Financial Statements 101

Whether you are looking to purchase a business, sell a business, or ensure your current business maintains its financial health, financial statements are key to making the right decisions. Ideally, a company should prepare financial statements monthly, quarterly, and annually. There are four main components to a financial statement: (1) the balance sheet; (2) the income statement; (3) the statement of owner’s equity; and (4) the statement of cash flows. Often times, footnotes will be prepared along with the financial statements at year-end to provide more detail on the company’s financial results. What do these statements and footnotes reveal? Why should they be analyzed? We answer all of your questions in this blog.

BALANCE SHEET

The balance sheet is arguably the most important financial statement of all. It allows you to clearly see your financial position at a particular point in time. For example, you can see where you sit financially at month-end, quarter-end,  and year-end, and whether your financial position is sufficient to fund future operations.

The balance sheet consists of assets, liabilities, and equity, and must always balance. The equation for the balance sheet is: Assets – Liabilities = Equity (or net worth). The balance sheet also distinguishes between long-term and short-term assets and liabilities. Appropriately distinguishing between long-term and short-term is key, as it allows users of the financial statements to determine whether the company has sufficient short-term assets to fund its short-term obligations. For example, if the majority of a company’s assets consist of property and equipment used for operations (long-term assets), it is unlikely these assets can be liquidated to pay short-term debt and/or other liabilities. On the other hand, if the company has a large amount of cash on hand and minimal short-term obligations, it might be time to consider investing the excess cash in assets that will provide a return for the company.

A company’s equity, or net worth, primarily consists of Retained Earnings + Contributions – Distributions. Retained earnings are the accumulation of a company’s earnings and losses since its inception. In general, positive equity represents that a company has been profitable over time and/or there has been a large amount of capital contributions. Negative equity, or a deficit, typically implies that a company has incurred continued losses and/or that its owners are taking distributions that are too large. There are situations where a deficit may be reasonable, particularly in regard to start-up companies; however, a continued deficit over time may raise questions as to whether the company is sustainable.

Statement of Owner’s Equity

The statement of owner’s equity breaks down the details of a company’s equity balance, which is summarized on the balance sheet. Depending on the type of entity, the statement of owner’s equity will show common stock, additional paid in capital (money contributed by owners of the company), retained earnings, and distributions. The details of the statement of owner’s equity can provide insight as to why a company’s net worth may be increasing or decreasing. For example, a company may be recording income each year, but finds that its net worth is decreasing. In this scenario, the statement of owner’s equity will likely prove that the company’s distributions are exceeding income resulting in a net decrease in equity.

The most important thing to remember about a company’s equity balance is that it must always roll from year-to-year. In short, this means that the prior year’s ending equity must equal the current year’s beginning equity.

INCOME STATEMENT

The income statement, in contrast to the balance sheet, provides a picture of a company’s performance over a specific time period. The income statement can be used for benchmarking, pricing, fixed and variable costs, and break-even calculations. Similar to the balance sheet, income statements should be run monthly, quarterly, and annually. This way, a company can compare how it has performed throughout the year and analyze any large fluctuations. The income statement consists of sales, cost of sales, operating expenses, and other income and expenses that make up a company’s final net income or loss for the period. Below is a brief description of each component:

• Sales- Represents revenues a company has made from its operations (for example, hauling a load for a trucking company)
• Cost of Sales- Represents the cost a company incurs to generate a sale (for example, truck driver wages and fuel.)
• Operating Expenses- Expenses incurred by a company regardless of whether sales are generated (for example, rent, office supplies, utilities, salary of the bookkeeper, etc.)
  • * If you are unsure whether an expense should be categorized as cost of sales or as an operating expense, ask yourself the following questions: “Is the expense dependent on making a sale? Or does the expense amount fluctuate based on the volume of sales?” If the answers to these questions are no, it is likely an operating expense. If a trucking company were to produce no revenue for a week, there would be no fuel expense and no driver wages; however, the company would still have to pay its rent, utilities, bookkeeper, etc.
• Other Income and Expense- These amounts all relate to non-operating expenses of the Company such as interest income or expense, insurance proceeds, investment income, etc. Non-operating income and expenses are transactions that are not part of day to day business operations. For example, if a trucking company sells one of its old trailers, the gain from the sale of the trailer would be recorded in other income because the company is in the business of transporting goods not selling equipment.

Properly categorizing income and expenses in the income statement allows companies to make better business decisions. Gross margin, which is calculated as sales minus cost of sales, allows a company to see how much revenue is left after considering the cost it took to make a sale. If gross margin as a percentage of total revenue is declining, then it might be time to review specific components of cost of sales. Such components might include supplier contracts, labor hours versus production, fuel costs, etc. On the other hand, if a company finds that its margins are strong, but its net income is declining, it is time to perform a review of operating expenses. If income and expenses are consistently categorized in the correct buckets, it is much easier to identify fluctuations and ensure the proper steps are taken to keep the company's margins and net income going in the right direction.

STATEMENT OF CASH FLOW

The statement of cash flow reveals changes in cash from one period to another.  It is key to remember that income is opinion, and cash is fact, when running a business. Although your income statement might show an increase in revenue, if the majority of that revenue is sitting in accounts receivable and not getting paid, the company may appear to be performing well financially, but it is actually strapped for cash.

There are three components to the statement of cash flow: (1) operating activities; (2) investing activities; and (3) financing activities. 

Operating Activities

Operating activities refer to any cash generated from business operations, such as selling products or services. Reductions in operating cash flow may include purchasing inventory, paying suppliers, or an increase outstanding customer balances. Typically, operating cash flow should be higher than or equal to net income.

Investing Activities

Investing activities show how a company is investing in its future. Cash used to purchase fixed assets and investments will appear as a reduction in cash flow. Similarly, the sale of fixed assets or investments will appear as an increase in cash flow for the reporting period. 

Financing Activities

Financing activities include all cash transactions related to owners and creditors. When a company takes out a loan, this represents an increase on the cash flow statement as the company is receiving cash. As the company pays back the loan it will result in a decrease in the cash flow statement. The financing section also includes distributions to owners (decrease in cash) and capital contributions (increase in cash).

The sum of the operating, investing, and financing sections represents the increase or decrease in the company’s cash balance over the period being presented. If a company finds its net income is increasing and cash is decreasing, the statement of cash flows may help identify the reason why. It could be possible that the company is paying its suppliers and employees every two weeks, but only receiving payment from customers every month. This results in a two-week delay of the inflow of cash compared to the outflow.

FINANCIAL STATEMENT FOOTNOTES

Footnotes to financial statements are a cheat sheet to a company and provide additional details about performance, accounting policies, commitments and contingencies, ongoing litigation, subsequent events, and any other information considered to be material to the financial statements.  

WHY FINANCIAL STATEMENTS SHOULD BE EVALUATED

If you want a clear picture of financial health, you need financial statements. Financial statements are evaluated to make informed decisions internally and externally. Internally, these statements are used for performance evaluation, planning, and management analysis. Externally, multiple parties rely on this information. Investors need proof they are making sound investments, lenders need to know a business can repay its loan. Other third parties include suppliers, regulators, and sometimes even customers.  

Although financial statements are necessary, they can be complex. If you need help analyzing your financial statements, or even getting them started, contact Lutz today.