Not everyone is gifted with the ability to crunch numbers. That’s why most business owners look for an accountant to worry about these for them. However, if you don’t know how to interpret an income statement and balance sheet, you are at risk of being clueless about the financial health of your business, which limits your ability to make good decisions.
So if you have an accountant, why do you need to know how to read a balance sheet and income statement?
As a business owner, you need to be able to understand the company’s overall financial health in order to make the right decisions to ultimately meet your goals.
Both balance sheets and income statements provide crucial information about the state of your company, so it is important to know how to interpret them.
Key differences between balance sheet & Income statement
Balance Sheet: provides a snapshot of your capital structure — how much your company owns (assets), owes (liabilities), and how much belongs to stockholders (equity).
Income Statement: a document that showcases your revenue and the expenses incurred to make that revenue. It will show you if you are making profit, breaking even, or losing money.
A balance sheet will show the business’s assets, liabilities, and shareholder equity at a specific point in time. A balance sheet is essentially an equation:
Total Assets = Liabilities + Shareholders Equity.
An asset is anything that has value in a company or will be used in the future to make money. There are three main places a business can find assets:
- Borrowing assets- getting a loan to buy “assets” like land, supplies or equipment, to help generate revenue in the future. The business, however, has the obligation to pay back what they borrowed. This obligation is a liability.
- Daily operations- this is the revenue a business generates daily from sales or services provided.
- Investors- when a business receives assets (i.e money) from investors, there are two responsibilities that businesses have to the investors:
- The first is to use that asset strategically and in a way that will generate a return.
- The investors then own a part of the business and share the profits. The parts of the business that is given to the investors is called common stock. The investors are called stockholders/shareholders and the commitment the business has to the investors is called stockholders/ shareholders equity.
Analyzing a Balance Sheet
The first thing you will see on a balance sheet will be the assets, or how much the company owns. There are a few different types of assets. The most common type will be cash and stock. However, you will often see accounts receivable, intellectual property, equipment and inventory. While it can be easy to analyze tangible assets like cash, things such as accounts receivable or intellectual property can be a little trickier to understand, since the money is not readily available but each part could be collected or sold to make money.
Accounts receivable vs. Payable
Accounts receivable is the money that the company has not yet collected. Companies will sell things on credit or have money that others owe them. Intellectual property are things such as patents, trademarks and copyrights, that will generate revenue in the future.
Next, you will see the other side of the equation: liabilities, which is money owed by the company. Usually, current liabilities and long term liabilities are listed here. Current liabilities are things such as current debt and notes payable. Notes payable is usually money owed to the bank from a previous loan.
Accounts payable are also listed in the current liabilities section and determine what a company owes to suppliers or other people who they’ve bought from using credit.
Long term liabilities may be bonds payable, or, bonds that the company has issued. Anything can be a long-term liability if it is a debt that the company will owe for more than one year.
Shareholder equity will be listed on the balance sheet. This is the money that goes to a company’s owners or shareholders. Shareholders equity is the net income, the money left over after expenses and deductions are taken out. This is an important number to pay attention to because it will tell you how much the company is worth.
The statement shows you how much money the company is making and how much it is spending. If the expenses are greater than the revenue, the income statement sheet will show you the net loss. Conversely, if the revenue is greater than expenses, the income sheet will show a net profit. When expenses are equal to the revenue, it is said that the company is breaking even.
An income statement will also show the earnings per share, the amount of money each shareholder would receive if the company decided to distribute the net income.
Key Things to Analyze in an Income Statement
There are a few things to consider when looking at an income statement:
- Check the Math: Run through all the numbers to make sure everything makes sense, even a small error can change the outcome, so although it might seem redundant, it’s absolutely necessary.
- Understand the Bottom Line: located at the end of the statement, you will find out whether your business is making or losing money. A positive-sum means profit and a negative-sum means loss. If your outcome is negative, start by tracing back to the expenses section to find out why.
- Look at Your Revenue: look at where and when the company made money, and see if it will be sustainable as it can show you trends of what was successful and what may need to be changed for the next time to ensure success. For example, if a shoe company made most of their profit off of one event, you would have to make sure that event could be repeated for the next year, or at least have a game plan as to what to do the next year to bring in revenue.
- Expenses: Look at where your money is being spent. Common types of expenses are salaries and supplies. Analyze all expenses to see if they are reasonable, and where you could be saving more money. Are the employees being overpaid? Are there too many employees? Are supplies reasonably priced? These are important questions to ask.
Key Term Definitions in an Income Statement
As a professor once said,
“accounting is not about math, it’s about learning a language. There are a few terms that you will see on an Income Statement.
Net– this term has been previously mentioned for both gain and loss. Net is what is left over after dedications/ expenses are subtracted.
Cost of sale (COGS-cost of goods sold)– This term usually appears in terms of manufacturing. This is what it costs to make a product or provide a service. I.e labor, cost of materials, raw materials and manufacturing costs.
Operating Activities– Operating activities are expenses or income that come from operating your business. Things such revenue made from providing a service or sales, advertising, manufacturing etc.
Financing activities– This is a measurement of financing, which is why it is called financing activities. Examples include the obligation a company has to investors, creditors, etc. Purchasing stock is a financing activity because it affects owner’s equity.
Investing activities-With the definition in the name, these activities cover things such as buying land, investing in other companies, buying other companies etc.
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About Raitchele Cornett
Raitchele (Hi-Chel-Ee) is from Curitba, Brazil, and grew up around entrepreneurs and business moguls.
Raitchele is a Boise State Alum and MBA Student with a passion for entrepreneurship.