The most important thing about your business is its financial statements. Financial statements are the window into your business’s inner workings. A smart investor knows how to read financial statements and how to tell very quickly whether a business or property is a good investment. But a less knowledgeable investor may only read a part of the financial statement and get the wrong picture. What type of investor do you want to be?
There are 3 elements that make up financial statements.
- Balance Sheet (What We’ve Got)
- Income Statement (How’d We Do?)
- Statement of Cash Flows (Where’d the Money Go?)
Balance Sheet (What We’ve Got)
The balance sheet is where most people learn to read financial statements and it’s the one most people are comfortable with. But a balance sheet isn’t the complete statement. It can tell you some things, but not the whole picture.
When you’re looking at a balance sheet you see two things: what a business owns and what that business owes. These two things need to balance each other down to the penny – hence the name “balance” sheet.
What the business owns is pretty easy – those are the assets, and they can range from the straightforward (cash, accounts receivable and property) to less-straightforward things like goodwill and intellectual property.
What a business owes is also pretty simple. It’s broken down into two sections – liabilities and equity, and may be broken down again within each of those categories.
Liabilities are what a business owes to outside third parties. A mortgage, a loan for equipment, the telephone bill – these are all examples of liabilities. Equity is the leftover profit that would be distributed to the business’s owners if it were folding up shop at that exact moment.
So far so, good, right? Now, what do the numbers say?
Well the first thing to look for is the ratio of assets to liabilities. If you’re looking at business records that show a business has twice as many assets as liabilities, that should be a good thing, and you should run right out and invest in that business, today, right?
Actually, the answer here would be “it depends.” What if most of those assets were tied up in Accounts Receivable? That’s not money in the bank, that’s money the business is owed, and as all business owners know, until the money’s in the bank nothing is certain. If you’ve got a business without a lot of cash and a lot of liabilities, that could be a sign of trouble.
Maybe you’re looking at a corporation’s balance sheet that looks good, the assets to liabilities ratio is good, and then you notice the company has a lot of money in retained earnings. That’s good, right? The company has a large contingency fund to cover emergencies.
Again, the answer is “it depends.” If the company is in a major growth cycle the money may be earmarked for future projects. But if you’re looking to invest in that company, presumably you’ll want to know how you’re going to receive a return on your investment. If the business isn’t distributing its profits regularly, you might be waiting to get your money out for a long time.
If you were to look at your company’s balance sheet, what would it say?
The Income Statement (How’d We Do?)
The income statement is the second element of a Financial Statement. It’s different than a balance sheet, which shows you where your business is at an exact moment. Instead, an Income statement shows you the ratio between a business’s income and its expenses over a period of time: anywhere from 3 months to a full year.
For some people the income statement (which is also sometimes called a Profit & Loss Statement) is the be-all, end-all financial statement. After all, if your business isn’t profitable, this is where you’ll find out why. If your expenses are higher than your profits, you can quickly see where you’re spending money and where you might be able to cut back. Or, you can see what products or services are making money and which are not.
But, as with anything else it isn’t always that simple. If your business is in its development stage it could easily be spending more money than it’s earning, and all of those expenses could be entirely justifiable. There are businesses which lost money for years (Amazon.com, for example), that are perfectly viable businesses – in Amazon’s case, it was positioning itself as a market leader in online retail (and trying to outlast its competition).
If you’re looking at a business with an upside-down income statement, the first question to ask would be “why,” followed by “how long does the business expect to be in this pattern?” You might even want to look back over previous Income Statements to see if you can spot a trend.
Take a look at your company’s income statement. What does it say about your business?
Statement of Cash Flows (Where’d the Money Go?)
The statement of cash flows is the third element to a financial statement and probably the hardest one to understand. It’s also my favorite.
With a statement of cash flows you’re essentially viewing where the money went that your business made. You begin with a business’s net income and then deduct things that directly impact the net income – such as inventory and accounts receivable. Then, you add back in items that don’t impact your business’s net income – such as depreciation, which affects your bottom line but doesn’t touch your business’s bank account.
A statement of cash flows is broken down into 3 parts, the cash you made (and spent) on operations, investments and through financing. This is really handy, as it can show you very quickly whether a business’s money is coming from sales, whether it is coming from investments the business has made that are profitable, or whether the money is coming from the owners’ pockets or the bank. If you look at a statement of cash flows that shows the majority of cash coming from financing, then you know the company is borrowing money from its owners or a bank to stay afloat.
The hardest part about understanding a statement of cash flows is why asset items that we generally think of as being positive, such as inventory and accounts receivable, are deducted. The reason for this is that these items impact a business’s cash flow. If you are spending a lot of money to purchase new inventory you have less cash available to pay your business’s bills. Likewise accounts receivable – if your accounts receivable balance is increasing you are tying up that cash until the receivables are paid. Think about it. You can’t pay your employees with receivables – you need money in the bank to cover those paychecks.
Confused? You’re not alone … but maybe we can help with that. In our product, Understanding Financial Statements, we have demystified the 3 elements to a financial statement and show you how to properly read each one. Once you know how to really read a financial statement you’ll be amazed at what you see – and how easy it is to avoid those businesses that aren’t a good investment.