“The Three Musketeers”, “The Three Amigos”, “Peanut, Butter & Jelly”. All phrases you’ve probably (definitely?) never used to describe the three main financial statements.
In reality, these three statements should be this closely related in your mind. If you can master producing and decoding the information included in these closely connected statements, you’ll have a very accurate view of the financial health of your company. You’ll also be in the perfect position to start making informed decisions, helping you grow your business while cutting costs and increasing profit. The best part is that all of these statements can easily be produced with a few clicks in your favorite accounting software. Sound good? Let’s dive into what these three statements are and why they’re important.
1) The Balance Sheet – The balance sheet gives you information in three main areas. What you own (your assets), what you owe (your liabilities), and what your stake is in the company (your equity). This information is of course helpful because it gives a good view of the amount of what you own in your company compared to how much the company owes other people. If you have a similar amount of liabilities to assets, that’s of course not a great position because the company would have a difficult time paying off all of those liabilities. The balance sheet also shows how much cash is available to the company for growing or investing. The balance sheet always shows your financial health for a snapshot in time. For example, if you run the balance sheet on 10/18/18, it will show your financial position for that exact moment. For this reason, it’s important to run this report monthly and compare from month-to-month. This is a financial statement that financial institutions will typically look at before approving loans or other financial products. It’s essential that your bookkeeping is accurate in order to have an accurate balance sheet (or any financial statement).
2) The Income Statement (Also called the Profit & Loss) – The income statement is probably the most commonly used financial statement. Once again, financial institutions will almost always want to take a look at this statement to get a good idea of the financial health of a company. The income statement shows all of the company’s revenue (money that’s been made through sales) compared to all of the company’s expenses (all money that’s been spent). This information is important because it shows the profitability of a company. By taking a quick glance at the income statement, you’ll be able to figure out if your company is creating profits, or creating a loss. Through the income statement you can also find information such as gross sales, net income, profit margins etc. The income statement shows it’s data for a certain range of time such as a month, quarter, or year. Pay attention to the top of the income statement where it will say “For the Fiscal Year Ended December of 2018”, this tells you what range of dates the data is showing.
3) The Statement of Cash Flows – This statement is the dark horse of the three. It’s the least commonly used, but it’s very important to look at as it completes the “financial picture” along with the other two statements. This statement shows how changes in balance sheet accounts (assets, liabilities, and equity) as well as net income, affect cash flow. The information is listed in three main categories: Operating Activities, Investing Activities, and Financing Activities. This gives you the most holistic view of your company. It tells you where your cash came from and where it’s going. It’s possible for a company’s real financial health to temporarily “hide” behind profits, but there’s no hiding behind poor cash flow. This is why this statement is so important when used in conjunction with the other two statements. Looking closely at this statement will tell the business owner whether they have enough cash to cover upcoming expenses (Like payroll, or lunch next week). It’s also very useful to compare the statement of cash flows (specifically the cash under operating activities) with the net income. If there’s consistently a higher cash flow than net income in these categories, that’s a good sign. If there’s consistently less cash than net income, that’s a red flag.
It’s essential for all business owners to have a clear idea of their company’s financial health. The best way to do this is to carefully inspect these statements each month. If you’re having a difficult time understanding these statements (they can definitely be difficult to understand) consult with an accountant or bookkeeper to get a better understanding of these statements. Once you have a clear understanding of your statements, you’ll be ready to make informed decisions for your company. Now, go grab a Three Musketeers candy bar and start taking a look at the Three Musketeers of Financial Statements.