As a business owner, one of the most important skills is reading a financial statement. This is an equally essential tool that investors have to guide their investing endeavors. Financial statements are documents used to track the financial health of a business. Moreover, it will guide business owners in making vital decisions like where to allocate resources and where to cut costs.
With this information, a residential home service contractor can make well-informed decisions. They can do this while strategically avoiding risk and identifying promising opportunities.
Reading and understanding financial statements is an easy task for accountants and finance experts but many business owners struggle to interpret them effectively. It’s critical for entrepreneurs to know how to do this as it gives insight into the performance of their company.
For this reason, we’ll provide you with a quick guide to reading a financial statement.
The Financial Statements
The quest to explain financial statements begins with defining their scope. Financial statements are records of a company’s historical financial activities. They’re used to provide insights into a company’s overall financial status, like health and performance. Reading a financial statement can be a daunting task for those who are not familiar. However, there is a greater risk of not going through the learning curve. Being aware of vital financial data is essential for any business to succeed.
To get started, the three main types of financial statements are the following:
- Balance sheets
- Income statements
- Cash flow statements
Financial statements are the barometers to fully understanding the financial position of a company. This covers both the company’s standing on its own and when compared to competitors within an industry. Residential home service companies are not excluded from this rule. In fact, they should be reading their financial statements with greater scrutiny given the industry’s volatility and ever-changing nature.
The Balance Sheet
The first financial statement is the balance sheet. The balance sheet is sometimes referred to as a company’s “book of value.” The reason is that balance sheets give a window into a company’s available resources and how they are leveraged. This financial statement lists three key things: the company’s assets, liabilities, and shareholders’ equity at a particular point in time. Usually the end of a fiscal year.
Assets are everything the company owns and can use to generate revenue. These elements must hold inherent and quantifiable value. Some assets can be converted to cash through liquidation. In a balance sheet, assets are tallied as positive values and they can be classified into two categories:
- Current assets
- Non-current assets
Current assets are the resources that companies expect to convert to cash within the fiscal year. This includes:
- Cash & cash equivalents
- Accounts receivable (money owed to the company by customers)
- Prepaid expenses
For example, in a plumbing business, the assets include products, materials, and cash to name a few.
On the other hand, non-current assets are investments for the long term. They’re the resources businesses don’t expect to liquidate in the near future, like:
- Properties and real estate
- Intellectual property
- Patents, trademarks, or brands
- Equipment used to render services
Using the same plumbing example, the equipment may be trucks and other heavy machinery used in providing your services.
The polar opposite of assets are liabilities. If assets are entities that a business OWNS, liabilities are things they OWE. When reading a financial statement like the balance sheet, they are normally tallied as negative values. Like assets, there are current and non-current liabilities.
Current liabilities are payables within one year, including:
- Wages and commissions
- Rentals used
- Utility bills
- Debt servicing
- Accounts payable
Noncurrent liabilities are long-term debts or obligations not due within the year, including:
- Payable loans or bonds
- Pensions provision
- Tax liabilities that are deferred
Also known as the owners’ equity, this is the profit leftover after all the liabilities are accounted for. You can compute this by deducting the liabilities from the assets. Shareholder’s equity is anything that belongs to the owners of a business when liabilities are accounted for.
The balance sheet alone isn’t enough to provide information on trends. You need to read other financial statements to fully understand your business’s financial position.
The Income Statement or Profit & Loss (P&L)
The next step to reading a financial statement is understanding the income statement. This is also known as the profit and loss statement. This financial statement outlines the revenues, gains and expenses of a business in a certain period. The P&L is often presented annually and quarterly through reports. Unlike the balance sheet, this document demonstrates financial trends over given periods.
Income statements normally include the following information:
- Revenue — This refers to the total amount of money that a company has earned in a given period from its primary sales activities.
- Costs of goods sold (COGS) — These are the variable costs of selling and delivering the goods or services that a company sells. It includes the cost of equipment, materials, labor, financing, commissions, services, subs, and permits.
- Gross profit — Total revenue minus COGS.
- Operating income — Gross revenue remaining after COGS are subtracted.
- Fixed expenses — The expense to run the operation. These amounts don’t fluctuate dramatically form month to month.
- Net income — Income after all fixed and variable expenses are paid, but before interest, taxes, depreciation, and amortization are calculated. This is also known as the “Net EBITDA“.
- Earnings per share (EPS) — This is the net income divided by the number of outstanding shares. It is a way to measure how much profit a company has generated for each share of stock.
Income statements are used by professionals to understand how well the company is doing. Is it profitable? How much is spent to render a service? Are there resources we could acquire for business’s growth? Are there efficiencies we could leverage?
Businesses see trends and plan accordingly by answering questions like: Are any individual expenses high? When does revenue come in? How much do I need to survive when revenue is low?
The Cash Flow Statement
The next step in reading a financial statement is familiarizing yourself with a cash flow statement.
Cash flow statements are used to provide detailed insights into a company’s cash inflows and outflows. This is measured over a certain period of time called the accounting period, typically daily or weekly. The purpose of cash flow statements is to gauge a company’s present liquidity. Cash flow dictates the business’s ability to operate in the short term based on how much it can generate and collect cash daily.
This financial statement is divided into three aspects:
- Cash Flow From Operating Activities (CFO)
- Cash Flow From Investing Activities
- Cash Flow From Financing Activities
The cash flow from operations illustrates the inflow and outflow of funds associated with rendering services. For example, all the revenue and expenses incurred during an HVAC technician’s tune-up service for a customer.
The cash flow from investments is gained from buying or selling assets. In an HVAC company, these assets may be selling old capital equipment and trucks, collecting interest and external dividends. This may also include the sale of real estate, patents, or other assets.
Finally, the cash flow from financing is from external sources to leverage the business. These are the interactions with shareholders and creditors, such as issuing new stock, taking out loans, and repaying debts.
Knowing the differences between cash flow and profit is essential in a business. Cash flow is simply the inflow and outflow of actual cash in a company. Profit is whatever remains after all expenses are deducted from the company’s revenue. Without access to liquid cash in the short term, there is no path to profitability since you won’t be able to pay the bills.
Reading a financial statement like cash flow can help business owners see which activities rake in the greenbacks. This will help you make informed financial decisions for the future.
Positive cash flow is vital for your business. While it’s not conclusive of profitability, it displays financial stability and growth potential. Accessing other financial statements is a must to determine a business’s profitability.
The Annual Report
Although not officially part of the three key financial statements, we included annual reports as they hold important value for every enterprise. You find the real value and overarching story behind these financial reports when you review them all together.
The annual report culminates all the above guide on reading a financial statement. The information you obtained and calculated with the balance sheet, cash flow, and P&L is then shared with shareholders. This report is a requirement for publicly-traded companies. However, even if your company is privately-owned, producing an annual report builds transparency and accountability.
In the annual report, the CEO will employ editorial and storytelling to describe the business’s activities, benchmarks, and achievements. Compared to individual financial statements, annual reports offer a better picture of a company’s targets and forecast. Of course, the annual report should envelop all necessary financial data. This covers all financial statements: the income statement, cash flow statement, and balance sheet.
Reading a financial statement is a three-pronged affair. You need all three financial statements for a better grasp of your business’s financial standing in the industry. Lastly, it’s the annual report that summarizes data into digestible information for company stakeholders.
Understanding financial statements indicate that you’re on the right track to business success. It gives you a clear perspective of where your company is today and where it should be headed. As a business owner, it’s your responsibility to ensure that your company is financially stable and growing. Otherwise, you’ll be putting your business at risk.