Finances are a crucial part of the foundation that holds your business up. You need accurate financial statements to fully understand your startup’s financial health. Without them, you can’t make financial projections, budget properly, or communicate effectively with your investors. Ultimately, you’re stuck making blind business decisions.
Instead of winging it in an Excel spreadsheet and wandering around in the dark, work with a finance expert to build financial statements for your startup. Get to know your financial statements intimately, and how to analyze them (or work with someone to advise you), so you can move forward with business decisions more confidently.
We’ve laid out a crash course on business financial statements below to get you started!
What Are Business Financial Statements?
Startup business financial statements summarize your startup's activities and are one of the most important data tools. They’re your first defense against financial problems and the first alarm bell when you’ve already hit one.
You can assess different facets of your business by analyzing different financial statements. You can even use them together to give a more holistic picture of your business and dive deep into others to assess specific areas.
What Are The Three Financial Statements Used By Businesses?
There are three key financial statements to familiarize yourself with. Investors, financial advisors, and founders utilize data on all three consistently, together, and separately. When used together, they help you understand your startup's assets, liability, revenue, expenses, and more.
The balance sheet highlights your company's assets and liabilities and your shareholders' equities. As a whole, the balance sheet demonstrates your startup’s current net worth. When utilized correctly, the balance sheet gives you a clear view of your startup’s financial position at any point. For startups specifically, balance sheets are also commonly used to calculate the debt-to-equity ratio, which shows the rate of return on shareholders’ investments.
Components of the balance sheet:
- Current assets – Cash, cash equivalents (things you can quickly convert into cash), accounts receivable, and fixed assets (computer equipment, office furniture)
- Non-current assets – Intangible assets such as licenses and patents
- Current liabilities – Accounts payable and company debt
- Long-term liabilities – Long-term debt, deferred revenue, and bonds payable
- Equity – Share capital (amount invested by shareholders), retained earnings (net income minus dividend payments), common and preferred stock
Profit And Loss Statement
The profit and loss statement (P&L) – also called an income statement – summarizes financial data over a set period (month, quarter, or year). This statement is pivotal in helping you make smart financial decisions, setting goals, and implementing solutions for problem areas.
Components of a P&L Statement:
You can also use a business income statement to measure profitability by looking at these components:
- Total revenue (gross profit) – Operating income, such as sales, plus non-operating income if applicable
- Cost of goods sold (COGS) – The total cost of producing your startup's goods or services
- Operating expenses – Includes research and development, payroll, and marketing
- Other income/expenses – Includes interest income/payments and income taxes
- Operating profit – Gross Profit (-) Operating Expenses (-) Depreciation (-) Amortization
- Net income – Gross income minus total expenses
Cash Flow Statement
The cash flow statement summarizes cash and cash equivalents that move in and out of your business during a period of time. Cash equivalents are short-term investments that you can convert into cash quickly, such as money market funds. But, unlike the P&L and balance sheet, which reflect future cash flows, the cash flow statement only reflects cash movement in the current reporting period.
The cash flow statement can assist you in making day-to-day operational decisions, such as product pricing or budget adjustments.
The cash flow statement focuses on three main business activities:
- Operating activities – Core business activities that generate revenue
- Investing activities – Cash flow from sales and purchases of assets and investments
- Financing activities – Cash flow between a company and its investors and creditors
Why Are Financial Statements Important To Businesses?
Startups use financial statements for several reasons. Most importantly, they give you a clear picture of how your startup is doing financially. By reviewing financial statements, you can assess multiple aspects of your business. After collecting data, you can create financial projections or analyze trends to further understand your company’s financial standing.
Mistakes happen, especially if you’re still relying on manual data entry. Consistently checking financial statements help you catch costly errors early on. For example, if the recorded amount paid to a vendor is less than invoiced, you may receive a late fee.
Accurate financial statements offer the same benefit. With up-to-date data, you can make the necessary changes to fix the problem. For example, if your expenses have shot up and there’s not enough cash flowing in to cover them.
They also help you to understand and plan for your tax liability by organizing and recording the information you’ll need when filing.
Your financial statements also play a critical role in obtaining funding for your business, particularly during the pre-seed to Series B stages. Investors and creditors rely on these statements to predict the future financial success of your startup.
Why Do Investors Look At Financial Statements?
When you pitch investors for funding, they want to know that your company manages cash well. Precise money management is a powerful indicator of future success. No investor wants to put money into a company that likely won’t be profitable.
Because startups don't have extensive historical records to prove consistent profitability, investors rely heavily on current financial statements. They want to see that your startup has a good balance between net income and expenses and that you can keep up with your debt.
Even after securing funding, investors will want to continue seeing financial statements to see where their money is going and to advise you as you grow. It’s common practice for investors to become part of your board of directors to help aid in this advisement and decision-making process. As such, they will expect you to use your financial statements to prepare for board meetings. In these meetings, you can impress by presenting an overview and forward-looking outlook of where your company stands.
Banks And Creditors
Creditors use financial statements to judge your company’s ability to pay back loans promptly. If you’re already contracted to a bank or third party and want to extend or increase your line of credit, they’ll check your financial statements. Accurate and well-prepared financial statements increase the likelihood of creditors offering you funding.
How Are Financial Statements Prepared?
While there are common steps that go into preparing financial statements for most for-profit organizations, the exact procedure can vary slightly from company to company. Factors that can affect the precise way a business prepares its statements include:
- The purpose of the statements – To obtain funding, present to board members, for government purposes, for the public, etc.
- The type of business – SaaS financial statements will differ from e-commerce statements
- The stage of the startup or size – Late stage startup finance statements may be more complex
Regardless of these factors, these are some of the most common steps that we advise startups to take to get your financial statements in order:
- Determine your financial reporting period (monthly, quarterly, or annually)
- Identify all of the business transactions that took place within that period
- Verify all supplier and customer invoices
- Settle any wages that you have not yet paid out
- Calculate the depreciation of your fixed assets
- Evaluate your inventory and determine the cost of goods sold
- Reconcile your bank accounts
- Record account balances in the general ledger
- Review ledgers and resolve any errors
Keep in mind that financial statement preparation is a time-consuming task that requires meticulous attention to detail and a sound understanding of accounting principles. Attempting to prepare your own statements is likely to result in outdated information and reports that lack structure.
Using financial experts to manage your accounting software and prepare your reports will ensure that they are accurate, up-to-date, and cohesive.
Financial Statements Connect To Work Together
While the three main financial statements can each be useful on their own, they are quite interconnected. Together, they provide a more comprehensive understanding of your startup's financial health.
For example, when referencing your P&L statement alongside your balance sheet, you can assess how efficiently your company uses its assets. The cash flow statement bridges the P&L and the balance sheet by providing deeper insight into the money that moves through your business.
How To Interpret Financial Statements For Better Business Decisions
Financial statements are important to investors and creditors, but they can also give you powerful insight into your startup's financial efficiency. Knowing how to interpret your financial statements will assist you in making better business decisions for continued success.
Interpreting The Balance Sheet
A startup’s balance sheet shows the state of its financials at a specific point in time. Financial experts use the balance sheet to produce financial ratios, which give you an understanding of different aspects of your business.
Four common ratios from the balance sheet can show how well your company is or isn’t generating revenue:
- Quick sheet ratio = (Current assets - Inventories) / Current liabilities. A ratio of 1 is a normal result, indicating that your startup has the assets it needs to pay off its liabilities. You may have trouble paying off your startup's liabilities if the result is less than one. A score higher than one indicates your company has more than enough resources to pay off its liabilities quickly.
- Long-term Debt to equity ratio = Long-term debt / Shareholders’ equity. The higher the debt, the more at risk your startup is of being unable to pay them off.
- Current ratio (or working capital ratio) = Current assets / Current liabilities. A result of 1.6 to 2 indicates your startup can pay its short-term debt and meet its cash inflow and outflow needs. A lower ratio often means a company will have difficulty paying off its debts.
- Total Debt To Equity Ratio (D/E) = Total liabilities / Shareholders’ equity – Shows how much your startup depends on borrowed funds and its ability to pay them back. Investors favor lower D/E ratios, typically at a 2.0 or lower.
Interpreting The Income Statement
Your income statement will signal whether your business expenses are too high compared to your profits so that you can make changes as needed. Some of the things you can learn by reviewing your company's income statement include:
- The amount of money generated by your business
- The money spent during the reporting period
- The cost of producing the goods or services that your company sells
- The earnings per share (net income divided by outstanding shares)
- How much value your assets have lost due to aging
There are two main methods of analyzing an income statement: vertical analysis and horizontal analysis.
- Vertical – Each line item shows as a percentage of gross sales. Line itemization allows you to compare your expenses to one another. You can use these percentages to compare your statement to other competitors' income statements and your income statements from past reporting periods.
- Horizontal – This method looks at line items in terms of absolute dollar amounts. You can use horizontal analysis to compare trends over time.
Interpreting The Cash Flow Statement
The cash flow statement is critical to understanding how money moves in and out of your company through operating, financing, and investing activities. Let’s break it back down into our three main cash flow areas:
1. Operating activities – To analyze this section of your statement, you can use the cash flow to sales ratio:
cash flow to sales ratio = operating cash flow/sales.
Rising sales coupled with an increasing cash flow to sales percentage indicates that your startup’s conversion from sales to cash is working effectively. If sales rise over time but the percentage decreases, your startup is not effectively converting sales into cash.
2. Investing activities – This section shows whether increasing profits are backing your spending on company assets. If rising profits don't back asset spending, you may face financial difficulties. In this situation, reexamine how much your startup is spending on its assets.
3. Financing activities – Look at these to see how often your startup raises capital and where the funding originates. If your business raises external capital frequently, it could indicate poor profitability.
Are Financial Statements That Important?
Financial statements are one of the most essential tools to understand your startup's financial health. But if you aren't able to fully interpret the statements, you will be missing out on a lot of important insights into your company. The accuracy of your financial records also limits the insights you gain.
If you try to manage your finances and prepare your statements yourself, you may fall behind on closing your books monthly. This leads to working with outdated information. When possible, closing books daily and having real-time financial data is key. Not only is using obsolete or inaccurate data ineffective, but it can also lead to decision-making that hurts your business.
Overall, understanding how to read and utilize your financial statements should be a priority. Putting this task to the side puts your startup at risk. If you’re struggling to do it alone, look into startup bookkeeping services to guide you through your finances.
All founders hit a learning curve. Successful founders continue learning as their startups grow.