Financial statements for small businesses: How to read and understand them

Financial statements are essential tools for small business owners. Although they may not be as detailed as those of large corporations, they offer numerous benefits that can help you succeed. Understanding financial statements can be tricky, but breaking them into smaller sections can make it easier.

Many business owners hire a CPA to prepare their company’s financial statements, but some prefer to create them themselves. If your small business uses Xero for your bookkeeping, you can automatically generate financial statements and other financial reports yourself. Regardless of your approach, knowing how to read and interpret financial statements is crucial for entrepreneurs to make better business decisions.

What is a financial statement?

A financial statement is a valuable reporting tool for your small business. It helps you understand the financial health of your business so you can better prepare for the future. Financial statements are essential for making business decisions and obtaining investments or loans.

Financial statements most commonly cover a year, a quarter or a month. Whether it’s an annual report or one for a shorter accounting period, financial statements have four main parts:

• balance sheet
• cash flow statement
• cash flow statement
• statement of changes in equity

The balance sheet

Balance sheets are financial reports that showcase the financial health of a business. Usually prepared by a business owner or bookkeeper, they look at the owner’s equity and business assets and liabilities.

What is a balance sheet?

A balance sheet is divided into two columns and has three main sections. The left-hand column lists assets (things of value); the right-hand column lists liabilities and equities. A balance sheet uses the following accounting equation to determine if a business can pay its debt and if it’s solvent:

Assets = Liabilities + Equities

There are three types of assets:

• Current assets are assets that can become cash within a 12-month operating period. Examples of current assets include cash, prepaid expenses, inventory, and accounts receivable.
• Tangible assets are long-term assets and typically take longer to convert into cash. They include property, equipment, real estate, and plant assets such as building improvements.
• Intangible assets are non-physical assets. They can include a company’s copyrights, patents, trademarks, and goodwill.

There are two types of liabilities:

• Current liabilities are liabilities that need to be paid within a 12-month operating period. They include things like employee salaries, utility bills, and office supplies.
• Non-current liabilities are liabilities that need to be paid in a longer time period than 12 months. They include things like mortgages and longer-term loans. They are separated out from the current liabilities on your balance sheet.

Why you need a balance sheet

Balance sheets help you keep track of the financial health of your business over time. Even though they provide a snapshot of your business, they let you compare seasons, years, and other financial periods so you can see how your business is doing.

Creating balance sheets at regular intervals provides opportunities for comparison and helps you understand the long-term financial position of your business. Besides being an important part of business planning, regularly preparing a balance sheet offers several benefits:

• Demonstrates financial health: Investors and lenders often ask to see your balance sheets for evidence of your business's financial health and its capacity to repay loans. A well-prepared balance sheet can instill confidence in potential stakeholders.
• Assesses liquidity: Your balance sheet is vital in determining your quick ratio. This ratio helps you evaluate whether your company possesses sufficient liquidity to cover its short-term assets and liabilities (its current liabilities).
• Evaluates leverage: The balance sheet can calculate your business's debt-to-equity ratio, which allows you to assess your company's leverage. This financial ratio compares the amount of debt your business has accumulated with the equity invested in the company.

The income statement

The income statement (also called a profit and loss statement) is a key part of a business’s financial statements. This report shows how much your business has spent or earned over a period of time. You can see the net profit or loss of your business. Owners usually want to review an income statement at the end of the month, quarter, and year.

What is an income statement?

Every income statement is made up of four key parts: revenue, expenses, gains, and losses. Here’s how each part plays a role in assessing a company’s performance:

• Revenue: The two types of revenue are operating revenue (also called operating profit, which relates to sales of goods and services) and non-operating revenue (includes other profits such as interest earned, rental income, and so on).
• Expenses: These include cost of goods sold (COGS), depreciation (the reduction in an asset’s value over time) or amortization (similar to depreciation), research, and development expenses.
• Gains: These include income from non-business revenue (for example, the sale of an asset).
• Losses: These are types of expenses, but differ from standard expenses. They include financial losses resulting from activities such as a lawsuit or the sale of an asset.

Why you need an income statement

An income statement provides valuable insight into business operations. For instance, it can help identify your business's underperforming sectors and gauge management's efficiency. Planning and forecasting can be more accurate if you know which areas are performing well and which need improvement.

One of the most important functions of the income statement is to show whether a business is profitable. The main calculation used for an income statement is:

(Revenue + Gains) – (Expenses + Losses)

The cash flow statement

The cash flow statement, also known as the statement of cash flows, shows where your money is coming from (inflows) and where it’s going (outflows). By highlighting the sources and uses of cash, this statement serves as a valuable tool in assessing a company's ability to meet its financial obligations and identify potential challenges in covering expenses.

What is a cash flow statement?

Understanding the three components of a cash flow statement can give you a deeper understanding of your business:

• Operating activities: These activities include accounts receivable and payable and income tax payable.
• Investments: These include some types of income (such as from sales of fixed assets) and expenses (including acquisitions or investment securities). Investments also include money spent on purchasing fixed assets or investments.
• Financing activities: These activities include money received for a loan and dividends from investments.

Why you need a cash flow statement

With a cash flow statement, you’ll know exactly how much money you have on hand during a given period of time, which can help you manage your money better. If you plan to expand your business, a cash flow statement can help you time the expansion for when you have the money available. It can also prevent a crisis by identifying minor problems before they become major ones.

Statement of changes in equity

A statement of changes in equity shows how equity flows through a business during a reporting period. It includes several sections, including opening balance, net income, other income, issue of new income, net loss, other losses, dividends, and withdrawal of capital.

Although it’s less common for small businesses than other types of financial reports, a statement of changes in equity can be helpful. For instance, you can use a statement of changes in equity to inform investors about the state of the equity in a business and how it changes across a reporting period. However, it’s usually used to inform shareholders.

Why your small business needs financial statements

For small business owners, financial statements offer valuable insights and help in decision-making. They show your company’s profitability. When you look at financial performance by analyzing revenue, expenses, and net profit, you can identify strengths and areas for improvement. Financial statements help you manage debt payments and spot and address problems early on, thanks to trend analysis and comparisons of financial data.

When you have accurate financial statements, it’s easier to secure financing and attract investors. They also serve as a reliable record and support in case of audits by the Canadian Revenue Agency (CRA) or other regulatory agencies.