I believe it’s important to start with the basics because many people don’t fully grasp what financial statements are or the insights they can provide. Throughout my career, I’ve attended numerous year-end client meetings and often observed clients looking either confused or disengaged by the information presented.
This experience has inspired me to create this guide on understanding your financial statements, so you can approach those year-end meetings with greater knowledge and confidence, enabling you to ask more insightful questions and creating more value out of those meetings.
So, what are your financial statements?
Financial statements are usually composed of two separate statements, the balance sheet and the income statement. Let’s break down these statements separately.
Balance sheet
A balance sheet is a financial statement that provides a snapshot of a company's financial position at a specific point in time (i.e. your year-end). It is divided into three main sections:
Assets: These are what the company owns. Assets are typically classified into two categories:
Current Assets: These are short-term assets that are expected to be converted into cash or used up within one year, such as cash, accounts receivable, and inventory.
Non-Current Assets: These are long-term assets that will provide value over a period longer than one year, like property, equipment, and intangible assets (e.g., patents).
Liabilities: These represent what the company owes. Like assets, liabilities are also divided into:
Current Liabilities: Obligations due within one year, such as accounts payable and short-term loans.
Non-Current Liabilities: Long-term obligations that are due beyond one year, such as mortgages and other long-term loans.
Equity: This section shows the residual interest in the assets of the company after liabilities are deducted. It includes items like common stock, retained earnings, and additional paid-in capital.
The fundamental equation of a balance sheet is: Assets = Liabilities + Equity
This equation reflects the idea that everything the company owns (assets) is financed either by borrowing money (liabilities) or by the owners’ investments (equity). A well-prepared balance sheet helps stakeholders assess the company’s financial health, liquidity, and overall stability.
Income statement
An income statement, also known as a profit and loss statement, summarizes a company's revenues and expenses over a specific period, typically a quarter or a year. It provides insights into the company's financial performance. Here are the key components:
Revenue: This is the total income generated from sales of goods or services before any expenses are deducted. It may include other income sources, such as interest or investments.
Cost of Goods Sold (COGS): This includes all direct costs associated with producing the goods or services sold by the company. Subtracting COGS from revenue gives you the gross profit.
Gross Profit = Revenue - COGS
Operating Expenses: These are the costs required to run the business that aren’t directly tied to producing goods or services. They typically include:
Selling, General, and Administrative Expenses
Depreciation and Amortization
Operating Income: This is calculated by subtracting operating expenses from gross profit.
Operating Income = Gross Profit - Operating Expenses
Other Income and Expenses: This section includes income or expenses not related to core business operations, such as interest income, interest expense, and gains or losses from asset sales.
Net Income Before Tax: This is the income before taxes are deducted, calculated by adding or subtracting other income and expenses from operating income.
Income Tax Expense: This is the tax liability based on the taxable income.
Net Income: This is the final profit or loss after all revenues and expenses, including taxes, have been accounted for. It’s often referred to as the "bottom line."
Net Income = Net Income Before Tax - Income Tax Expense
The income statement helps stakeholders evaluate a company’s profitability, operational efficiency, and overall financial health over the reporting period. It’s a crucial tool for investors, management, and analysts to assess performance and make informed decisions.
So, what are your financial statements telling you?
First, it's crucial to emphasize that having up-to-date financial statements is essential. Ideally, you should have your accountant prepare these statements within one to three months after your fiscal year-end to ensure you have the most relevant information for your year-end meeting. If you’re already six months into the new fiscal year, the data from the previous year may be outdated, and you could miss valuable insights into your operations and financial condition which may potentially cause you to be repeating those mistakes from the past year.
Financial statements provide a wealth of insights into a company's performance and health. Here are some key insights you can gain:
Profitability: The income statement reveals how well the company generates profit. You can assess metrics like gross profit margin, operating margin, and net profit margin to understand overall profitability.
Revenue Trends: Analyzing revenue over multiple periods can help identify growth trends, seasonality, or areas that may need improvement.
Cost Management: By examining costs of goods sold (COGS) and operating expenses, you can pinpoint areas where spending might be optimized or where efficiencies can be achieved.
Liquidity: The balance sheet provides insights into your company's liquidity, or its ability to meet short-term obligations. Ratios like the current ratio and quick ratio help assess financial stability.
Solvency: Evaluating total liabilities against total assets allows you to determine the company’s solvency and long-term financial health, which is crucial for investors and creditors.
Cash Flow: While not directly shown on the income statement or balance sheet, the cash flow statement reveals how cash is generated and used. This helps assess operational efficiency and liquidity.
Investment Potential: Financial statements can indicate how well a company uses its assets to generate returns, which is essential for potential investors assessing the risk and reward of investing.
Operational Efficiency: Ratios like inventory turnover and accounts receivable turnover help analyze how effectively the company manages its resources and operations.
Financial Ratios: Key ratios derived from financial statements, such as return on equity (ROE) and debt-to-equity ratio, provide quick insights into performance and risk.
Trends Over Time: Comparing financial statements across multiple periods can highlight trends, making it easier to forecast future performance and identify potential issues early.
By regularly reviewing these insights, you can make informed decisions that enhance your business’s financial health and strategic direction.
Do you even need financial statements prepared by your accountant?
In some cases, you might not need financial statements and only require your accountant to prepare and file your tax return. This is often true for smaller, owner-managed businesses where you are the sole user of the financial statements. However, as the number of users increases, you'll likely need your accountant to prepare financial statements. Depending on the users and their specific needs, they may require greater assurance from these statements, such as reviewed or audited financials.
Is your accountant creating value for you?
In my experience, particularly with smaller businesses, accountants often review financial statements line by line without explaining the significance of the numbers. They typically provide you with any taxes owed, their invoice, and then send you on your way until the next year-end. If this sounds familiar, it might be time to consider finding a different accountant who can offer more insights and value during those meetings.
This is one of the reasons I started my own practice: to empower my clients and help them to better understand their financial situations and business operations. I believe that all businesses, especially the small businesses, deserve exceptional and personalized service from their accountant.
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