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How to read financial statements

How to read financial statements

Your balance sheet, income statement and cash flow statement are vital tools to check the health of your business.

Master these documents, line item by line item so you know your assets from your elbow. Check out the definitions and examples for each part of these three key statements.

Mastering financial statements is the first step to reaching your goals — whether you want to enter new markets, develop a new product, or sell up and move on. You’ll have the numbers to back your decisions.

The three most important, and most common, financial statements for any business are:

  • Balance sheet: Shows what a business’s financial position is at a moment in time.
  • Profit and loss, or income statement: Shows financial performance in a particular period of time.
  • Cash flow statement: Records money coming and going for a particular period of time — like your bank statement, but with insights into patterns and/or problems.

These statements are especially important when you ask someone to invest in your business. You’ll have to show how your business makes its money — financial statements are how you show them.

On this page we explain each part of the statements — what’s included, how you might use it, and how you work it out. If you’re already up to speed, jump ahead to how to analyse your statements or dig into financial forecasting and modelling.

Case study

Case study

Sam the house painter

Sam is a sole operator with a small house painting business. He’s been using his station wagon for work, but it’s too small to carry the paint and equipment needed for bigger jobs.

He’d like to buy a van. The only problem is he never has enough cash for a deposit. Sam decides it’s time to understand more about the financial side of the business.

The business’s bank account is not looking healthy. So Sam and his partner Alex, who does the books, spend an evening going over the financial statements.

The balance sheets balance. But the cash flow statements show more money going out than coming in.

Sam always thought it a good sign to see so much money in the assets column of his balance sheet. But most of it is accounts receivable, which is money owed by customers. Any money he does get is spent on buying paint for the next job.

In accounting terms, he doesn’t have enough cash flow.

Sam and Alex decide to tighten up the invoicing process. At the moment, the payment due date is several months after a job is finished. As Sam doesn’t like to pester people, he rarely sends reminders.

But now he can see the impact this has on the business, he agrees to Alex setting shorter due dates and sending polite reminders before the payment deadline.

See Sam’s before and after figures in our sample balance sheet:

Follow Sam’s journey as he gets a better grip on his finances and improves his cash flow.

Balance sheets

A balance sheet is a snapshot of your business’s financial position at a particular time. It’s in three parts, each with line items within it:

  1. Assets
  2. Liabilities
  3. Equity

The aim is for these three parts to balance — this means a final result of zero. All businesses use balance sheets to track what is happening between reporting periods, from the biggest multi-nationals to the smallest start-ups.

Balance sheet and cash flow statement

Key equation on balance sheets: assets = liabilities + equity

Key equation on balance sheets: assets = liabilities + equity

It’s also common to see assets — liabilities = equity

Assets aka stuff your business owns

Assets are the tools of your trade which help you do your business, eg a van for a delivery company, a secret recipe for your house cocktail, or a written agreement with a supplier.

Your balance sheet shows what each asset is worth, which is important if you want to raise money or sell your business.

These types of assets are common line items on a balance sheet. Which will be on yours depends on what your business does and what it owns.

Current assets: Items expected to convert into cash within 12 months, including:

  • Inventory: What you sell to make money for your business, eg shoes in a shoe shop.
  • Accounts receivable: Money you’ll get in the near-future by customers paying on credit. Offering some credit can help build good relationships. But too much is a risk. You might not have enough cash to invest in your business — or cover your bills.

Fixed assets: Items expected to last longer than a year, eg land or equipment. These are not for sale (that’s inventory), and they are depreciated in value over time.

Intangible assets: Ideas, practices or agreements you have bought from someone else, including:

  • Intellectual property, eg secret recipes or patents.
  • Goodwill: Value added to a business by assets that can’t be itemised, eg a reputation for making better cheese scones than a nearby rival, or loyal relationships with suppliers. Goodwill should only be on your books if you bought a business and paid a higher price due to its goodwill. Talk to your accountant about turning it into an itemised asset instead, eg brand value or a formalised supplier agreement.

Prepaid expenses: Money you’ve paid in advance for goods or services to help run your business, eg paying in advance for a 12-month insurance policy. It’s an asset because your business will receive value from it in the near future.

Capital expenditure: An accounting term to track money invested in current or fixed assets, also known as capex. When buying a new asset or upgrading an existing one, eg replacing your businesses computers, the money will be counted as capex.

Financial assets: Investments in other businesses, eg shares or bonds. Or it could be an asset that’s not part of your regular business activities, eg a tech company buying a vacant lot to sell in a few years to make money.

Regularly check your working capital. It’s your readily available assets, eg cash and accounts receivable, minus current liabilities.

Regularly check your working capital. It’s your readily available assets, eg cash and accounts receivable, minus current liabilities.

Working capital is often calculated in accounting software and spreadsheets. It’s also a good idea to calculate your working capital ratio. This is your readily available assets divided by your current liabilities.

Working capital ratio (current ratio) explained

Liabilities aka money you owe

This is money you owe, or will have to pay in the future, eg PAYE tax due the following month. Tracking liabilities in a balance sheet help you get to know the cost of running your business and the bills heading your way. This puts you in a better position to plan your spending and saving, and spot risks on the horizon.

These types of liabilities are common line items on a balance sheet.

Current liabilities: What you’ll have to pay out within a year, including

  • income tax
  • salaries
  • unused employee leave or holiday pay
  • bonuses for employees likely to hit agreed targets
  • loan/mortgage instalments for next 12 months. The rest of the loan is listed in non-current liabilities
  • unearned, or deferred, revenue — pre-paid orders and other money you are been paid in advance.

Unearned revenue is a liability because you haven’t yet done what you’ve been paid to do, and costs linked to supplying it haven’t yet come out of your pocket. Once the sale is completed, the amount paid is no longer a liability — it’s recorded as revenue on your income statement.

Checking deferred revenue will help you manage cash flow. It also shows potential buyers or investors a fuller picture of your business’s earning potential and sales to be completed.

Accounts payable: Money your business owes for goods or services, eg to a vendor or supplier.

Keep track of these figures to plan your spending, make sure bills are paid, and keep an accurate idea of costs for each job or project. Potential buyers or investors will look at accounts payable to see if your finances are under control.

Non-current liabilities: Money you’ll have to pay out over a number of years, also known as a long-term liability, including:

  • Long-term debt, eg loans and mortgages: Total amount borrowed, minus payments for the next 12 months — these are a current liability.
  • Long-term leases, eg hire purchase of a vehicle: Total amount borrowed, minus payments for the next 12 months — these are a current liability.

Equity aka the net value of your business

This measures the accumulated money in your business, including money from you or an investor. Positive equity means your assets are worth more than your liabilities. Negative equity means your liabilities outweigh your assets.

These types of equity are common line items on a balance sheet. For small- to medium-sized businesses, equity might be retained earnings alone. For larger businesses, balance sheets tend to include shares and other types of equity. If you have business partners, or an investor who owns part of the business, this is where their stake will show up.

Retained earnings: It’s the cash reserves your business has built up.

Here’s how your balance sheet works it out:
Previous statement’s retained earnings + net income — dividends paid to shareholders = current retained earnings

It’s important to master retained earnings when you want to grow. A positive number means you have money to invest back into your business or pay off debt faster.

Negative retained earnings means your business has built up more losses than income over time — it isn’t earning enough, or is spending too much. Fast-growing businesses might have negative retained earnings. This is OK if it’s planned and for a short time only. If it’s not planned — or becomes a unexpected pattern — it shows you need to look again at how to make your business profitable. It’s a red flag for you, and to any investors or buyers.

Total shareholder equity: Also known as net assets, this is funds contributed by the owner — and any others with a stake in the business — plus retained earnings. Potential investors like to see an owner with equity, commonly called skin in the game, before they agree to put money into a business.

Keep across your top-line figures at least. You’ll know how your business is doing and have better discussions with your accountant or advisor.

Keep across your top-line figures at least. You’ll know how your business is doing and have better discussions with your accountant or advisor.

This means revenue, net profit, net profit margin — your net profit as a percent of your year-to-date revenue — and monthly operating costs.

Case study

Case study

Dani's goodwill asset

Dani has been working in her parents’ bakery since she was old enough to reach the till. Now they’ve retired, she’s taken over the business. It’s a popular bakery, and she’s keen to expand.

Her first step is to check how much its worth in case she needs to borrow money. On the balance sheet, Dani and her accountant find $15,000 worth of goodwill in the assets column.

It dates back to when her parents bought the bakery and paid a higher price because of its good reputation. Dani’s accountant recommends turning goodwill into a different type of asset more appealing to lenders or investors.

Dani asks her parents what goodwill means for the bakery. They say it reflects their good relationship with local cafes — selling doughnuts to other businesses is what helped make the bakery a success 20 years ago.

At the moment, the bakery has informal arrangements with three local cafes to supply doughnuts and other treats. Dani’s accountant recommends writing up formal supply agreements for each cafe.

Each cafe agrees to order at least $90 worth of baked goods a week for 48 weeks a year — total sales worth almost $13,000 each year.

Now Dani’s balance sheet has more in its intangible assets column:

  • $2,000 in goodwill
  • $13,000 in supply agreements.

Supply agreements are a valuable asset, and they give Dani the reassurance of guaranteed income.

Follow Dani’s story as she explores how to expand on our analysing numbers page.

Profit and loss (P&L) statements

A profit and loss statement, also called an income statement, tells you about the financial performance of your business for a particular period. It’s in three parts, each with line items within it:

  1. Revenues
  2. Expenses
  3. Net profit

It tracks how your business is doing and can help explain changes, eg why profit is down even though revenue is steady.

Profit and loss statement

Key equation on P&L statements: revenues – expenses = net income

Key equation on P&L statements: revenues – expenses = net income

Revenues aka money you earn

This is the money your business earns from all sources before you pay expenses, taxes and other bills.

If your business makes money in different ways, eg you run a café, a market stall and sell wholesale to other businesses, each gets its own line in the revenues section.

The aim in business is always to have money coming in — showing as positive number in the revenue section. But if your expenses are higher than your revenues, you’ll end up with a net loss.

Expenses aka money you spend

The expenses part of the income statement lists all the things that your business has spent money on. Some of the terms only apply to some businesses, so don’t worry if your income statement doesn’t show all of them.

These types of expenses are line items on an income statement.

Cost of goods sold (cogs)

The cost of goods sold, also called cost of sales, is the amount of money it takes to make the product or service you’re selling — how much you spend on materials, labour, and expenses. It can also take into account your stock at the beginning and end of a year. It’s a good idea to talk with an advisor about how your business can measure and record stock levels.

It’s used to calculate your gross profit and contribution margins.

Gross profit

Also called gross margin. The higher your gross profit, the more money your business has to cover operating expenses and earn net profit.

Here’s how your statement works it out for you:
Gross profit = total revenues — cost of goods sold

If your income statement shows negative gross profit — below zero — it might be because:

  • your costs of goods sold (cogs) are too high
  • your prices are too low
  • there’s a mistake in your final stocktake or your accounting, eg costs incorrectly codes as cogs.

Operating expenses

Also called operating costs or overheads, this is the cost of running your business, including rent, marketing and taxes. Many statements include depreciation and amortisation.

It’s a good idea to give each expense its own line under operating expenses. This makes it easier to:

  • see changes over time and spot trends, eg rising electricity bills
  • get clues about how to cut costs, eg comparing power companies’ prices
  • track the effect of changes you make, eg switching to a new electricity company.

Businesses often find it easier to cut costs rather than increase income. The goal is the same — better profit margins. This frees up money for what you’d most like to spend it on, eg new machinery, pay rises or a marketing push.

Operating profit or EBIT

Accountants tend to talk about EBIT — which means earnings before paying interest and tax — while most other people talk about operating profit.

It’s the money you make from carrying out your core business, after operating expenses have been paid. It paints a truer picture of how good your business operations are at turning earnings into profit.

If your operating profit is positive, that’s a good sign. Your business is selling products or services for more than it costs to make them and run the business. If it’s negative, your business isn’t earning enough to cover costs. You’ll need to look into how the business is operating.

Net profit aka your bottom line

Also known as profit after income tax, this is the money your business makes minus all its expenses. It’s the quickest indicator of the health of your business.

Here’s how your statement works it out:
Net profit = income – (cost of goods sold + operating costs + interest + tax + depreciation + amortisation)

A positive net profit — above zero — shows your business makes more than enough money to cover costs. This is also called net income. If your net profit falls below zero, it’s time to find ways to earn more and/or spend less.

Depreciation and amortisation are ways to spread the cost of an asset over time.

Depreciation and amortisation are ways to spread the cost of an asset over time.

Depreciation is for physical assets like vehicles, machinery or computers. Amortisation is for intangible assets like intellectual property, eg licensing someone’s patent for 10 years.

Case study

Case study

Merryn and Leni's tech company

Merryn co-owns a tech company with her brother Leni. The pair set it up after leaving their jobs and taking part in a business innovation incubator programme.

Their new digital point-of-sale system is popular, but being in business is expensive. The pair don’t want to raise prices or lose any of their five employees, so what can they do?

Merryn and Leni book an appointment with their accountant to look for other ways to improve their finances.

Using figures from their income statements, the accountant finds operating costs have ballooned. The company started in the spare room in their apartment. It quickly grew, so the pair moved the company into a converted warehouse in the inner suburbs.

With their lease up for renewal, now is a great time to explore other options. One of Leni’s contacts suggests a new co-working space aimed at tech firms. Its flat rate includes rent, furniture, wifi, electricity, kitchen supplies, and in-house mentors. This will halve their operating costs.

When Merryn and Leni find out the co-working space hosts regular pitch events to connect businesses with potential investors, they decide to move in.

See their before and after figures in this sample profit and loss statement.

Follow the story as Leni analyses costs vs sales to set a limit, or benchmark, on future operating costs.

Cash flow statements

A cash flow statement is a summary of your business’s cash transactions over a certain time period — the money coming in and going out. It’s like checking your bank statements, but with insights into patterns and/or problems.

It’s in five parts:

  1. Cash flow from operations
  2. Cash flow from investing
  3. Cash flow from financing
  4. Closing cash balance
  5. Net change in cash

Your cash flow statement is a better reflection of the current state of your business’s available cash than the income statement, as it doesn’t include income still to be collected (accounts receivable) or expenses still to be paid (accounts payable).

This is why you’ll be asked to share your cash flow statements if you want to borrow money, attract investors or sell your business. They’ll be interested in the trend up or down in your net change in cash.

Key equation on cash flow statements: net change in cash = operating cash flows + investing cash flows + financing cash flows

Key equation on cash flow statements: net change in cash = operating cash flows + investing cash flows + financing cash flows

Cash flow from operations

This shows the comings and goings of cash related to your core business, eg cups of coffee sold if you run a cafe, or call-outs and fit-outs if you’re a plumber.

Your cash flow statement works out net operating cash flows from these types of line items:

  • cash from customers
  • cash paid to suppliers
  • cash paid for operating expenses
  • changes in inventory
  • changes in accounts receivable
  • interest paid
  • tax paid.

If your net operating cash flow falls below zero, you’re not earning enough to cover costs in your day-to-day business. You may need to rely on loans to pay your bills. If it’s unplanned, it can be a sign you need to change how you do business.

Cash flows from investing

This shows the comings and goings of cash if you buy and sell:

  • shares in the financial market
  • land
  • intellectual property.

It also includes any one-off sales of a long-term asset, eg a work vehicle.

Cash flow statements for small businesses don’t always include net investing cash flows. So it may not appear, or your accountant or bookkeeper might put “nil” in this line.

Cash flows from financing

The cash you get from taking out a loan, and the cash your business spends on dividends or repaying long-term debt.

Net financing cash flow is the total cash remaining after all transactions related to financing are tallied. It’s likely to be a negative number if you pay dividends or pay off a loan or other debt.

Closing cash balance

The total of the statement’s:

  • cash flows from operating
  • cash flows from investing
  • cash flows from financing
  • opening cash balance (closing balance from previous cash flow statement).

This then becomes your opening cash balance on the next period’s cash flow statement.

Net change in cash

The difference between your opening and closing cash balances.

It’s a good idea to check whether this has increased or decreased each time you get this statement.

If your closing balance is positive, it shows your business can do one or more of these things:

  • grow
  • reduce debt
  • carry out its day-to-day activities without sinking into unplanned debt
  • pay dividends to investors.

But if the closing balance is negative, your business can’t cover costs solely with money made from day-to-day operations over this time period. To stay in business you might have to borrow or seek investors if you can make a strong case for growth.

One or two cash flow statements with negative net change in cash isn’t necessarily anything to worry about — it may be because your business is going through a period of growth. You might be hiring more staff or investing in a project. Either way, you’ll need to see returns from this spending soon.

But several statements in a row with negative net change in cash is a cause for concern. Talk to your accountant about possible reasons. It’s commonly down to late payments from customers or suppliers — you can fix this by invoicing promptly, and politely reminding people before and soon after your payment deadline.

Case study

Case study

Anika the designer

Anika owns a successful clothing line. She uses New Zealand fabrics — it’s a great selling point — but imports special fastenings from Australia.

Her goal for the year is to gain a deeper understanding of her business’s financial performance. Her first step is to get more comfortable with her financial statements — she’s noticed the fastenings switch from liability to asset and back again.

Anika books a working lunch with her mentor to find out why.

Because she pays in advance for a year’s worth of quarterly deliveries, the fastenings are a prepaid expense in the liabilities section of her balance sheet until the delivery arrives. She has paid for them, but can't yet make money from them.

Once the fastenings are in her workroom, they become a tangible asset on her balance sheet. She can now sew them into her dresses and send the finished garments to her stockists.

While talking about fastenings, her mentor suggests Anika thinks about her high cost of goods sold. Anika is determined to keep using New Zealand fabrics. But she’s keen to find a new type of fastening, as the Australian ones are expensive and about to go up in price.

She finds a supplier in India, and has to weigh up the pros and cons of switching.

  • Australian fastenings cost more but arrive within a week. With no delays in getting finished dresses into the shops, she recoups her costs quickly.
  • Indian fastenings are cheaper but can take several months to arrive by container ship. Because she has to order in bulk and pay upfront, she’s out of pocket for longer.

This prepaid expense means she will have negative cash flow for much of the season. It will only improve once she sells all her dresses. See her figures in this sample cash flow statement:

Follow Anika’s story as she works out her profit margins with Australian vs Indian fastenings.

Knowing how much cash you have means you can make better budgeting and planning decisions.

Knowing how much cash you have means you can make better budgeting and planning decisions.

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