. There is the traditional and basic cash basis reporting which is used by extremely small business operations. Most third party creditors and outside readers of these types of reports will discount or refuse to accept them as cash basis accounting is not considered sophisticated for business activity. Cash basis is also customarily used for tax purposes by most small businesses.
Sophisticated business activity is appropriately accounted for using the accrual basis of accounting. This means that every economic transaction through the date of the report is recorded to the books of record and nothing is withheld. This method is required for publicly traded financial reports.
The third basis of reporting is called modified accrual or industry compliance reporting. Simply stated some industries use a particular type of accounting in order to present a clearer financial status due to a higher reliance on the process or a particular asset. Examples of industries that use industry specific include non-profits, mining and oil extraction, banking and government service agencies. Even your local government uses a particular type of accounting and reports financial information in a unique way.
The final basis of reporting is tax basis and is rarely used and it is often cash based and not accrual based for accounting purposes.
If you are interested in learning more about these different forms of accounting, please read: Various Sets of Accounting Books.
For the average small business operation accrual accounting using industry terms is most appropriate for reporting purposes. So let’s discuss the five separate reports.
In a typical set of financial statements the balance sheet is the first report presented. The balance sheet reflects existing assets against the corresponding liabilities and equity combined. The reason it is called a balance sheet is because the two halves are equal or ‘balanced’.
There are several different names for a balance sheet and depending on the industry or the nature of the entity determines the proper name for this particular report. Some examples include:
- Statement of Financial Position – name currently advocated by the International Accounting Standards Board to replace the term ‘Balance Sheet’. This newer name is advocated because it is oriented towards the function of the statement. It will ultimately happen but we are talking about tens of years before it is fully accepted. Currently this name is the most commonly used name for this report with non-profit organizations and churches.
- Fund Balance – this a rarely used report name but basically it refers to total assets in excess of all liabilities which equates to the total equity position or ‘Fund’ balance.
- Statement of Net Position – this name is almost exclusively used by local governments and agencies. The reason for this is because governmental entities should have a low or almost nil financial position as most state laws prohibit governments from having excess funds or equity. In effect to have an equity position means that the local government is generating revenues via taxes that are in excess of what they spend. The goal of government financial management is to only raise the amount of revenue to match the corresponding expenses to operate the government. Therefore there would be no net income and no accumulation of net earnings over time and thus no ‘Net Position’.
What most small business owners fail to understand is that this particular report reflects the status of all assets and all liabilities along with the corresponding equity at a given moment in time. It is extremely easy report to manipulate. A smart business owner can easily contribute capital at year end which increases the cash balance, changes several financial ratios and then at the beginning of the new year take back his capital contribution. Thus the report looks great but in reality it isn’t. This isn’t illegal except in publically traded entities or in registered entities. So for readers, they need to understand the dynamics of this report.
Another key attribute of the balance sheet is that it can change significantly in a single moment based on one or two transactions. A good example is management purchasing an expensive asset such as a piece of equipment and borrowing money to make the purchase. Both the asset side of the balance sheet increases and the liabilities section increases in a corresponding amount. Both sides of the balance sheet stay in balance.
The balance sheet reflects assets and liabilities at a single moment in time. The traditional reporting date is at year end. The balance sheet can change significantly from day to day depending on the nature of activities conducted by management.
Experienced readers of the balance understand this dynamic and use the report to gain an understanding of the overall asset position and the liability situation. Basically the reader wants to understand the equity status of the business operation.
Below is a simple balance sheet for illustration:
December 31, 201X
Fixed Assets 135,000
Other Asset 12,500
Total Assets $157,500
Long-Term Note 78,100
Total Liabilities & Equity $157,500
Notice how the assets equal the total liabilities and equity of this business. The obvious fixed asset is a boat and the long-term note is attached or assigned to that boat. More importantly the reader can deduce that the business does well because the equity position is almost half the asset value of the company. So this report would tend to inform the reader that the business is financially sound whereas most small businesses are ‘Thinly’ capitalized. Thinly means less than 10% of the entire asset portion is financed by the equity.
For any owner of a small business your goal should be zero debt and a strong equity position related to assets. The higher the equity is as a ratio of assets the more financially sound the operation is.
I have written many articles related to the balance sheet and if you desire to gain a higher level of understanding I encourage you to read the following:
- How to Read a Balance Sheet – Simple Format
- How to Read a Balance Sheet – Equity Section (Simple Format)
- An Explanation of Current Assets
- The Fixed Assets Section of the Balance Sheet
- The Current Liabilities Section of the Balance Sheet
- Long Term Debt – Financial Statement Presentation
- Quick Ratio – Definition, Explanation and Proper Use
For you the important lesson here is that the balance sheet is the accumulated lifetime financial position of the company as the date in the header. To understand the impact of the current accounting period the reader will want to see the income statement.
What is really interesting about this particular report is that the most common name isn’t ‘Income Statement’ but ‘Profit and Loss Statement’ or P&L. Accountants use the term ‘Income Statement’ whereas the common businessman says P&L. Basically the two terms are interchangeable. I use P&L throughout my articles mostly because it is more widely accepted.
Other titles for the same statement include:
- Statement of Earnings – used by mining and oil exploration entities.
- Statement of Comprehensive Income – this title is advocated by the international community over the GAAP name of ‘Income Statement’.
- Statement of Activities – government based term
- Statement of Revenues, Expenditures and Changes in Fund Balances – governmental and non-profit based
- Sources and Uses of Funds – one of the titles used by non-profits
The P&L is time period driven. This is important for the reader to understand. When you look at the title of the document it will specifically state the time period the statement covers. In more formal sets of financial reports the time period is usually the fiscal or calendar year. In the small business world the time periods are usually a month or a quarter. So the header will look like this:
Profit and Loss Statement
For the 12 Months Ending December 31, 201X
Profit and Loss Statement
For the Month Ending June 30, 201X
The purpose of the statement is to identify the net profit earned during the period reported. The problem with this is that the term ‘Net Profit’ is defined differently for small business than for publically traded operations. Many small businesses are taxed on the profit at the owner’s level and this is referred to as pass-through as the net income is assigned to the owners for tax purposes. The most common entity format that allows this is the S-Corporation. Other pass-through business entities include Limited Liability Companies, Partnerships, Limited Partnerships, and Trusts. All these entities use Form K-1 to notify the IRS and the owners of the taxable income assigned.
In a taxable entity such as a regular corporation the net income reflects the amount earned as profit after taxes. So for the reader, when you look at the net profit of a P&L always ask if this is before or after income taxes.
In general the P&L is divided into three distinct sections. The first is revenue and revenue includes all sources of income including the main source of sales. Yes, there is a difference between revenue and sales. The second section is labeled ‘Cost of Sales’ and has many different titles as the following illustrates:
- Cost of Goods Sold – traditional retail title
- Cost of Services Rendered – professional organizations and service based industries use this title
- Cost of Meals Served – food service industry
- Costs of Construction – residential and commercial construction
- Costs of Manufacturing – self explanatory
- Costs of Departmental Operations – commonly used in hospitality and multiple division types of companies
The third section is called ‘Overhead’ or for most publicly traded operations ‘General and Administrative’ or G&A. Small business uses ‘Overhead’. Overhead is comprised of general expenses such as rent, office operations, management payroll, insurance, taxes, professional costs, licenses and others. In general these costs are not directly related to the product sold or service rendered.
So the P&L looks somewhat like this:
Profit and Loss Statement
For the Month Ending June 30, 201X
Cost of Fishing (ZZZ,ZZZ)
Gross Margin ZZ,ZZZ
Net Profit $Z,ZZZ
Most P&L’s have more detail than this but notice the three major sections of revenue, costs and overhead.
I want to point out the wording used. Most readers believe due to hearing the term frequently that the costs section should only be called Cost of Goods Sold. Cost of Goods Sold is the generic phrase used in accounting and in the education process. However, for the small business owner, you should use the Cost of ???? to reflect exactly what you do in business. If you build steel structures then use Cost of Fabrication, if involved in trucking use Cost of Transportation, if involved in storage, use Cost of Warehousing and so on. Stay focused on your business so that any outside reader can quickly understand what you do for business. Remember the most common outside reader will by your bank or investment group.
One last important connection for everyone to understand; the last line is the net profit or ‘Current Earnings’ and should also be in the Equity section of the balance sheet. In general the Retained Earnings part of the Equity section is the lifetime accumulated earnings except for the current reporting period from the P&L. If they do not match, make sure the dates are the same for the two reports. The balance sheet should reflect the last day of the reporting period covered by the P&L. If you want to have an in-depth understanding of this relationship then read: Retained Earnings – How it Works.
Now that I’ve introduced retained earnings it is time to transition to the third report in the financial statements.
The equity section of the balance sheet is divided into two main groups. The first group is the investment group whereby the values reflect the initial and ongoing investment made by all owners and those with rights of ownership. Traditional impressions for most novice and intermediate business investors include the initial purchase of stock and other issues of stock. In addition this section includes preferred stock and convertible instruments.
The second section of the equity section identifies the lifetime to date earnings of the business. Different terms are used depending on the nature of the business i.e. the legal format. But the most common name is Retained Earnings. Other names for this section include:
- Statement of Shareholder’s Equity
- Statement of Owner’s Equity
- Statement of Changes in Owner’s Equity
- Statement of Partner’s Equity
- Statement of Changes in Partner’s Equity
The names reflect the legal status of the entity. For shareholder’s it is a corporation. Owner’s is a term for sole proprietorship and ‘Partner’s’ is a term used for traditional partnerships or the more modern day limited liability corporations. Sometimes the term ‘Member’s’ is substituted for ‘Partner’s’ as the term member is the correct legal term for a limited liability corporation.
In a corporation format this section or statement identifies the lifetime to date earnings of the business. Basically the format follows the mathematical formula used to determine retained earnings as follows:
- Beginning Balance – the balance of the retained earnings for the period of the report; similar to the P&L the report covers a period of time and the beginning balance is the carryover balance from the prior period. For most operations this report is an annual statement therefore the beginning balance is the balance on January 1 of the year reported.
- Add Earnings – the net income or loss as reported on the P&L for the period of the statement is inserted here.
- Add or Subtract Extraordinary Items – although rare sometimes some prior period issues were reported incorrectly so their respective effect on retained earnings is inserted here to adjust the retained earnings.
- Less Dividends/Distributions/Draws – depending on the nature of the entity any dividends (C-Corporations), distributions (S-Corporations, Trusts, LLC’s) or draws (sole proprietorship, partnerships) are recorded here.
- Ending Balance
If a partnership has a limited number of partners like only three or four, the statement is sometimes columned by partners such as the following:
Statement of Changes in Partner’s Equity
For the Period Ending December 31, 201X
Partner ‘A’ Partner ‘B’ Partner ‘C’ Total
Beginning Capital $10,100 $11,400 $9,700 $31,200
Earnings 107,000 141,300 98,000 346,300
Available Capital 117,100 152,700 107,700 377,500
Draws 87,000 105,000 86,000 278,000
Ending Capital $30,100 $47,700 $21,700 $99,500
For those of you not familiar with partnerships, the equity does not have to be equal; their ownership issues are dictated by the partnership agreement.
The key is that the report has a beginning balance, adds current earnings from the P&L and then subtracts any payments made to the owners and then identifies the ending balance. Notice the impact the draws have on the cash of the business operation? To analyze and review the cash situation of the company the financial statements use a cash flows report.
The statement of cash flows reports the sources and uses of cash for a business operation over the same time period as reported with the P&L. Basically the accountant takes the beginning cash balance on the first day of the reporting period and explains the changes in the cash balance that derives the ending balance. I have written an article that is really basic introduction to cash flow if you desire to learn the basics; it is an example of a really small business and how Cash Flow – A Basic Definition works.
The report is sometimes called the Sources and Uses of Cash Report.
There are two different methods to derive the change in cash balance. The first method is referred to as the indirect method which is merely a condensed version of the second method called the direct method. The direct method is a line by line report that takes the net profit from the P&L and adds and subtracts cash adjustments related to the P&L first and then each of the respected line items on the balance sheet. For you the key is that there are four values you need to use in evaluating overall performance. Three of the values are discussed below related to the respective sections of the cash flows statement. The fourth value is merely a summation of the three sections (values) and this is the total change in cash. Either cash increased or decreased since the start of the reporting period. This report explains how this change occurs. Remember cash is all the cash accounts combined; so it includes petty cash, your operating accounts, any trust bank accounts and the payroll account if you use one. All of these cash accounts are aggregated together for total cash in the company at the beginning and end. The difference is explained via the three sections of the report.
Both methods have three sections built into the report. The following are the three sections and a short explanation related to each:
Cash from Operations
Absolutely without a doubt this is the MOST IMPORTANT SECTION of the report. It clearly states if the basic core operation of the business generated positive cash flow to ultimately add value to the business. Basically the formula involved is this:
Net Income is the starting point. Think of this as the total cash earned from operations, however, it isn’t necessarily earned in the form of cash. So we have to make adjustments.
Additions to Net Income from the P&L:
Depreciation – remember this is a noncash expense which is arbitrary in nature.
Additions/Subtractions to the Net Income Related to the Balance Sheet:
Accounts Receivable – any change in the receivables over the period of time is either added or subtracted to the net income. If the receivables increased during the period this means customers did not pay their entire bill which means basically the business loaned them money (like giving them cash) and therefore the net income is decreased by this amount, i.e. the increase in receivables is subtracted from the net income. If the receivables decreased during this time period, the business collected more money from customers related to the past and therefore this increase cash, remember the customers pay with cash. So in this cash, the value is ADDED to the net income.
Accounts Payable – here your business borrows money from vendors or gets value from them. So if the payables increase it is no different than getting money from them, the only difference is you get some kind of good or service from them. If the payables balance decreases then you paid the balances down with cash which is a subtraction from the net income.
Accruals – very similar to payables except you are borrowing money from other sources such as credit cards, employees via accrued payroll or even the bank for a line of credit.
Inventory/Work in Process – when you increase the value of the inventory or WIP since the beginning of the period, you are effectively using cash to increase this balance. Therefore any increase in the value is a subtraction from net income and any decrease in value is an addition to net income.
Cash Flow from Operations
The formula is much more convoluted than above, but you need an accounting degree to make heads or tails of the very complicated formula. For almost 90% of all small business operations, the above more than covers the math. If the cash generated from operations is positive related to the above, then this is great. This is an important value to appreciate and understand as you want to know why operations generated cash or absorbed cash. Allow me to explain a little.
Suppose that the final number is a negative cash flow from operations of a few thousand dollars. Almost any reader would immediately go ‘Oh my God, I didn’t make money’. Well not necessarily, suppose that you paid down your payables more than the negative cash flow. Well this is a good business move. Anytime you reduce your debt it’s a great thing. So if you reduced your debt more than your negative cash flow it must mean you earned more than enough money to accomplish this which is good business. So I often explain to clients it isn’t about the value of cash flows from operations, it is about what you did with the cash that determines if you operated appropriately as a business owner.
On the flip side, suppose the number is positive several thousand dollars. OK, I would want to know what generated the positive value. If my receivables decreased more than the positive value this tells me that customers paid their bills but I may not have earned enough from the true core value of operations. So look at this report objectively and get your accountant to explain this to you when he hands the report over to you. You want to know if the core business itself generated positive cash flow. If it didn’t then you have a serious problem that needs some research.
Now there are other sources of cash and uses of cash in the business. The most common use of cash generated from operations is expansion of the business. Normally this is done by purchasing more equipment. Well this is a function of investing.
Cash from Investing
For any business operation investing involves either spending cash to purchase fixed assets or selling fixed assets to acquire cash. These are the two primary drivers of this section of the report. Other investing activities include purchasing intangibles or selling some other assets such as disposing of a long term note or sell some options or rights to an asset. All of these are referred to as investment activities.
Think of investing activities as going beyond the time period of the reporting period. The particular asset purchased or sold will either serve the business for a long period of time or was purchased in prior periods.
Now many of you reading this will say, ‘Well Dave, when I buy an asset I borrow money to purchase the asset like a truck’. Well this is normal so to address long term debt the third section is reported which is called financing.
Cash from Financing
This section of the cash flow report identifies the value associated with any borrowing and paying back on long term debt. In addition it includes any dividends/Distributions/Draws paid out to the owners of the business. In general it looks like this:
Cash from Financing:
Add New Borrowings $ZZZ,ZZZ
Subtract Principle Payments (ZZ,ZZZ)
Dividends Paid (ZZ,ZZZ)
Cash from Financing $ZZ,ZZZ
In general expanding operations tend to have an increase in the financing section has they continue to raise capital even if they issue more stock which is included in this section of the report. Older more mature operations tend to have negative cash from financing as the business lends itself towards rewarding the investors via dividends or distributions from overall operations.
The report is divided into these sections and the cumulative sum is combined to indicate the overall change in cash. This change should match the change between the beginning and ending balance for the cash of the business.
Most novice and even your sophisticated business owners have difficulty understanding this particular report. Don’t be alarmed or embarrassed as many CPA’s have a difficult time in generating this report. It took me a couple of years before I finally had the ‘A-HA’ moment and figured it out. For you the primary key is to understand that there are three major sections and the most important section is cash from operations as this will really identify if the business is making real money at the end of the day. The other two sections relate to long term cash issues.
To appreciate the totality of all the reports combined, the reader of a financial report should also read the notes to the financial statements as these notes clarify some of the issues related to the information presented.
The fifth and final report that is a part of the financial statements is notes. This section goes into more detail related to the statements as presented.
In general the notes start out by explaining what the company does as a business. Next it explains what method of accounting is used in presenting the preceding statements, e.g. cash, accrual or modified accrual. Then income taxes are explained. The most common note related to income taxes is a statement to the effect that the company is an S-Corporation and therefore income taxes are paid at the ownership level and not at the corporate level.
Other notes include:
- Fixed Assets – a note explaining what deprecation method is used and the expected remaining lives of the existing fixed assets on the books.
- Other Assets – this note provides more detail related to any intangible assets and if there is a long term receivable the associated interest rate the expected payoff date.
- Leases – a note explaining any existing leases, the expected annual obligation and the associated terms of the leases. In addition there is a chart presented that identifies amounts due over the next year, the following four years (note by adding year 1 and the 2nd line of years 2-5 you get the combined amount due over the next five years).
- Long-Term Debt – similar to leases, a statement about each long term loan and their associated terms are explained and a chart for principle amounts due over several years is presented.
- Ownership – a note identifying the majority owners of the business is presented. In general any individual or business that owns more than 10% of the company is identified.
- Reliance – if any single customer or contract generates more than 20% of the revenue for the business, this customer is identified for risk purposes. The larger the customer’s financial position especially any publically traded operations decreases the risk associated with reliance on the revenue stream. If the reliance is contract dependent, the terms of the contract are explained.
- Issues – any legal or accounting issues is detailed in this paragraph. The most common issue is a pending lawsuit or possible claim the business is currently addressing. A degree of likelihood and the associated financial impact on operations is revealed.
The business owner can add more notes at his discretion.
I encourage notes on an annual basis for the financial statements. For shorter periods of time or with the regular reporting of operations notes are not necessary unless some significant event has occurred.
For those operations that are contract dependent I encourage additional notes related to the respective contracts such as overall value, percentage of completion and expected margins from the project. If any project has issues, you should describe them and identify how these issues are getting addressed.
There are five sections of financial reports comprising the set of financial statements. The balance sheet identifies the ending date of the reporting period, the income statement identifies the time period covered, the statement of retained earnings illustrates the accumulated lifetime to date earnings of the business including the current period of the financial reports, cash flows statements is divided into three sections that combined reveal the change in cash since the beginning of the reporting period and finally notes add value to the reader by identifying any relevant issues related to information provided. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.
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