How to Understand Business Financial Statements for Your Small Business

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Understanding Financial Statements for Small Businesses

This section will guide you through the fundamental elements of financial statements. You'll learn about balance sheets, income statements, and cash flow statements using practical examples and insights. By understanding these financial statements, you'll gain a clear picture of your business's financial position, enabling better strategic planning and decision-making.

How to Understand Business Financial Statements for Your Small Business – Transcript

Wouldn't it be great if you had a startup or small business idea and you could get an understanding of whether it would work or not just by looking at three pieces of paper? Well, you actually can do that, and we're going to be taking a look at exactly how in this video. 

Hey, Will Scheren here for Small Business Startup Guide by TRUiC. This video is part of a larger course dedicated to helping small business owners cut through the noise and get to the essentials of starting and operating their business. If that sounds really useful to you, be sure to like and subscribe. 

In the last video in the course, we finished entering financial projections into LivePlan.com, and as a result, it produced three projected financial statements for us to be able to gain an understanding of whether or not the imaginary small business that we're building could serve the owner of the business to meet his goals. 

In this video, we're going to take a look at these three projected financial statements. We'll learn what they are, how to read them, and how to actually get value from them so that you can make business decisions for any startup or small business idea that you have. 

At TRUiC our mission is to offer all our resources and information for free - but we support our work by using affiliate links, meaning we earn a commission on many of the amazing deals we’ve negotiated for you. Full transparency, LivePlan.com is one such affiliate partner. Link in description below. 

Projected financial statements are reports that summarize important financial projections about your business. There are three main types of projected financial statements: the balance sheet, the profit and loss statement or income statement, and the cash flow statement. We're going to look at what each of these statements do and how they can work together to give you a full picture of a business idea’s viability. 

Let's start with the balance sheet. A balance sheet gives you a snapshot of your business's finances at a given point in time. Essentially, it tells you what you own and how you paid for it. 

Balance sheets are broken up into three general categories: assets, liabilities, and equity. Here's what LivePlan projected our imaginary barbershop’s balance sheet would look like after one year of being in business. 

Assets are anything valuable that a business owns, including cash, furniture, inventory, patents, and more. On a balance sheet, assets are broken up into current assets and long-term assets. Current assets are cash or cash equivalents — something that can be sold quickly. 

In the next section of the balance sheet, we have liabilities. Liabilities are debts that you owe to other people. This can be business loans, credit card debt, mortgages, and accrued expenses like utilities, taxes, or owed wages. 

Like assets, liabilities are often split into current and long-term liabilities on a balance sheet. Current liabilities are debts that are owed within the next 12 months, and long-term debt is debt that you owe further than 12 months into the future. 

The last category of a projected balance sheet is equity. Equity is the remaining value of the company after subtracting the liabilities from the assets. For small businesses, equity can come in the form of initial investments from the owners or in retained earnings, which is the amount of net income that you have left over for your business after you've paid any dividends to the owners. 

Now here's where the whole balance part of the balance sheet comes into play. The value of the assets section will always balance with the value of the liabilities plus the owner's equity. This is the balance sheet equation: assets equals liabilities plus equity. So we can see on the projected balance sheet for our imaginary barbershop the value of the assets at the end of the first year is the exact same as the liabilities, plus the equity. 

That's a quick overview of the balance sheet. It's a good idea to prepare a projected balance sheet as well as a current balance sheet for your business every three months, depending on how many assets you have moving in and out of your business. Now, what can you really learn from a balance sheet? 

For one, you can measure the liquidity of a company, which is a measure of how quickly you could pay off debt using the current ratio, which is the current assets divided by the current liabilities. Businesses that have projected balance sheets that maintain a current ratio of higher than 1.0 can project that they'd be able to pay off any current debt that they have in the next 12 months. 

With the projected balance sheet, you can also calculate your business's exposure to risk. This is done by looking at your debt-to-asset ratio, which is equal to your business's total debt divided by their total assets. Properly deciding on a debt-to-asset ratio that would be wise for your business to plan for requires the owner of the business to research available industry information concerning average debt-to-asset ratios for the industry, as well as measuring their own risk tolerance. 

Next, let's talk about projected income statements. The projected income statement tells you how much money your business is projected to spend and earned over a given period. This will let you calculate your projected net profit. Here's what the projected income statement looks like for our imaginary barbershop for the first five years of its existence. 

Projected income statements have seven main sections that you need to pay attention to. 

Revenue, which is how much money you earn. 

Direct costs, which is how much money it costs to make and distribute your product or service. These costs don't include costs like software costs or rent, those are operating costs. 

The gross margin, which is revenue minus direct costs. This is a measure of how profitable your products and services are. 

Operating expenses — these are costs of running a business like utilities, rent, and your support staff. These are commonly called overhead costs. 

The operating income or loss — this is the gross profit minus your operating expenses. It shows you how profitable your business is and how efficient you are at making money. 

Nonoperating expenses like taxes, interest, and depreciation are expenses that are out of your control but still have an effect on your business. 

And net profit, which is your operating income minus your not operating expenses. This is the amount of money that your business projects that it can walk away with after it's accounted for all of its expenses. 

The value of the projected income statement is pretty obvious. It shows you if your business has the ability to be profitable or not. It also can help you understand if you're spending too much money on your products or too much money on overhead. 

The last projected financial statement that LivePlan produces from your financial tables is the projected cash flow statement. The projected cash flow statement can show you how much cash is projected to leave or enter your business over a given period. This is different than the projected income statement. A projected income statement will show you how much you plan to spend and how much you plan to make. The projected cash flow statement shows you what the projected cash reality of your business will be. 

Your business will always need to have cash on hand to take care of any current liabilities and take advantage of opportunities that require immediate payments. If your business allows payment terms to customers, allowing them to make payments in the future, then your income statement will show that you generated income at the same time that you invoiced them, but it would not provide an accurate reading of how much cash you had at the time. This is what the projected cash flow statement for our imaginary barbershop looks like. 

A projected cash flow statement has three parts. The first part shows cash from operating activities. This is all of the core business activities selling goods and services and buying items required to do business, as well as adjustments for things like accounts payable and receivable, taxes, depreciation, and amortization. 

Below that, you can see cash from investments. Changes in this section will come from changes in the valuation of your total assets. And finally, you'll see cash from financing activities. This will include changes to the cash situation of a business, including owner investments and distributions, as well as any debt that the business is managing. 

If you add all of these three sections together, you'll get your total change in cash, and if you add the beginning cash to your total change in cash, you'll get your ending cash. 

Most banks are investors that you had asked to provide you with cash for your business will want you to have these three financial documents prepared for your business for the duration of the time that you're prepared to work with them, with the majority of the detail of the projections allocated towards the first few years of the projection. 

Namely, they’ll want you to present these documents to prove to them that you have a plan that will accomplish three things: That you'll grow the total value of the company that you're operating, that you can ensure that you're growing the business in a way that would leave it with the ability to pay back its loans or satisfy its investors' interest in the future, and ensure that the business will never run out of cash and be unable to pay its bills. 

So if you finished your financial projections and they're not showing that they justify any of these three components of a healthy business, you should go back and rework them. 

But lenders and investors will also want you to justify the projections you've made, which will require you to be able to speak articulately about who your customers are, the problem you solve for them, and the manner in which you'll go about solving their problems, and we're going to be spending the next several videos preparing you to launch your business idea by showing you how to do exactly that. 

This video is part of a step-by-step course that gives small business owners all of the essential information to start and operate their business. We've provided a link for you to get access to all of the free and discounted business tools that we mentioned in the course below this video. 

Be sure to like and subscribe to get more of this content. We'll see you in the next video, and if you have any questions, let us know.