All business owners should review their financial statements at least quarterly. Doing so will help you make better business decisions and stay on top of your business finances.
Your financials tell a story. But not everyone knows how to read them. So, what terms should you be aware of when reading a business’s financial statements?
Here are financial statement terms in simple words:
• Income Statement
Revenue – Expenses = Net Income
This tells you how much revenue you have and what you spent your money on.
It answers “Are you profitable?”
It is similar to your personal budget.
• Balance Sheet
Assets = Liabilities + Stockholder’s Equity
This statement helps you understand what you own, what you owe, and what you’re worth (as a company).
It answers “Are you healthy?”
It is similar to your net worth statement.
• Statement of Cash Flows
Beg Cash Balance + Net Increase/Decrease of cash during period = Cash at end of period
This tells you the flow of money through the company.
It answers “Where did the cash go?”
It’s comparable to looking at your bank account.
Revenue is another word for sales.
Sale Price x Units sold
Whether your financial is Cash or Accrual Accounting determines if this means money is coming in the door.
• Cost of Goods Sold
These are costs directly related to revenue.
For products, this is simple: the cost of the product.
For services, employee hours connected to revenue is Cost of Goods Sold (COGS).
For Software as a Service (SaaS), these are costs directly related to building of the product.
• Gross Profit
Gross Profit = Revenue – Cost of Goods Sold
The money value generated related to revenue “sold.”
• Gross Profit Margin
Gross Profit Margin = Gross Profit / Revenue
You want to see margins go up, as it shows the company is healthy.
Because Cost of Goods Sold (COGS) is your biggest expense, changes in Gross Profit Margin can squeeze your available dollars for overhead-related expenses.
• Operating Expense
Gross Profit – Operating Costs
This is the bottom line structural cost of your business.
Businesses can be restructured to get rid of non-operating costs, but cannot survive very long if not generating an operating profit.
• Operating Margin
Operating profit / Revenue
This speaks to the ongoing viability of the company.
We want to raise this as high as possible and watch the trends closely.
Depreciation is a non-cash expense that is used to allocate the cost of a physical asset over a fixed period of time.
This is the same as Depreciation, but with intangible assets.
• Net Profit
Revenue – Expenses
Net profit tells you the dollars “generated” by the business, though if Accrual Accounting this does NOT equal dollars coming in.
• Net Profit (Income) Margin
Net Profit Margin = Net Profit / Revenue
This should be positive, which reflects that your business is “making money.”
A negative margin could mean you need to generate cash from Investing or Financing Activities.
• Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
This measures company performance but excludes interest, taxes, depreciation, and amortization.
These are considered financing or debt structure that could change based on an owner’s decision.
That explains why EBITDA is often used to value a business for sale.
• Cash & Accrual Accounting
Cash Accounting records sales when the cash is received and expenses when paid.
Accrual Accounting records sales when the sales commitment is made and expenses when incurred (committed or matched to sale).
• Cash Flow
As it sounds like, this represents the movement of cash in the business.
If cash flow is positive, that means more is coming in (via sales) than going out (expenses & capital expenditures)
• Operating Cash Flow
Cash Received from sales – cash paid for expenses related to the operation of the business
This is the cash generated from normal business operations.
It tells you if the business is generating enough cash from sales to stay in business.
• Free Cash Flow
Operating Cash Flow – Capital Expenditures
This tells you what’s remaining to pay debt, interest, and as dividends to the owners.
• Working Capital
Current assets – Current liabilities
This tells you the short-term position of the company.
When positive, it tells you how much of a cushion you have.
If negative, you’re in a bad position.
• Cash Burn Rate
(Cash Balance Beginning of Period – Cash Balance End of Period) / # of Months in Period
If making money, this can tell you how quickly you’re building your cash reserve.
If unprofitable, it tells you how much cash you have to support continued operations.
• Cash Runway
Total Cash Reserve / Burn Rate
Based on the burn rate, your cash runway will tell you how many weeks or months you have left in operation.
Burn Rate can temporarily be negative if you’ve made big purchases, so it’s important to understand where that cash went.
Something a company owns. It’s broken down into current & non-current.
> Prepaid Expense
> Accounts Receivable
> Property, plant, and equipment
> Intangible assets
• Accounts Receivable
Accounts Receivable is revenue invoiced to customers, but not yet paid.
The older an invoice is without getting paid, the less likely it is to get paid.
It’s important to watch this report closely.
A liability is money you’re legally obligated to pay to someone.
Whether you’ve agreed to buy a product or service.
• Accounts Payable
This is money owed to others.
When struggling with cash flow, companies use this report to manage what’s outstanding and prioritize who to pay.
• Shareholder’s Equity
Assets – Liabilities = Shareholder’s Equity
The amount of value retained in the company after all obligations are taken care of.
This can be called the book value of the company.
• Return on Equity
Net Income / Shareholder’s Equity
Return on Equity takes into account the value left in the business.
Businesses with high leverage will generally have a good return on equity.
Ideally, you should be generating 15-20% or more return on equity.