Accurate financial statements are a critical part of every business. They are used by not only yourself but often outside sources as well such as your bank if you need to take out a loan. A standard set of financial statements that we provide at Wisdom CPAs consists of a Balance Sheet, Profit & Loss, Statement of Cash Flows and General Ledger for the period. Depending on the level of service you have selected we will issue these reports annually, quarterly or monthly. One of the many uses of financial statements is to gauge the health of your company.
Balance Sheet
The first of the financial statements we will cover in this post is the Balance Sheet. This report shows the status of your business at a point in time, showing the balances of your assets, liabilities and equity accounts. To break a down a bit more the accounts that are often included in these categories are:
- Assets – Think of this as what you own, and money owed to you.
- Current assets – this includes cash and anything that can be easily converted to cash in under 1 year.
- Cash Bank Balances or Money Market Accounts
- Accounts Receivable
- Inventory
- Other Investments that can be easily converted to cash
- Non-Current Assets – These accounts are for things that would take over a year to convert to cash.
- Fixed Assets
- Long-term investments
- Intellectual property
- Fixed Assets – Include long-term assets that are purchased and capitalized (depreciated) over a period of time. These assets have a life span of over a year, examples would be buildings, large equipment, computers, or vehicles.
- Other Assets – We often use this if there are loan receivables, either to employees or shareholders.
- Current assets – this includes cash and anything that can be easily converted to cash in under 1 year.
- Liabilities – These accounts show you what you owe to others.
- Current Liabilities – Amounts that will come due in the next year.
- Credit Cards
- Payroll Tax Payments
- Sales Tax Payments
- Long-Term loans that are coming due
- Long-Term Liabilities – Amount that are owed, but not due in the next year.
- Loans
- Mortgages
- Current Liabilities – Amounts that will come due in the next year.
- Equity – Representation of the owner stake in the business.
- Common/Treasury Stock – Par value of any stock that was issued or repurchased.
- Additional Paid-In Capital – Is the excess paid for stock over par value.
- Owner’s Draw or Contribution – Cash paid either to owners directly or for non–business expenses on the owner’s behalf.
- Retained Earnings – This shows the amount of earnings made during the business life. Positive retained earnings will indicate a year-over-year profit, while a negative could suggest losses or excessive withdrawals out of the company.
This is all great but what does the Balance Sheet really tell us about our business? The foundation of financial statement analysis is using ratios to determine how your business compares to others in the same industry or your prior years financial statements. The Balance Sheet provides the information needed for many of these ratios, we will cover only two below.
- Current Ratio: This is a liquidity ratio, meaning it shows how liquid your business is and is often used to determine if you can pay short-term debts. This is calculated by taking your current assets divided by your current liabilities.
Current Ratio =Current AssetsCurrent Liaiblities
- Quick Ratio: Similar to the Current Ratio the Quick Ratio is a liquidity ratio that shows the ability of a company to pay its short-term debts. The difference between the two is the Quick Ratio excludes inventory in the calculation. Since inventory is often dependent on sales in order to recover the full price of the inventory using the Quick Ratio if your company tracks inventory will be more accurate.
Quick Ratio= Current Assets – InventoryCurrent Liabilities
A ratio greater than 1.0 in means that as of the balance sheet date you have the cash (or can easily convert to cash) to cover your short-term debts. Generally, the current ratio between 1.5-2 is good. If your current ratio is less than 1, it would indicate you don’t have the ability to cover short-term debts.
What to do if your ratio is below 1.0? First check that your current liabilities are accurate to only show the amounts due for the coming year. Second look at your accounts receivable, are there any balances that are aging that you can call on to collect some cash. Finally reducing unneeded spending until some short-term debt is paid off is a way to improve your current ratio.
Profit & Loss (P&L)
When someone asks you about your financial statements my guess is that the first thing that comes to mind is your P&L. This report shows all of the important stuff, mainly your profit over the period, right? Yes, it does show your net income for the period, but it can be used for so much more. First let’s go over what you will see on your P&L statement:
- Income – Pretty straight forward, this is the money coming in from sales or services that you provide. You may also track any discounts or refunds that you give to customers.
- Cost of Goods Sold (COGS)– These are often called “Direct Costs” they are the costs directly related to creating products or providing services to the client. An easy way to determine if it’s a direct cost or not is to ask yourself if sold more of your product would you need more of this expense?
Example if you owned a cleaning company and wanted to know if the cost of cleaning solution and a local advertising expense was a COGS. If I cleaned more houses I would need more cleaning solution, so it would be COGS, I wouldn’t need more advertising, so that would be an indirect cost. Common COGS accounts are:
- Supplies/Raw Materials
- Direct Labor – wages paid to those working on a product, an employee’s wages can be split between direct and indirect costs.
- General Expenses – Expense not related to the production of goods and services are called “Indirect Costs” or sometimes referred to as “Overhead Costs”. These costs stay consistent period to period.
So, what else can your profit and loss tell me about my business other than just the bottom-line net income. Two easy ways to see how efficient your business is operating from numbers found on the P&L are to calculate your Gross Profit Margin and your Net Profit Margin
- Gross Profit Margin: Your gross profit margin is going to show you for each dollar of revenue how much is being converted into gross profit. Be careful using this, as it does not consider any indirect costs. If your business has large overhead costs Net Profit Margin may be a better indicator.
Gross Profit Margin = Revenue – COGSRevenue
- Net Profit Margin: Very similar to the Gross Profit Margin, your net profit includes the indirect costs in determining your percentage of profit for each dollar or revenue. If you’re unsure if your allocating COGS correctly this may be the better option.
Net Profit Margin = Net IncomeRevenue
Statement of Cash Flows
Have you ever looked at your net income and thought to yourself that your bank account doesn’t seem to reflect the success your P&L is showing? This is where the Statement of Cash Flows report can help you. While the P&L shows all your income and expenses, it doesn’t take into consideration all cash transactions. If you have sales on account that are sitting in accounts receivable waiting to be collected, or if you are making loan payments, those are cash transactions that are not being recorded on the P&L.
The Statement of Cash Flows shows the inflows and outflows of cash for all business transactions. The three main sections of the Statement of Cash Flows are:
- Cash Provided by Operating Activities
- This will show all inflows and outflows of cash from the operation of your business. Showing the adjustments made from outstanding accounts receivable, payroll liabilities payable and other non-cash transactions that were shown in the P&L.
- Cash Provided by Investing Activities
- Investing activities include the purchase or sale of fixed assets (property, plant or equipment). As well as any income from investments, or cash paid for investments.
- Cash Provided by Financing
- Financing activities will show all loan payments made during the period as well as any new loan proceeds.
Below the three sections will show a net change in cash for the period. Seeing negative cash flow in these areas isn’t necessary always a bad sign for a business. Maybe you’re trying to pay down debt causing a negative cash flow from financing, or you’re investing in new equipment so there is a cash outflow from investing. Depending on your goals for your business what you want to see from you Statement of Cash Flows is going to be different.
General Ledger
The last financial statement that Wisdom CPAs issues as part of our financial statement package that we send our clients is the General Ledger. This report is pretty simple, it shows every transaction that occurred during the period and well as which account it was coded to. It is good practice to review this report, even if you’re doing your own bookkeeping, to ensure that all transactions are being accounted for correctly.
Understanding what your financial statements are telling you is a crucial part of running and growing a business. Remember your financial statements are only as good as the information that you put into them. If you would like to improve your financial reporting, please reach out and we would be happy to discuss adding financial reporting to your current services we already provided to you or your business.