How to Read and Understand Financial Statements

What are Financial Statements?

Financial statements were created to make a better overall sense of one’s financial picture. Before financial statements companies used giant ledger books to write down all the transactions and tally everything up. Now they create an easy way to track how things are moving around and help get a better sense of how things are going from a debt perspective, as well as an asset and liability perspective. Financial statements create a standard way for a business to track how the financial side of their business is running.  

Profit and Loss

The profit and loss looks at a period of time. For example we could look at profit and loss as a monthly, quarterly, fiscal year to date, or a whole year basis. The profit and loss shows you all the revenue for that period, as well as all of the expenses made during that period. It’s important to note that profit does not equate to cash. This is because the timing of payments may not be taken into account. You could send an invoice to a client in August and they may not pay it until September.

Additionally, there may be yearly expenses that we use everyday, such as insurance for company goods. Even though it’s paid yearly, it should be reported as a monthly expense. So the cash will be impacted immediately but the expense will be recognized on a monthly basis.

How to Read Your Balance Sheet 

Your balance sheet outlines what you owe and what you are owed. This is your assets, your liabilities, and your loss. Your assets include your cash and cash equivalent. 

There is also your accounts receivable, which is something that you are owed, such as an invoice that hasn’t been paid. This revenue is recognized in the profit and loss sheet right away, but it remains on the balance sheet as money that is owed. Once that balance is paid, it will go into cash and out of accounts receivable. Next, there’s fixed assets. These are purchases that are used for long term use and are tracked on the balance sheet.

The liability component is who you owe. These may be payable bills that haven’t been paid right away. This means that the expense sits on the balance sheet as money because the expense hasn’t been paid. When the bill is eventually paid it will bring your cash down. This is why it is important to remember that on financial statements, profit does not equate to the cash balance that will be in your bank account. 

Finally we have loss. At the end of each year the total profit for the year gets moved from the profit and loss section of your balance sheet and over to your equity section. This will have an account called retained earnings which tells you how much profit the company has left over from the fiscal year. 

A tip for reading financial statements is to remember this simple formula: Liability + Equity = Assets.

Top 3 Common Financial Mistakes to Avoid 

1. No or Poorly Set Up Accounting Software. This results in an inability to track business results and makes it easy to make errors causing the numbers to be unreliable. As a solution, implement/re-implement Quickbooks Online or Xero
2. Poor budgeting and forecasting creates no financial goals for the year and means you have no way to know if you are on track. It also makes it hard to make decisions when unexpected expenses or opportunities arise. In order to solve this, remember to set a budget annually and adjust the budget if there are any major changes to the business during the year. Also remember to review the budget-to-actual results monthly to ensure you are on track! 
3. Inflexible Fixed Expenses. This puts financial strain on the business unnecessarily and can easily be solved by budgeting and planning your spending.