Financial Statements Are Mind Boggling

Understanding financial statements is crucial for assessing a business’s performance, especially when valuing it. Surprisingly, many small business owners struggle to grasp their financials, while accountants often assume you already understand them.

Privately owned small businesses tend to have simpler accounts, and the majority are often owner-operated. These owners prioritize making money and growing sales over financials because that is where their focus is.

However, comprehending financial statements can also help manage and optimize a business. This skill should not be over looked as it can reveal areas that you can invest more money into. Vice versa, which areas you can spend less money on.

For publicly listed companies, investors lack firsthand insight into operations. This makes it even more important to understand financial statements. Although reading numbers is straightforward, financial statements form a language of their own.

Simply reading accounts and balances isn’t enough as a financial statement tells a story. To gain a full understanding, you must see how the income statement, balance sheet, and statement of cash flows interconnect.

Breakdown Of Financial Statements

Financial statements consist of three key components: the income statement, balance sheet, and cash flow statement. These elements are interconnected and provide a comprehensive view of a business’s financial health.

The income statement and balance sheet are often deemed more crucial, especially for small businesses, where accountants might skip preparing a cash flow statement. However, cash flow is just as vital, particularly for evaluating publicly listed companies.

Understanding the layout of financial statements is essential and they are typically organized by immediacy.

What does this mean?

In simple terms, accounts and balances are listed from the most immediate to the least. This means direct sales or expenses appear first.

Income Statement

Take the income statement as an example. Revenue is always listed at the beginning, followed by the cost of goods sold (COGS).

This is because revenue and COGS are the most direct sources of income and expense. Net profit appears at the bottom, calculated after deducting all operating expenses, finance costs, and income taxes.

Balance Sheet

The balance sheet follows a similar logic, listing accounts by liquidity. Cash and cash equivalents are always first under current assets, followed by inventory and receivables. These assets are the easiest to convert into cash, typically within a year.

Long-term assets, like property, plant, and equipment, are harder to liquidate quickly and are therefore listed after current assets.

This rule also applies to liabilities where the more immediate expenses will be listed in order of urgency.

Cash Flow Statement

The cash flow statement is no exception to the is rule and follows the other financial statements. It starts with cash received from sales and lists expenses next, as they are the most immediate revenue and expense items.

It then details cash from investing activities, followed by cash from financing activities, culminating in the ending cash balance.

In summary, financial statements are organized to show the most immediate costs from top to bottom. Keeping this order in mind will help you better understand the financial health of a business next time you review its financial statements.

Financial Statements Don’t Match

Ever notice that the final balances on the income statement and cash flow statement never match? That’s because the income statement follows accrual-based accounting, while the cash flow statement uses cash basis accounting.

In simple terms, accrual-based accounting records revenue and expenses as they are incurred. In contrast, the cash flow statement records transactions only when cash is received or spent.

Think of the income statement and balance sheet as snapshots of a business during a specific time frame. The income statement shows financial performance, while the balance sheet reflects financial health.

The cash flow statement differs because larger companies often sell and buy goods on credit. This results in a timing delay between when revenue or expenses are recorded and when cash is actually received or paid.

For example, capital equipment purchases are typically depreciated and expensed over their useful life. You’ll see a large outflow of cash under cash flow from investing, but only a fraction of this expense appears on the income statement.

Similarly, if a customer buys a product with a 3-week credit term, the sales revenue is recorded on the income statement immediately, but no cash appears on the cash flow statement until payment is received.

Understanding the nuances between financial statements helps you evaluate a company’s performance and financial management.

Key Takeaways

• Financial statements comprise the income statement, balance sheet, and cash flow statement, which together provide a complete view of a business’s financial health, organized by the immediacy of accounts and balances.
• Understanding financial statements is essential for evaluating business performance and making informed investment decisions, as they reveal vital details that numbers alone can’t convey.
• The income statement uses accrual-based accounting, while the cash flow statement uses cash basis accounting, causing their balances to differ. Understanding these nuances is crucial for evaluating a company’s financial health.

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