Your company’s income statement, balance sheet, and statement of cash flows make up your company financial statements. All are important and each plays a significant part in demonstrating your company’s financial health.
My answer is that no particular component of a company’s financial statements are any more or less important than others. They all interconnect in a meaningful manner. Banker’s want to see a holistic view of your company and care about all three major components of your company’s financial statements. So should you.
There are three main parts of a set of company financial statements.
The Income Statement shows a company’s income, expenses and gross profits. The income statement is generally laid out in a particular format with gross income at the very top, cost of goods sold below gross income and gross profits shown next which are gross revenues minus cost of goods sold. Cost of goods sold are all the direct expenses of manufacturing or providing a product or service.
The next part of the Income Statement is generally general and administrative expenses (G & A). These are the costs of the company’s operation that are not directly related to COGS. So administrative expenses such as company clerical, insurance, rent that is not directly tied to COGS, and any other expenses that are necessary to operate the business are considered G & A expenses.
The money left over after COGS and G &A expenses are subtracted from gross revenues is operating profit. Often this figure is known as earnings before taxes, depreciation, and amortization or EBITDA.
When a banker looks at your income statement they are looking to see that you have sufficient operating profits to cover any loan payments they make to your company.
Often interest and taxes are shown below operating profits.
Net profits are the profits that are generated from your business after all expenses including interest and taxes are calculated. Non-cash deductions are taken for amortization and depreciation.
A company’s Balance Sheet lists the company’s assets and liabilities it uses to generate revenues.
The balance sheet is very organized. It starts off with current assets. It lists each current asset in the order of most to least liquid. Cash is considered the most current asset so it always appears first on the balance sheet. Most businesses have the current assets shown in the following order: 1) cash 2) negotiable securities, bonds or a CD with a maturity less than a year, and 3) inventory. Inventory is usually considered the least liquid of current assets so it most often shows up last on the balance sheet. Current assets are assets that have a life of one year or less.
Long-term assets are shown next. These are assets that have a useful life of greater than one year. Assets like equipment, vehicles, computers and furniture all qualify as long-term assets.
It is important to properly classify assets correctly as either current or long-term because the values are used to calculate certain important ratios that measure your company’s performance and liquidity.
After long-term assets come liabilities. Like current assets, a company shows their current liabilities as those that are less than one year until maturity. Current assets are such items as accounts payable, the current portion (less than one year) of long-term liabilities, and other obligations that must be paid within the next twelve months.
Long-term liabilities are shown after current liabilities and they are debts that exist mature over one year in the future. The balance of long-term liabilities are reduced by the portion that are current (meaning due in the next twelve months).
The long-term liability portion of the balance sheet does not show the portion of long-term debt that is due in the next twelve months.
The last part of the liabilities section of the balance sheet is usually called shareholder equity. That is the cash used to originally capitalize the business plus retained earnings plus current profits (net profits from the income statement) plus all liabilities.
This is a critical point about the balance sheet is that assets must equal all liabilities plus shareholder’s equity.
The Statement of Cash Flows is the third part of most financial statements. Many business owners don’t focus enough attention on this part of their financial statements.
This part of your financial statements shows cash at the beginning of the period being measured, with inflows of cash added and outflows of cash subtracted. The net difference shows whether your business has been cash flow positive or negative. If it has been positive you have more cash at the end of the period than you started at the beginning. A negative cash flow means you spent more cash than you took in.
Cash flow is not profits. Companies can be profitable and be cash flow negative. Cash flow is what you use to operate your business with. It is possible to have operating profits of $200,000 for the year ( what you will have to pay tax on) but have a negative cash flow position of $50,000 or more. This is critical to understand because fast growing businesses and those that are not generating substantial profits don’t replenish cash as fast as it goes out.
CPAs generally prepare all three parts as described above. It is not unusual for companies that self prepare their own financial statements without producing a statement of cash flows.
As you see each part of a company’s financial statements are important and show different indicators of a company’s health. It is important for business owners to learn how to read all three portions of the financial statements so you can best understand the overall health of your business.
Sam Thacker is a partner in Austin Texas based Business Finance Solutions.
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