Understanding Financial Statements: How to Analyze Your Business's Financial Health

June 19, 2023
The Profit Plot


Welcome back to The Profit Plot, a podcast where we help small business owners unlock the story behind their profitable business by unpacking one complex financial topic at a time. Our mission is to make financial concepts more accessible, empowering you to make informed decisions and grow your business. I am your host, Jeremy Millar.

In today's episode, we'll be diving into the world of Financial Statements. Financial statements are ripe with potential value. They're much more than just a confusing array of numbers compiled by your accountant. Most people don't realize that financial statements are like a report card for your business. A concise overview filled with crucial insights into your performance and financial health.

Venturing to understand the underlying story packed into each statement can tell you a lot about your business, helping you make well-informed decisions and ensuring your long-term success.

We'll discuss financial statements' importance, explore three key statements, and share practical tips for analyzing your financial health.

I've spoken to many business owners who have simply never looked at a financial statement. Many of them take the position of: "If I look in my bank account and I have money, that's good enough for me."

As a small business owner, you're responsible for making countless decisions every single day. One of the most significant factors in actually making the right choices for your business comes from having a clear understanding of your financial health. Just looking checking your bank account balance is not enough.

This is where financial statements come in. They provide a snapshot of your business's financial performance, helping you monitor progress, identify trends, and spot potential issues before they worsen.

Your business's financial statements serve as a compass, guiding you through tough decisions and challenging market conditions. Regularly looking at your financials can help you stay on track and make course corrections when necessary, ensuring your business remains healthy and sustainable in the long run.

That's why it's so important to review your financial statements consistently; so that you can make more informed decisions and take proactive steps to improve your business's financial standing.

It's great to know that financial statements have an essential purpose, but abstractly talking about the benefits of using your financials as a guide doesn't exactly help us practically understand how they can help.

So, let's discuss the three key statements you need to be familiar with as a business owner: the balance sheet, the income statement (also called the statement of Profit and Loss), and the cash flow statement. I'll break down each of these statements and explain their components, so you can better understand how they relate to your business's financial health. But, in order to fully understand the breakdown of each financial statement, it's important to understand the basics of accounting first.

Accounting is a system that uses five different types of buckets: assets, liabilities, equity, income, and expenses. All financial activity in your business gets organized in your accounting system according to these buckets.

Assets are what your business owns. It's something of monetary or economic value that can be used for future purposes. Assets are easily thought of as things like bank accounts, vehicles, equipment, and real estate.

Liabilities are what your business owes. A liability is a monetary or economic value owed to another party. These are most commonly thought of as things like loans or business credit cards.

Equity is what your business has left over. In the accounting equation, your business's assets minus its liabilities are equal to the balance of its equity.

Income is money your business makes in exchange for the goods or services you sell. Every business needs income - it's the economic engine!

Expenses are the money that your business spends, typically in the form of cash or credit—purchasing software to help you be more efficient, paying your employees a fair wage, and even paying for the office to be cleaned. These are expenses.

Our financial statements are how the activity that occurs in each of these buckets is communicated on paper.

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Let's start with the Balance Sheet. Think of your balance sheet as a snapshot of your business's financial position at a specific moment in time. It gives you an overview of what your business owns, which, again, are called assets, what it owes, known as liabilities, and finally, what's left: equity.

A balance sheet can be incredibly helpful in evaluating a business's outstanding debts, cash position, and value to the owners. It's an excellent statement for getting a good understanding of a business's financial health and liquidity because it's always on an "as of" basis.

That means this statement will show each asset, liability, and equity account balance as of a certain date. For example, you can pull a balance sheet at the beginning of a month, such as January 1st, as well as the end of the month, January 31st, and see a difference in the value of each account depending on what's occurred.

Has the amount of cash your business has on hand grown? Have you taken on new debt that didn't exist prior to those dates? Are you consistently servicing your existing debts and paying bills on time?

Comparing your balance sheet across periods allows you to evaluate a company's financial position and continually ensure that it's healthy.

Now, let's move on to our Profit and Loss.

A well-formatted P&L shows your business's financial performance over a specific period, like a month, quarter, or year. It summarizes your revenues, expenses, and net income, revealing whether your business is making a profit or experiencing a loss. Revenue is the money your business earns from selling goods or providing services. Expenses are your business's costs to generate revenue, such as salaries, rent, and advertising. Net income is the bottom line of your income statement, showing the difference between your revenues and expenses: either a profit or a loss.

The purpose of a P&L is to show a business's performance at a high level. It's a 30,000-foot view of what's going on inside the company from a financial standpoint.

The way your Profit and Loss is laid out can have a huge impact on the insights you're able to draw from it. The problem is, most small business owners' P&Ls are far too crowded and granular to be significantly helpful.

It's a common misunderstanding that we want our P&L to be as detailed as possible to show how money moves. Detail can be helpful, but without the context of the larger picture, it can just cause confusion.

At the top of every P&L is a business's income - the revenue that you're generating through sales. Most businesses don't sell just one thing! You likely have multiple streams of revenue that your business is earning consistently. So, often having just a single general "Sales" account where all revenue is accounted for may not be enough information.

For this reason, some businesses choose to separate out those revenue streams on their P&L. For example, in an accounting business you may have things like "Bookkeeping Income," "Tax Advising Income," and "Payroll Income."

However, some people begin to get too granular when doing this. They begin to split out their income streams into more and more specific accounts, trying to understand the revenue that they're bringing in.

This information can be beneficial in trying to understand the revenue that your business is bringing in, but having a large swath of income accounts ultimately brings more confusion. It's better to dive into, segment, and study your revenue outside of your accounting system.

Bottom line: this is a misuse of the P&L. We've taken something that's intended to be concise but informative and created something overly detailed and useless.

On every P&L statement, below revenue, we'll find our expenses. Again, many people fall into the trap of building an accounting foundation with too much detail. Instead of keeping the Chart of Accounts (the list of all accounts available) concise and high-level, it becomes a muddled mess.

We find expense accounts that are nested within other expense accounts, accounts that have tiny, immaterial balances, and more clutter.

For your P&L to communicate a story that is useful for making educated decisions, it has to be designed intentionally. Each expense account should fit into an overarching category that measurably impacts the business.

We typically see these main organizational summary categories as Cost of Goods Sold, General and Administrative Expenses, Payroll Expenses, Facilities Expenses, and Legal and Professional Expenses. These summary accounts help to split up our list of expenses into helpful categories so that we can easily see what's happening at a high level in the business.

Seeing your P&L clearly laid out allows you to identify trends and patterns in how your expenses change throughout the periods. You can more effectively create budgets and projections based on your information and ultimately plan better for the future with a greater understanding of your company.

An important part of monitoring your company's performance lies in its ability to manage cash. While the balance sheet is an excellent snapshot of your assets, liabilities, and equity at a given point, and your P&L will show you where money flows in terms of income and expenses, there's more to the story when it comes to cash.

Your business's cash flow statement tracks the movement of cash in and out of your business over a specific period. It shows how your business generates and uses cash, providing insights into its liquidity and ability to meet short-term obligations.

The cash flow statement has three main sections: operating activities, investing activities, and financing activities.

Operating activities are the cash flows related to your business's core operations, like selling products or providing services.

Investing activities involve cash flows related to purchasing and selling long-term assets, such as equipment, property, or investments.

Financing activities include cash flows related to your business's financing, like issuing or repaying debt, raising capital, or distributing dividends to owners.

Understanding how your cash moves within the business is the final component of understanding your business and creating an excellent plan for the future.

It's important to know that something like servicing debt will not show up on your Profit and Loss, because loan repayments are not an expense to the company - it's the settlement of liability! This can feel confusing without a proper understanding of accounting.

Remember, assets, liabilities (aka debt), and equity are a component of your balance sheet. Your P&L will show you the breakdown of income and expenses, and your balance sheet will show you the value of your assets, liabilities, and equity at a certain point in time, but to understand the movement of cash within your business, the statement of cash flows is king.

So, there you have it - the balance sheet, income statement, and cash flow statement. Understanding these three financial statements will give you a comprehensive view of your business's financial health.

As I said at the beginning of this episode, I've spoken to many business owners who have never looked at a financial statement. They take the position of: "If I look in my bank account and I have money, that's good enough for me."

I'm not sure if it's that they don't see these financial statements as helpful, or they simply don't understand them!

The bottom line is, looking at the balance in your Chase app is like starting a novel you've never read on page 147, or jumping into a movie halfway through - you have no context for what's happened, where you've been, or where you're going.

You miss out on quite a bit of context that you otherwise would've had if you'd been following along from the beginning. It's worth it to take the time to learn and understand your business from a financial perspective. The result is more confidence, clarity, and a well-defined path toward accomplishing your goals.

That's it for today's episode of The Profit Plot. I hope you found this discussion on the importance  of financial statements useful and illuminating! Don't get discouraged if you're struggling to grasp how these statements should work. It takes time and experience to unlock the full potential of these things! If you'd like some additional resources on how to understand your financial statements, check out our free course on financial storytelling by going to amarlo.co/tell-your-story or check the link in the description.

Don't forget to subscribe to the Profit Plot podcast on Spotify, Apple Podcasts, or wherever else you get your podcasts from. If you found today's episode particularly insightful, please share it with a small business owner in your life so that other entrepreneurs can benefit from this valuable information. The more knowledge we can share with one another, the better off we'll all be.

Join us again soon as we venture to unlock the financial story behind your profitable business. Looking forward to having you here with us next time, on the profit plot.

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Jeremy Millar
Written by:
Jeremy Millar

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