The Four Financial Statements Essential to Managing and Evaluating a Business

Accounting isn't everyone's favorite subject. I know it isn't mine. But that doesn't change the fact that if you're in business, or thinking about owning one - even if as an investor, you'll need to know how to read and analyze the four financial statements that matter most. Some of them are known by other names, but for our discussion here, we'll stick to these names:

• Balance Sheet
• Profit and Loss Statement
• Cash Flow Statement
• Statement of Retained Earnings

All of these financial statements have special significance, but ultimately, each has one common goal...

Show me the Money!

Let's take a look at each of the four financial statements in detail, starting with...

The Balance Sheet

The Balance Sheet is a statement of...

• Assets: What the business owns
• Liabilities: What the business owes
• Capital or Equity: What the owners and shareholders own after all liabilities have been paid.

And it looks something like this...

The balance sheet got its name from the fact that its two sides must balance. On the left side, you will see the table of assets, and on the right side, you'll see liabilities and equity. The way to balance the balance sheet is to use this calculation:

Assets = Liability + Equity

In other words...

Assets - Liabilities = Equity

Looking at the assets and liabilities columns, you will notice each has current and long-term items.

Current assets are short-term assets such as cash, accounts receivable and inventory, while long-term assets include land, property and other fixed assets. Essentially, current assets are those items which can be easily and quickly converted into cash.

Current liabilities are short-term liabilities such as accounts payable and short-term loans. Typically current liabilities are those which are due within the next 12 months. So if a company has a long-term liability such as a mortgage on its property, the mortgage amount payable within the next 12 months will be listed as a current liability. Long-term liabilities include mortgages as mentioned, or long-term loans.

How does a balance sheet help you make financial decisions? Well, it tells you what assets and resources the company owns, and what its financial obligations are to its creditors. Looking carefully at a company's balance sheet, you can know whether a company is able to meet its long-term commitments.

The second of the four financial statements we'll look at is...

The Profit and Loss Statement

The profit and loss statement focuses on the profitability of your business. Its purpose is to show whether the company is earning a profit or whether its losing money. However, it's especially important to look at the profit and loss statement in context - it's common for a very profitable company to record a loss from time to time, due to many factors. Comparative financial statements let you see the company's performance in context (and that's actually true for all four financial statements).

The profit and loss statement lists the company's revenue, expenses and earnings. A simplistic way to understand this statement is to look at this calculation...

Net Profit = Revenue - Expenses

Here's what a profit and loss statement looks like:

 

Revenue, as you already know, is money that the company makes. Expenses is the money that the company spends.

However, notice that in the profit and loss statement, some costs are listed directly below sales, and deducted from sales. These are the costs of goods sold, or direct cost of sales. The costs are directly related to selling the company's products or services.

Gross margin is the company's sales revenue, minus those direct costs. You'll often see gross margin expressed as a percentage. This percentage is calculated as...

Gross Margin % = Gross Margin ÷ Total Sales

So, the profit and loss statement will give you insight into the company's profitability.

Now, let's talk about the third of the four financial statements...

The Cash Flow Statement

The cash flow statement may often show you a different picture to what the profit and loss statement says. It's not unusual for a business to be profitable, yet face financial difficulty due to cash flow problems. In fact, many profitable businesses have gone under because of poor cash flow management. So, in many ways, the cash flow statement is the most important of the four financial statements.

So what is a cash flow statement, and what is its purpose?

A cash flow statement illustrates the inflow and outflow of cash within the business. It shows where the cash comes from into the company, and how it's used. In the end, it lets you know how much cash is left after deducting outflows from inflows and any existing cash balance.

In other words, the cash flow statement tells you whether the business has enough cash to carry on doing business and pay its bills.

The cash flow statement is created from:

• Beginning and ending balance sheet for a specific period
• The profit and loss statement for the same period

There are two important indicators in the cash flow statement:

• Positive or negative cash flow
• Positive or negative cash balance

A business aims to maintain a positive cash flow. But it's both normal and acceptable for the business to have negative cash flow from time to time. Negative cash flow simply means more money exited the company's balance sheet than came in during a specific period. The key is achieve positive cash flow on a consistent basis.

However, more importantly - to the success or detriment of the business - is the cash balance. Think of cash balance as the money you have in your bank account. If the balance were to run down to zero, you'd be bankrupt. And also that's true of any business which falls into negative cash balance.

Simply put, ending cash balance is calculated as:

Ending Cash Balance = (Beginning Cash Balance + Cash Received) - (Cash Invested + Cash Spent)

And here's what a cash flow statement looks like...

The cash flow statement lets you determine how strong a company's cash balance is. It also gives you an indication of how efficiently it manages its business.

And finally, let's look at...

The Statement of Retained Earnings

The statement of retained earnings is the last of the four financial statements. This statement focuses on changes in retained earnings. It's closely linked to the balance sheet. If you remember, we talked about equity earlier. Retained earnings is what's left in the company's equity after any additions and subtractions to the beginning equity.

In simple terms...

Ending Equity = Beginning Equity + Investments + Income - Withdrawals/Dividends

The ending equity in turn shows up on your balance sheet.

Wrapping Up

As you can see, all of the four financial statements are interactive. Each one affects or is affected by the other in one way or another. Even though they each serve a unique purpose, they all have one common goal: to evaluate the health of a business.

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