Understanding your company’s financial position is integral to its success. One tool that can help you is financial reporting, which is an objective way to assess your company’s financial health. Financial reporting results in a financial statement, which can indicate whether your company is bringing in a profit or heading towards trouble. Let’s dive into the basics of a financial statement and how to use it.
What are financial statements?
Financial statements are reports that explain a company’s financial performance and profitability for a certain period of time. There are three basic financial statements:
- Balance sheets
- Income statements (or profit and loss statements)
- Cash flow statements
Business owners use other financial reports, such as the statement of retained earnings, less frequently.
Why financial statements are important
Financial statements are important because they let stakeholders—such as shareholders, creditors, and regulators—understand a company’s overall financial performance and health. If you’re ready to seek funding for your business, lenders will look at your financial statements as they determine your eligibility for a business loan. Public companies are also required to publish their financial statements in an annual report.
Typically, financial statements provide information about a business’s:
- Economic resources and obligations
- Earning capacity
- Potential cash flows
- Management status
- Accounting policies
Most importantly, financial statements help business owners better understand their bottom lines and make smarter business decisions. The right tools, like accounting software, can make generating financial statements simpler.
How are financial statements prepared?
Because financial statements serve as fundamental sources of financial information, you need to apply basic accounting principles to ensure accuracy and consistency. You can prepare financial statements using three principles.
1. Recorded facts
An original or historical cost of accounts can help you prepare financial statements. Typically, you record prices and assets you purchase at different times at the original cost.
2. Accounting conventions
Using accounting conventions makes your financial statements comparable and realistic. For example, the principle of consistency requires accountants to apply standards consistently year after year.
3. Personal judgments
Your financial statements are based on personal judgments and estimates to avoid overstating assets and liabilities.
Now that you understand the concept of financial statements, let’s look at the various reports that make up financial statements.
3 types of financial statements
In the world of financial reporting, there are many tools business owners can leverage to get the job done, but in general, the business owner utility belt holds three important tools:
Balance sheet
A balance sheet (or statement of financial position) is a financial statement that lists a company’s assets, liabilities, and equity balances. It showcases a business’s financial position at a particular point in time. A balance sheet provides information for three categories: assets, liabilities, and equity.
- Assets are resources that generate revenue (or sales) and profits in a business. An asset may be tangible, like a vehicle, or intangible, like a patent or other intellectual property.
- Liabilities are amounts the business owes to other parties, including accounts payable (current liabilities) and long-term debt.
- Equity is the difference between assets and liabilities, and refers to the true value of a business. Equity includes common stock, additional paid-in capital, and retained earnings. Equity is also known as shareholder’s equity, owner’s equity, or net worth.
The balance sheet formula drives the three components of the balance sheet. The formula subtracts assets from liabilities to determine equity. The formula follows:
Assets – liabilities = equity
The double-entry accounting system requires the accounting equation to stay in balance as transactions post. Balance sheet accounts calculate working capital and other important ratios.
Review the balance sheet for Centerfield Sporting Goods as of December 31, 2021. Total assets ($185,000) equals the sum of total liabilities ($150,000) plus equity ($35,000).
How is a balance sheet connected to an income statement?
An income statement connects to the balance sheet through the net income account. A company can generate its income statement using the income statement formula, which subtracts revenue from expenses to determine net income. The formula follows:
Revenue – expenses = net income (net profit)
Income statement accounts are known as temporary accounts because the account balances adjust to zero at the end of each month and year. However, balance sheet accounts are permanent. The ending balances carry from one month to the next.
At month-end, the books close, and all revenue and expense accounts adjust to zero. The net impact of the income statement activity posts as net income on the balance sheet and increases the equity balance.
Income statement
An income statement shows a company’s revenue and expenses for a period of time. It provides information relating to returns on investments, risks, financial flexibility, and operation capabilities. The income statement formula generates an income statement. Most companies produce a multi-step income statement, which documents how a firm produces net income.
How does a multi-step income statement differ?
In a multi-step income statement, you first find your gross profit then your operating income for a period of time.
Assume, for example, that you’re a small furniture manufacturer, and that you’re creating a multi-step income statement for May. Most of your business activity will flow through gross profit.
Your material, labor, and overhead costs post to the cost of goods sold account. In May, you sold $1,200,000 in furniture, and your cost of goods sold (material and labor costs) totaled $900,000. So you made a $300,000 gross profit.
But you also incurred expense line items—advertising costs, sales commissions, and home office costs—to operate your business in May. Let’s say those expenses totaled $170,000 for the month. You can subtract your $300,000 profit from your $170,000 expenses to find your $130,000 operating income for May.
Operating income vs. non-operating income
You can generate operating income from the day-to-day business activities. In May, furniture sales produced $130,000 in operating income. Your company also earned non-operating income, including $2,000 in interest income and $4,000 from an equipment sale. So your net income for May now totals $136,000.
Your business must produce a majority of its net income from operating income activities because operating income is sustainable. Non-operating income is inconsistent and unpredictable. No company can rely on it to produce annual profits.
Review the Centerfield company’s income statement for the period ending December 31, 2021. Sales totaled $520,000, and the cost of sales totaled $420,000. So their gross profit was $100,000. And Centerfield had operating expenses of $90,000. That gave them $10,000 in operating income for the period. Since the company did not generate any non-operating income, its operating income was its net income balance.
Cash flow statement
The cash flow statement (also called the statement of changes in financial position) documents a company’s cash inflows and outflows. Cash flow separates into three categories.
- Operating activities indicate the sources and uses of cash related to a business’s daily activities. Operating activities include cash from customer sales and inventory. A company should produce most of its cash inflow from day-to-day operations, which they can sustain over months and years.
- Investing activities refer to cash activity related to buying and selling assets like machinery, equipment, and vehicles.
- Financing activities occur when a company earns money from a stock or bond issue. The financing category also accounts for cash repayments to investors.
Most of the cash activity in a business takes place in the operating category. When an accountant generates the cash flow statement, they should identify the investing and financing transactions first. All remaining cash activity is in the operating category.
Review Centerfield’s statement of cash flows for the accounting period ended December 31, 2021. Note that the ending cash balance ($40,000) equals the cash balance in the balance sheet.
How a statement of cash flows is connected to the balance sheet
The statement of cash flows adds all cash inflows and outflows to find the net change in cash for a period. The cash flow statement’s ending cash balance should equal the ending cash balance in the balance sheet.
Creating more accurate financial statements
Ultimately, the best way to increase the accuracy and dependability of your financial statements is to automate the process wherever possible. Using accounting software, for example, leverages technology to handle all the number crunching.ç
So no more late nights sifting through piles of receipts and punching keys on the adding machine calculator.
Another way to maintain accurate financial statements is to choose your accounting conventions and stick to them. It can be extremely frustrating when trying to compare current performance to previous years only to be lost in the milieu of different categorization methods or accounting methods.
On the other hand, there are a few ways in which you can make financial statements inaccurate or ineffective. We will dig into that subject next.
4 common mistakes on financial statements
A financial statement is an important part of your financial accounting system. Making one of these common mistakes can affect the accuracy of your financial statements and business decisions.
1. You’re not including comparative data.
Including prior-year, prior-month, or budgeted amounts makes it easier to see if actual amounts meet expectations.
2. You’re not reflecting reality.
Financial statements should always reflect the true financial condition of a business. Consider having your financial statements reviewed by a third party to identify inaccuracies.
3. You’re not revising procedures to reduce discrepancies.
If you identify an error or discrepancy in your financial statements, take the time to revise your accounting procedures.
4. You’re not auditing your financial statements.
Financial statements are only beneficial if they’re accurate. Don’t generate a financial statement just for the sake of having one. Read the statement, address any discrepancies, and use it to understand your business’s financial health better.
3 financial statement red flags you can find (and fix!)
Your financial statements help you assess your business’s financial health, and there are a few red flags that can indicate trouble. Learning to spot these red flags early on can help you make smarter financial decisions for your business.
1. Rising debt-to-equity ratio
This indicates that the company is absorbing more debt than it can handle. If the debt-to-equity ratio is over 100%, it may be cause for concern.
2. Revenue consistently trending down
If a company has consistent declining revenues over the years, it’s not a good investment. Cost-cutting measures could help offset the downturn.
3. Large “other” expenses on your balance sheet
Small “other” expenses are normal in your income statement. If an “other” item has a high dollar amount, find out what it is and if it’s likely to recur.
Make a financial statement in your business
If you’ve made it this far, you’re ready to take the next step and incorporate financial statements into your workflow and processes. Not only will these statements help you better manage your business, but they will highlight areas in need of improvement and opportunities for growth.
Related:
This article originally appeared on the Quickbooks Resource Center and was syndicated by MediaFeed.org.
More from MediaFeed:
18 business ideas for freelancers
Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money. The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Whether you’ve come to embrace WFH culture, need to supplement your income or have joined the Great Resignation and are now looking for more fulfilling work, starting a freelance business can be a great solution.
Freelancing often comes with a number of perks, like getting to be your own boss, setting your own hours, and working from wherever you like. Start-up costs are often low. And, if you need some capital to get your business going, you may qualify for a small business loan for self-employed people.
However, starting your own freelance business can take a lot of hard work and hustle, and it may be some time before you start making real money. If you’re up for the challenge, here are some home-based small business ideas to help you brainstorm the best way to tap into your talents and flex your entrepreneurial muscles.
Related: How to run a successful small business: 9 helpful tips
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If you have a great eye and a decent camera, you may be able to turn your creativity into cash. One option is to sell your photos to a stock imagery site like Getty Images or Shutterstock. If your home is particularly picturesque, you might offer to do headshots or portraits in your yard or set up a home studio. If you’re interested in event photography, you can market your services to people who need professional photography for weddings, graduations, engagements or other events.
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If you are both creative and technical, you might enjoy freelance web design. A web designer typically builds all the elements of a website, including the graphics, type fonts and layout. You’ll likely need to have some knowledge of basic programming languages, such as HTML, CSS and JavaScript, and also know your way around image editing software like Photoshop. You can learn these programs through research and practice or classes. When you’re ready, you can create your own website to showcase your skills and market yourself to potential clients.
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Virtually every business needs creative elements like logos, web designing, memes, blog posts, infographics, ad banners and more. That means there is often a lot of opportunity for a good graphic designer to get freelance work. To become a graphic designer, you typically need to have strong drawing skills, knowledge of graphic design theory, and mastery of design software (such as Photoshop and Illustrator). You can take a degree course in designing or learn it online. Once you have some solid skills, you can start marketing your design services to potential clients.
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If you have an eye for color and composition and love to create beautiful, inviting spaces, you may want to think about getting gig work as an interior designer. You don’t necessarily need to have a degree in design to become an interior design consultant. You can just create a portfolio of some of the successful redesigns you’ve done and ask your friends and family to start recommending you.
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If you have video editing skills and are looking to freelance, you may find yourself in demand. With the growing prevalence of video in social media and marketing, the need for video producers has grown in recent years. Even if you don’t have a lot of experience cutting and editing video, you can hone your video skills with online classes and tutorials. As a video producer, you can have the flexibility of working from home on a variety of projects while also utilizing your creativity.
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Does your skill set include online advertising, content writing and SEO? If so, you may want to consider starting a digital marketing services business. When companies roll out new products, they often need help handling external communication and messaging, including email campaigns, online advertising, and social media marketing. And since it’s digital marketing, you aren’t likely to be rooted in any one location.
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If you understand how engaging multimedia content can be used in marketing, then social media consulting may be a good fit for you. As a social media manager, you can help companies understand how to use Facebook, Twitter, Instagram and other platforms to reach their business goals. If you can stay on brand, share content appropriately, and reply to customers intelligently, you might make a great social media manager.
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Companies of all types and sizes are using data analytics to understand trends in customer behavior. Data analysts use a variety of analytical tools to assess things like sales numbers and performance, identify market trends, and then write reports that chart their analysis and recommend future strategies. This can be a great freelance option for people who have been working in data analytics. However, beginners can take online courses and enroll in certification programs to master the required skills.
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To stay competitive, email marketing is a must for many companies. And that can be great news if you are a strong and creative writer. Having a background in sales and marketing can also serve you well. Email marketing pros need to be able to craft creative and compelling copy about a company’s products, services and promotions, and convert readers into buyers. The job may also include monitoring email marketing campaigns, building email databases and tracking results.
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SEO service providers utilize search engine optimization to make sure a company’s site comes up high in online search results since a high-ranking placement generally translates into a lot of site traffic. If you’re an SEO pro who understands Google’s algorithms and the value of keyword frequency and meta descriptions — or you’re willing to learn — you may find your services in demand by a range of different organizations who need help with their SEO content strategy.
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Blogging can be a profitable freelance job. If you are able to build a large following, you may be able to sell advertising space, which can bring in a small revenue stream. You can earn even more through sponsorships and affiliate marketing, which is when brands you believe in pay you for advocating their goods and services. If you don’t want the limelight yourself, you may be able to blog behind the scenes for companies and individuals (like high-profile folks who need a blog but don’t have the time to feed the beast) who may pay you handsomely by the hour or post.
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Copywriters typically create material that encourages consumers to buy goods or services. Copy can be used for advertising, websites, billboards, email campaigns, newsletters and more. As a freelance copywriter, you may find yourself creating catchy taglines for online or print advertisements or composing a unique blog article optimized for the web. Freelance copywriters can work directly with clients or through intermediaries such as agencies or online work exchanges.
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If you’re an ace at organization and love throwing parties for your friends, event planning could be a good fit for your freelance business. An event planner ensures that events, such as parties, weddings, fund-raisers, meetings, and conventions, are planned, organized and executed correctly. The job typically includes scouting out locations, securing any services needed at the event (such as food, transportation, and entertainment), and being on-site the day of the event to make sure everything runs smoothly and everyone has a great time.
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Maybe math is second nature to you, or your grades on essays were always A+. Or perhaps you are a gifted piano player. Whatever your particular talent, there is a good chance that there are folks out there who need some assistance in that area. You can start advertising your tutoring or teaching services through friends, family and neighbors and build out from there.
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If you’re an animal lover, pet-sitting allows you to enjoy pets without the responsibility of ownership. All you typically need to get started is an understanding of how to properly care for dogs and cats (or any other pets that may need your services). For many, this freelance job can be a win-win: You get to build relationships with the animals and get paid for showing some TLC.
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Do you have a talent for crafting or creating handmade goods? It could be quilts, decorative pillows, hand-knit sweaters, jewelry, you name it. If so, you may be able to turn your hobby into a freelance business by advertising your goods on a craft-selling site like Etsy, Handmade at Amazon or ArtFire. In addition to selling online, you may also want to take advantage of opportunities to sell at street fairs, bazaars and festivals.
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If you’re a fast and accurate typist, you may want to consider becoming a freelance transcriber. This kind of work involves listening to an audio recording, such as a webinar, video conference, interview, or speech, and then typing every word that is spoken into a document. There are all kinds of companies that hire freelance transcribers, as well as transcription services that hire individuals to transcribe audio for various clients.
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Once you have your cosmetology license, you typically have a lot of flexibility in terms of when and where you work. Who says you have to be in a salon all day? Many hairstylists and makeup artists work for themselves and offer mobile services, in which they serve clients right in the client’s home. Or you might offer services in your own home. You can also start a hair or makeup blog or post tutorials on YouTube to generate an additional revenue stream.
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When it comes to starting a freelance business, having a good idea is only the beginning. A great next step is to develop a business plan. This involves deciding your company’s purpose, figuring out what service or products you will offer, and setting measurable targets and goals.
In addition, you may want to determine business financing options if you need initial capital to get started and then create a business budget.
It’s also a good idea to choose a business structure (such as a sole proprietorship or limited liability company), get any required licenses or permits, and purchase any equipment and supplies you may need, being sure to keep receipts since these expenses may qualify as self-employed tax deductions.
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There’s much appeal to the freelance life. You get to call the shots and work as much or as little as you like. And turning your marketable skills into your own home-based freelance business may be easier than you think.
One of the biggest challenges you may face is how to fund your business. You may have savings to get you going or have family and friends who will help you launch. If not, you can look into getting a small business loan.
Learn more:
This article originally appeared on LanternCredit.com and was syndicated by MediaFeed.org.
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