Now, let’s look at the income and cash flow statements.

Income Statements

An income or profit loss statement is a report that shows how much you’ve earned over a specific time period. An income statement shows the costs and expenses associated with earning that money. The literal “bottom line” of the statement usually shows the company’s net earnings or losses.

Income statements also report earnings per share (or “EPS”) which calculates how much money shareholders would receive if you distributed all of the net earnings for the period.

At the top of the income statement is the total amount of revenue from sales of products or services. This top line is often referred to as gross revenues or sales, because expenses have not yet been deducted.

The next line is money the company doesn’t expect to collect on certain sales such as discounts or merchandise returns.

When you subtract the returns and allowances from the gross revenues, you get your net revenues.

Next there are several lines that represent various kinds of operating expenses. Although these lines can be reported in various orders, the next line after net revenues typically shows the costs of the sales, or cost of goods sold. This is the amount of money you spent to produce the goods or services sold during the accounting period.

The next line subtracts the costs of sales from the net revenues to arrive at a subtotal called “gross profit” or sometimes “gross margin.”

The next section is operating expenses. These are expenses that go toward supporting a company’s operations for a given period. Marketing expenses are another example. Operating expenses are different from “costs of sales,” which were deducted above because operating expenses cannot be linked directly to the production of the products or services being sold.

Depreciation is also deducted from gross profit. Depreciation takes into account the wear and tear on some assets, such as machinery, tools and furniture, which are used over the long term. Accounting spreads the cost of these assets over the periods they are used. This process of spreading these costs is called depreciation or amortization. The cost for using these assets during a certain period is a fraction of the original cost of the assets.

Next you arrive at a total called income from operations. Operating expenses are deducted from gross profit to arrive at operating profit before interest and income tax expenses.

You must also account for interest income and interest expense. Interest income is the money you make from any investments.

Finally, income tax is deducted and you arrive at the bottom line: net profit or net losses. Now you know how much the company actually earned or lost during the period.

Cash Flow Statements

Cash flow statements report your company’s inflows and outflows of cash. While an income statement can tell you whether your company made a profit, a cash flow statement can tell you whether your company generated cash.

A cash flow statement shows changes over time rather than absolute dollar amounts at a point in time.

The bottom line of the cash flow statement shows the net increase or decrease in cash for the period. Generally, cash flow statements are divided into three main parts. Each part reviews the cash flow from one of three types of activities:

1. Operating activities
2. Investing activities
3. Financing activities

1. Operating Activities

The first part of a cash flow statement analyzes your company’s cash flow from net income or losses. This section of the cash flow statement usually reconciles the net income (as shown on the income statement) to the actual cash your company received from or spent in operating activities.

Net income is adjusted for any non-cash items (such as adding back depreciation expenses) and any cash that was used or provided by other operating assets and liabilities. When a cash flow statement is accurate, it can be a helpful tool in determining the value of your business.

2. Investing Activities

This is the cash flow from all investing activities, which generally include purchases or sales of long-term assets, such as property, plant and equipment. When you buy equipment, the cash flow statement would reflect this as a cash outflow from investing activities. If you sell an investment, the proceeds from the sales would show up as a cash inflow.

3. Financing Activities

The third part of a cash flow statement shows the cash flow from all financing activities.

As a business owner, it is imperative to keep a close eye on your financial position. It may not be as sexy as developing new products or marketing campaigns but it is necessary to your business’s survival.

The good news is you do not need to be an accountant to read financial statements. The basics of accounting are simple. If you can follow a story, you can learn basic accounting. So, anyone can learn to read basic financial statements.

There are three main financial statements:

1. Balance sheets: Shows what your company owns at a fixed point in time.
2. Income statements: Show how much money your company made and spent over a period of time.
3. Cash flow statements: Show the exchange of money between your company and the outside world over a period of time.

Balance Sheets

A balance sheet provides detailed information about a company’s assets, liabilities and shareholders’ equity.

Assets are what your business owns that has value. This typically means they can either be sold or used by the company to make products or provide services that can be sold. Assets include physical property, such as plants, trucks, equipment and inventory.

There are also intangible assets that can’t be touched but nevertheless exist and have value, such as websites, trademarks, and patents. Cash and property are also assets. So are the savings and investments your business accumulates.

Liabilities are the debts that your business owes. This can include long term and short term obligations. Liabilities are money owed to suppliers for materials, the payroll you owe employees, environmental cleanup costs, or taxes owed to the government. Liabilities also include obligations to provide products or services to customers in the future. Long term debts are notes or mortgages paid usually over years.

Shareholders’ equity is sometimes called capital or net worth. This is the money that would be left if you sold all of your business assets and paid off all of your business liabilities. This leftover money, or owner’s equity, belongs to you, the shareholder or owner.

The accounting formula for a balance sheet is:

Assets = Liabilities + Owner’s Equity

Your company’s balance sheet is set up like the basic accounting equation shown above. On the left side of the balance sheet, you list assets. On the right side, you list liabilities and shareholders’ equity.

Assets are generally listed based on how soon they will be converted into cash. Current assets are things a company expects to convert to cash within one year. A good example is inventory. Most companies expect to sell their inventory for cash within one year.

Noncurrent assets are things you do not expect to convert to cash within one year. They include fixed assets. Fixed assets are assets used to operate the business but that are not available for sale, such as vehicles, computers, furniture and other property.

Liabilities are generally listed in the order they are due. Liabilities are also labeled as either current or long-term. Current liabilities are obligations a company expects to pay off within the year. Long-term liabilities are obligations due in more than one year.

Shareholders’ equity is the amount owners invested in the company’s stock plus or minus the company’s earnings or losses since inception. When a company distributes earnings, instead of retaining them, they are called dividends.

A balance sheet shows your assets, liabilities, and shareholders’ equity at the end of the reporting period. It does not show the flows into and out of the accounts during the period.

For more information on income and cash flow statements, click here to read Introduction To Financial Statements (Part 2).

The simplest definition is it’s the amount of money you need to keep your business afloat. It’s like the blood in your body. If you run out of blood, you die. So, if you run out of cash, you’re out of business.

An easy way to master this concept is to picture your business checkbook. Will the balance be enough to pay the bills? As it is fairly easy to determine your expenses for at least a few months, will the revenue you expect to receive during that time allow you to continue meeting your obligations?

It will take a lot of discipline to consistently look at your cash flow on a daily basis when there are so many more interesting business issues vying for your attention.

You might even consider developing a spreadsheet customized for your particular business that requires you to make entries on a daily basis and thus keeps your financial situation at the forefront of your mind.

Cash flow can be seen from two different perspectives:

1. Prevention: Which focuses on managing the business in such a way that you are able to see problems that might arise before they become too large to manage.

2. Cure: Deals with problems once they have already reared their ugly heads.

Prevention, as is true in other aspects of life, is the best option in business management. The farther you can look ahead and search for any potential problems that may arise, the more likely you are to be able to head them off or at least lessen the toll they have on your bottom line.

If you do come upon an unexpected cash flow problem, you will have several options from which to choose.

• You can borrow from your own personal account.
• You can delay paying suppliers.
• You can put off payroll for another week.
• You can try to collect on past due balances.

However, the best option is probably to have a line of credit that you can draw from at your local bank. You can think of this as overdraft protection for your business checking account.

In order to obtain and maintain credit with your local financial institution, develop a relationship with your banker. Send him frequent financial reports in order to make him feel that they are seen as a part of your organization, not as an outsider.

The more he is kept informed about the financial status of your business, the more he will trust you and be willing to help you out of any unforeseen financial crises that do arise.