Build a Better Business: 3 Main Financial Statements to Know as an Entrepreneur
Most of us entrepreneurs don’t go to school to learn how to run a business. Oftentimes, we see a need in the marketplace and dive right in, ready to use our skills and talents to help others and make a living along the way. While that entrepreneurial spirit should be applauded, we need to equip ourselves with additional tools to build a sustainable and thriving business. One of those tools is your small business financial statements.
In this article, I share the must-knows about the three main bookkeeping reports every entrepreneur will encounter in their bookkeeping – the Profit and Loss (PnL/P&L) Statement, the Balance Sheet, and the Statement of Cash Flows. Keep reading to find out more about how you can use these three financial statements to build a better business.
Why are Financial Statements Critical for Entrepreneurs?
As an entrepreneur, your goal is to make money in your business. However, running a business is not just a matter of bringing in income. Many of us are first-time small business owners and don’t have mentors or coaches to turn to for guidance on the financial aspect of our business. Most of us also did not study entrepreneurship or even take an accounting class to become well-versed in the numbers aspect of the business.
Yet, this knowledge is critical to being able to manage your business well.
That’s where financial statements are useful. Financial statements tell us about the health of the business. Looking at the numbers in your business and doing your bookkeeping will help you keep a pulse on how your business is performing and allow you to assess if you are meeting your financial goals. Even if you outsource your bookkeeping and accounting, it is still essential that you, as the CEO and founder of your business, are aware of what the numbers in your business mean.
Having an understanding of what the different numbers on your Profit and Loss statement, Balance Sheet, and Statement of Cash Flows mean can help you make better decisions in your business. From knowing if you can afford to hire a new team member to what your options are if you have a sudden cash expense, understanding your financial statements as a small business entrepreneur is fundamental to building a better business. Additionally, these financial statements are important information to have on hand if you ever plan to sell the business or get investors on board.
Pro Tip: Set aside time every week or month to review these bookkeeping reports. Doing so will help you get familiar with the financial aspect of your business and you can avoid any nasty surprises!
#1: Profit and Loss Statement
The most basic of all the financial statements in your business is the Profit and Loss (P&L) statement. This is a summary of the income and expenses of the business over a fixed period. It is also known as the income statement. This financial statement shows how the business is performing for that period.
Most businesses would have a quarterly P&L statement. At the end of each financial year, the business will also generate an annual P&L statement. Each P&L statement will have the time period indicated at the top for easy reference.
We can think of the P&L statement as being divided into three main sections.
This section includes all the sources of business income. In service-based businesses, it can include services provided, products sold (e.g. digital courses or eBooks), and even subscription income from memberships. Any money coming into the business would be recorded in this section. These different sources of income would be added up and reflected in the line Total Income.
This is the section where all the money flowing out of your business would be recorded. This section is often divided into different types of expenses – this can make your accounting for tax time much easier. In this section, you would be able to see how much your business has spent on things like advertising, fees, contractors, and more. The total sum of all your business expenses is recorded in the line Total Expenses.
Also known as the bottom line, this is the final line of the P&L statement and shows the overall financial situation of the business for that financial period. This number is obtained by a simple deduction: Total Income less Total Expenses equals Net Income. A positive number indicates a profit for that period, while a negative number indicates that the business is running a loss. Losses are traditionally highlighted in red.
#2: Balance Sheet
The second financial statement that you should be familiar with as an entrepreneur is the Balance Sheet. While the P&L statement shows how the business has performed over a certain time period, the Balance Sheet is more of a snapshot of the business at that moment.
Smaller businesses may only get a Balance Sheet once a year or once a quarter, while businesses that make a lot of transactions could prepare the Balance Sheet every month, week, or even daily. Because the Balance Sheet only shows the assets and expenses of the business at a specific moment in time, it cannot be assessed on its own. For a clearer picture of how well the business is doing, it is important to compare the numbers on the Balance Sheet across different time periods.
Similar to the PnL Statement, information in the Balance Sheet is presented in three main sections.
This section records anything of value that is owned by the business. Cash and cash equivalents (e.g. money in the bank), inventory, equipment, furniture, and property are some common examples of assets a business might hold. It is also possible to record intangible assets such as patents and goodwill, particularly if they are acquired (rather than developed in-house). Assets may be divided into current assets (can be converted into cash within a year, more “liquid”) and long-term assets (require a longer period to be converted into cash) when presented on a Balance Sheet.
Liabilities are what the business owes to others. Bank loans, employee wages, outstanding credit card bills, and accounts payable are often listed in this section. As with assets, liabilities are presented as current liabilities (due within one year) and long-term liabilities (due anytime after one year).
This is the final section of the Balance Sheet and is calculated by employing a simple formula: Assets less Liabilities equals Equity. This is the value of the business that is attributable to the business owner(s) and/or its shareholders. Shareholders’ equity, retained earnings, and stocks are examples of line items that would be listed in this section. Owner’s investment (money you put into the business when you start it, for example) and owner’s draw (the portion of the profits paid out to the owner) are also listed here.
Pro Tip: Check that the figure for total assets is the same as the sum of total liabilities and equity. If not, you might need to check your numbers again!
#3: Statement of Cash Flows
The third type of financial statement every entrepreneur should be familiar with is the statement of cash flows. This is a crucial document because it showcases how funds (cash) are moving in and out of the business over a certain period and allows you to ensure that you can make sound financial decisions.
The cash flow statement is divided into three main sections: Cash Flow from Operations, Cash Flow from Investing, and Cash Flow from Financing. The section Cash Flow from Operations would reflect all the cash moving in and out of the company from regular business processes. Cash Flow from Investing shows items like capital expenditure, sales of long–term investments, and business acquisitions. Under Cash Flow from Financing, you would see debt and equity transactions.
The statement of cash flows is a useful tool to understand and manage cash surpluses and shortfalls. This information can be used to ensure that you have sufficient funds on hand for necessary expenses (e.g. paying the rent on your office space) or to take advantage of opportunities.
Take a Deeper Dive into Financial Statements
Knowledge is power and at Exceptional Tax Services, we are committed to equipping business owners and entrepreneurs like you with the necessary financial knowledge so that you can build a better business.
Learn everything you need to know about financial statements and how to use the information they offer to make better decisions to grow and scale a thriving business in the House of CEO Masterclass: Financial Reporting for Entrepreneurs: Understanding Key Financial Statements Replay. Get access here.