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