Your small business may be chugging along just fine, but is it really growing? A survey found that 59% of businesses were in fair or poor financial condition. If you’re one of these businesses, you may want to look at your financial statements.
Although this may seem like a daunting task, understanding your balance sheet and income statement can be the first step in gaining more control over your small business’s finances. To start, you’ll want to break down the basics of each.
Balance Sheet Basics
As a small business owner, you’ve probably already mastered keeping your operation in balance each day. Now, you need to master your balance sheet. Understanding your balance sheet can help you improve your finances and business performance.
Your balance sheet will start off by listing your small business’s current and fixed assets, liabilities, and shareholders’ equity.
Examples of the assets shown on your balance sheet include:
- Prepaid expenses
- Accounts receivable
Examples of liabilities shown on your balance sheet include:
- Accounts payable
- Wages due
- Taxes due
- Other debts
The shareholders’ equity section equals the difference between your total assets and total liabilities. It will include:
- The par value of stock. This is a minimum amount per share that your stock would pay; it does not equal the market value of the stock.
- Amounts paid in capital. This is the money your stockholders have paid in order to acquire their shares of your small business’s stock.
- Retained earnings. This is your net income from when you first opened your business to your current operation date.
Your balance sheet will show the position of your small business at a specific point in time—like a snapshot—rather than showing results across a time period.
Income Statement Basics
If you haven’t heard of an income statement, then maybe you’ve heard of a profit and loss, or P&L, statement. Both names refer to the same document, which reports your small business’s revenue and expenses. Every income statement you generate will represent a specific accounting period. This time period could be monthly, quarterly, or yearly. It all depends on your personal preference and business needs.
Your income statement will outline your sales and expenses for the time frame you choose. It will first outline sales, and then work its way down to net income and earnings. Your income statement will also be broken down into two parts. They are:
- The operating portion. This is the portion of your small business’s revenue and expenses that comes directly from your regular business operations. This includes revenue from products and services you sell. It also includes expenses incurred from creating those products.
- The non-operating portion. This is the portion of your small business’s revenues and expenses that are not involved in your small business’s regular operations. This can include selling items not related to your product, such as equipment from your workplace.
In addition to these categories, income statements are often laid out in one of two ways. They are:
- A multi-step format. The multi-step format shows multiple rows, including sales, operating expenses, operating income, non-operating or other income, and net income. There will be multiple subtractions from your net income.
- A single-step format. Single-step formats have three rows. The first is revenues and gains, followed by expenses and losses, and then net income is calculated below both. This format involves only one subtraction from your net income.
Sole proprietorships and partnerships often use the single-step format. This format follows the equation:
Net Income = (Revenues + Gains) – (Expenses + Losses).
The revenues section of this equation includes the money you’ve earned from customers. Your expenses section will include the costs your small business takes on to create products for customers. This can also include expenses needed to perform services.
Differences Between the Income Statement and the Balance Sheet
Each facet of your small business’s operation is unique, and so are the financial statements that represent them. This means you’ll need to understand the key differences between your income statement and balance sheet. These differences include:
Balance sheets outline assets, liabilities, and shareholders’ equity for your small business at a moment in time. In comparison, your income statement will focus on your revenues, expenses, and what your small business has gained or lost during a specific time period.
Balance sheets provide a snapshot of your small business’s finances at a certain point in time. In contrast, income statements provide information that spans over a designated period of time, not one specific time.
Balance sheets and income statements require different equations for interpreting and analyzing their data.
For instance, the balance sheet equation “Assets = Liabilities + Equity” is the foundation for the whole balance sheet. This equation shows you what your small business owns and owes. It also shows you what shareholders have invested in your small business. In addition to the balance sheet equation, there are a number of ratios used to interpret and draw conclusions.
Balance sheet ratios include:
Solvency ratios. These ratios look at your small business’s cash, assets, and debt. Financial strength is represented by having a high amount of cash and assets coupled with low debt.
One example of a solvency ratio is your small business’s quick ratio. Quick ratios follow the equation:
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
This ratio measures your ability to turn assets into cash. For example, if you have a ratio of 2.0, this means you have $2.00 of assets for every $1 of liabilities.
Debt/equity ratios. These analyze the amount of financing your small business has coming from investors. The higher your ratio, the more bank loans and investor financing you have received. They can also mean that your small business has been acquiring debt to grow. A high ratio can indicate that you could have trouble paying off the debt. Typical debt/equity ratios are below five or six. Ratios above or in the five to six range are not ideal for investors.
Working capital ratio. This ratio reports how your small business is doing with meeting financial obligations. This ratio can be an indicator of your ability to pay your bills, payroll, and loan payments in a timely manner. Higher ratios mean you will be able to meet your financial obligations easier. A ratio of 2.0 indicates a good financial standing. Ratios below 1.0 can reveal financial problems.
There also are a few important metrics that can be obtained from your income statement data. Income statement ratios include:
Operating income. Operating income measures your small business’s earnings from normal business operations. Your operating income subtracts operating expenses. These expenses include wages, depreciation, and cost of goods sold. It follows the equation:
Operating Income = Gross Profit – Operating Expenses
Your operating income indicates how much of your income will be kept as profit. This means the higher your operating income, the better your small business is doing financially.
Earnings before interest and taxes (EBIT). This is also known as operating earnings, operating profits, and profit before interest and taxes. EBIT measures your small business’s profit from operations and focuses only on your ability to generate earnings from your business operations. It incorporates what you earn before interest or taxes are calculated. Your taxes and interest will be subtracted from the EBIT equation. It follows the equation:
EBIT = Revenue – Operating Expenses
To give you an idea of where your small business stands, look at your industry’s and competitors’ average ratios. The average EBIT will vary, based on your industry.
Net income. Your small business’s net income is also known as your net earnings or profit. The equation for it lets you know how profitable your small business is. The equation is:
Net Income = Total Income – Depreciation, Interest, Taxes, and Other Expenses
This equation allows you to see if your small business’s total revenue exceeds your total expenses. The revenue you have left over can then be used to pay your debts or invest in new areas for growth. Net income is used to calculate earnings per share. Generally, the higher your net income amount, the better. Higher income can help you grow your business efficiently, ultimately leading to more profits.
Cash flow. Every successful business produces cash during their operation. The cash flow equation for your small business represents the cash that is produced from your small business. The operating cash flow equation is:
Cash Flow = Net Income + Depreciation +/- Other Charges to Income from Operating, Investing, and Financing Activities
As you consider your small business’s cash flow, you’ll want to break down these activities into more detail:
- Operating activities. This section includes cash received from your customers, cash paid for expenses, and cash paid to your suppliers.
- Investing activities. This section includes any cash paid to get new or additional equipment for your small business.
- Financing activities. This section includes cash received as an investment from owners, cash received from bank loans, cash paid for bank loans, or cash paid to owners.
This equation tells you how well you’re generating cash to pay your debts and fund your operations as they occur. The higher your cash flow is, the more success your small business is likely to have.
Balance Sheet and Income Statement Linked
Your business is made up of a variety of interlocking pieces, including your financial statements. For instance, your small business’s balance sheet and income statement intersect with each other. The connection between them revolves around net income.
For example, say your balance sheet’s assets, liabilities, and owners’ equity are reported at the last accounting year. If the owners did not withdraw it, the owners’ equity will likely be the same amount as the net income earned by the business. Net income, as you already know, is reported on your income statement.
Creating Your Balance Sheet and Income Statements
You can’t make progress without “doing.” Now that you have a good understanding of balance sheets and income statements, you’ll want to put that knowledge to work by creating them.
As a small business owner, you want to run your business as successfully as possible. To do this, you will need to make a balance sheet. To start, you’ll want to:
- Gather and add your assets. Cash, securities, accounts receivable, inventory, land, equipment, intellectual property, supplies, and prepaid insurance are all examples of what you should look for as you list your assets.
- Gather and add your liabilities. The same process you just did for assets will need to be repeated here with liabilities. Liabilities include accounts payable, taxes owed, unearned revenue, bonds payable, wages, payroll, and any loans or lines of credit the business is responsible for.
- Determine your equity. To do this, you will to subtract your liabilities from your assets.
Balance sheets can be created in a spreadsheet, with accounting software, or even by hand. Typically, assets are listed on the left side of the report. Liabilities and owners’ equity are listed on the right.
You may also have prior period items reported on your balance sheet. These are either income or expenses for your current period that are a direct result of errors or omissions from the prior period’s balance sheet.
Once you’ve created your balance sheet, it’s time to create your income statement. To start this process, you’ll need to:
- Pick your preferred timing. Your income statement can span any time frame, such as monthly, quarterly, biannually, or even annually. However you want your balance sheet date to end
with your income statement period and the cumulative net income. This is because you want your small business’s inception to be reflected on your balance sheet equity.
- Add up your income. Your income or revenue includes what your small business has earned from selling goods or services to customers.
- Subtract your expenses from revenues. This will give you your small business’s profit and loss numbers. As you calculate these expenses, you will want to include what you spend on your business. This includes payroll, taxes, and other expenses.
Your income statement can be created in the same ways that your balance sheet can be, including spreadsheets, accounting software, or by hand. Most income statements consist of one column. They start with revenues listed and totaled. Then underneath that, your expenses and losses are listed and totaled. The last item on the statement will be your net income at the bottom.
You may also have prior period items reported on your income statement. These are either income or expenses from your current period that are the result of errors or omissions in the prior period’s statement.
Overall Business Health
After putting in hours of hard work, it can be difficult to admit that your small business truly can’t survive without support from others: You’ll need customers to clear your shelves and, often, investors to continue funding your small business. Luckily, you can use your balance sheet and income statement to communicate your small business’s financial standing easily. This can help you gain new investors, as well as keep your current ones. Offering investors a look at both your balance sheet and income statement can provide a deeper look at your small business’s financial standing.
Setting time aside to analyze and create your small business’s balance sheet and income statement won’t be a waste of time. These two financial statements can open the door to deeper calculations and analyses. Your balance sheet and income statement will assist your small business every step of the way, as you grow and expand.