What Is the Most Important Part of a Company’s Financial Statements?

Recently
I received the following question about small business financial
statements, “What is the most important part of a company’s financial
statements?”


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.
Direct Email address: sam@lesliethacker.com
Twitter: @SMBFinance