Mark is a freelance tech journalist covering software, cybersecurity, and SaaS. His work has appeared in Dow Jones, The Telegraph, SC Magazine, Strategy, InfoWorld, Redshift,…
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Show me the money — it’s the fundamental demand any investor makes before backing a business venture. When you need to see revenues and expenses gathered in one place, Financial statements are the place to look.
Banks, investors, and customers use financial statements to assess a company’s commercial standing. They come in three forms — balance sheet, cash flow statement, and profit and loss statement (P&L). Together they paint a coherent picture of profitability and stability.
That may sound complex, but the truth is, if you can work out the carbs and calories on a cereal box label, you can read a financial statement. There are a few terms to learn, but after that, it’s no more difficult than following a recipe. In this article, we’ll explain the main elements and walk you through how to interpret them.
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A financial statement comprises several sub-statements, and you’ll need to review them all, from balance sheets to P&Ls to cash flow statements. Often they’re published as part of an annual report. Each one enables a different kind of analysis.
A balance sheet shows you the book value of a company, e.g., its total assets minus its total liabilities. For a specific date, it lists the resources the firm has and how they were financed under three major categories: assets, liabilities, and owner’s equity. In other words, what the business owns, how much it owes, and how much is left over.
Assets mean all the items a company owns that have a measurable value, e.g., that could be sold for cash, used to provide services and generate income, or used to make products for sale. Assets can be physical, like equipment, vehicles, real estate, or stock in a warehouse. Assets can also be intangibles like patents and trademarks, which could be licensed or sold. Of course, any cash sitting in the firm’s bank account would be considered an asset, along with any investments held in the company’s name.
Liabilities mean the money the firm owes to vendors and creditors. The term covers a range of debt obligations like payroll, bank loans, taxes, rents, or supplier invoices sitting in accounts payable. Liabilities can also cover contracts where there is an agreement to provide customers with goods or services at a future date.
Owners equity means the money left over if the company sold off all its assets and cleared all of its debts. Sometimes called net worth, the amount leftover belongs to the company’s owner(s).
The three categories are listed in the balance sheet in different ways.
Assets are the most complex. Normal practice is to prioritize them under three sub-categories based on how quickly they could be turned into cash:
Liabilities, like bills, are listed according to their due dates and prioritized in the balance sheet under two sub-categories:
Shareholders’ equity, the amount leftover when total liabilities are subtracted from total assets, is usually listed last.
While a balance sheet tells you how much a company is worth, a cash flow statement tells you how well the company can generate cash. They’re designed to give a detailed account of where a firm’s cash has gone within a specified accounting period (usually a month, quarter, or year).
The point of maintaining one is to demonstrate that the business has enough cash flowing in and out to operate — both in the short and long term. If a company doesn’t have enough cash on hand, it won’t be able to purchase products or raw materials, pay bills, or pay its people.
The cash flow statement captures changes over time rather than the money available on a given date. To do that it takes information from the balance sheet and the profit and loss statement.
Cash flow statements are usually organized into three main sections for three types of activities:
Operating Activities are listed first and calculate a company’s cash flow from the perspective of net income or net losses. In many cases, this section takes the net income from the P&L and reconciles it with the actual cash the company took in during the period.
Investing Activities come next and show the cash flow (in or out) from the purchase or sale of long-term assets like equipment, property, or any financial investments like stocks and bonds. If a company purchases a new delivery vehicle, for example, the cash flow statement would show the purchase as a cash outflow from investing activities. If a company sells the vehicle later, the proceeds would be listed as a cash inflow from investing activities.
Financing Activities capture the cash flow from financing activities. These can include cash raised by taking on a bank loan and the cash going out in monthly loan repayments.
At the bottom of a cash flow table, you’ll see a figure for net increase or net decrease in cash for the period.
A Profit & Loss Statement (P&L) is an essential tool for managing your business. It gives you a monthly, quarterly, or annual snapshot of business performance; and shows you how much revenue you’re bringing in — and from where.
Crucially, it also delves into the places where the business is incurring costs and eating into profits. At the end is the bottom line: the figure showing the company’s net earnings or losses over the period.
P&Ls typically include the following calculations:
Balance sheets serve two very different purposes depending on the reader. When a balance sheet is reviewed within a company, it’s designed to show whether the firm is succeeding or failing. When a balance sheet is reviewed externally, it’s usually a potential investor deciding whether or not the business is worth putting money into.
To read a balance sheet, you’ll need to understand these three concepts:
If you wanted to work out the value of your business’s current assets, the accounting equation you’d use is: Liabilities + Owners’ Equity = Assets
When you review a cash flow statement, you’re trying to get an idea of the firm’s operational stability. Is there enough money coming in from week to week to pay bills and people?
The answer can reveal if the business is in a rapid growth phase, like a startup or a mature and profitable SMB. It can also signal if a company is going through a slow period.
To understand all the line items that could appear in a cash flow statement, it’s useful to understand the following:
One common cash flow calculation is Operating Cash Flow. You arrive at it using this equation: (operating income + depreciation) – (taxes + change in working capital).
The P&L is designed to tell the financial story of a business’s operating activities in a given time period. When you review one, you’re looking for proof that the business is profitable or if it’s spending more than it earns. In either case, it’s also useful to know if costs fluctuate on a seasonal basis, how much it costs to produce its products or deliver services, and whether there’s money available to put back into the business.
A P&L’s simplicity can be a blessing if you want a fast snapshot of overall performance — or a curse if you don’t understand all the labels in the table. In addition to basics like revenues and costs, knowing these terms will make things clearer:
EBITDA: A common accounting measure of a company’s ability to generate cash flow. It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
Gross profit: The profit after deducting costs associated with delivering a firm’s services or making and selling its products.
To arrive at an EBITDA figure, add interest, taxes, depreciation, amortization, and net profit together.
If you’re a stakeholder in a business, ‘show me the money’ is a standard request. Reliable businesses tend to be very good at capturing what they earn and spend in P&Ls, cash flow statements, and balance sheets.
If you’re a business owner, aspiring entrepreneur, or want to better understand how your retirement savings are being invested, the ability to read and understand them is absolutely essential.
To learn more about financial statements, read more of Techopedia’s accounting guides.
For businesses, the primary financial statements are the profit and loss statement (P&L), the balance sheet, and the cash flow statement.
Debit what comes in and credit what goes out, credit the giver and debit the receiver, all income types are credits, and expenses are debits.
Balance sheets are structured around a core equation: Liabilities + Equity = Assets
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Mark is a freelance tech journalist covering software, cybersecurity, and SaaS. His work has appeared in Dow Jones, The Telegraph, SC Magazine, Strategy, InfoWorld, Redshift, and The Startup. He graduated from the Ryerson University School of Journalism with honors where he studied under senior reporters from The New York Times, BBC, and Toronto Star, and paid his way through uni as a jobbing advertising copywriter. In addition, Mark has been an external communications advisor for tech startups and scale-ups, supporting them from launch to successful exit. Success stories include SignRequest (acquired by Box), Zeigo (acquired by Schneider Electric), Prevero (acquired…
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