How to Put Together Good Financial Statements

If you tuned in last week and followed my step-by-step cleanup process to get your books in order, you should be more or less ready to dive in here.

If not, no worries. Do the following to get caught up or enlist the help of a good bookkeeper to do it for you.

This post will walk you through these steps in more detail if needed.

1. Tag all transactions

2. Accrue any expenses that may not be in the right months

3. Complete your bank reconciliations

4. Check your data quality one final time.

With your financial data in good shape, we can prepare the following core statements.

1. The Income Statement, or P&L

2. The Balance Sheet

3. Cash Flow Statement

The Income Statement

Just as the name suggests, the income statement tells you whether you made a profit or operated at a loss for a given year. It also clues you in as to where all the money goes as soon as it hits the bank account.

Your income statement will typically look something like this:

Now, let’s discuss what makes up a standard P&L.

The top line shows your total revenue for the period. It also appears as “Sales” quite often. All it is is the total amount of everything you sold or the services you delivered in that year. Just remember to subtract out any discounts given before you finalize this top-line amount to get your net sales.

Cost of sales, or Cost of goods Sold (COGS), typically appears right below revenue and includes all the expenses incurred that were directly related to the sales you made. An important note here is that COGS does not refer to the cost of materials or inputs that you purchased in that reporting period—only the costs associated with the revenue earned.

Gross Profit is what you get from subtracting revenue for the period from your direct costs to produce that revenue (Sales-COGS).

Selling, General, and Administrative Expenses (SG&A) include your other business expenses such as rent, utilities, travel, and salaries. A good way to think about this line item is anything that supports the operations of the business but does not directly produce revenue.

It can be helpful to break this category up into as many sub-categories as is helpful for your business to stay organized and maintain good spend visibility. Doing so can help you identify where to cut costs without affecting the quality of your product or service.

Operating Income is the profit made after accounting for the additional expenses (SG&A) required to actually run the business.

Interest Expenses, also referred to as Finance Costs, are then listed separately from SG&A and represent your business’s cost to borrow. They need to be reported separately because they are not costs incurred in the day-to-day running of the business.

Before arriving at Net Income, you will also need to subtract out any losses or gains on asset sales to arrive at your income before taxes. From there, subtract your tax obligations. You will then be left with your net income, or true profit/loss for the year.

Before we move onto the Balance Sheet, a quick note on taxes.

Unless you’re structured as a C-Corp, you’ll typically get to skip the tax reporting on your P&L. Instead, the business profits will pass to the owner and get reported on the individual Form 1040.

As a CFO though, I still recommend accounting for your tax obligations to get a more definitive picture of how much money you made—and most importantly kept—for the year.

The Balance Sheet

While your P&L tells you how much money you made or lost for the year, I would argue that the Balance Sheet is still your most important statement.

Why?

Because it shows the organization’s overall financial health.

It also spells out to everyone what the business is worth, so accurate reporting here is critical when dealing with partners and potential buyers.

This statement captures the financial picture for a specific point in time. This is usually the last day of the fiscal year.

The statement itself is prepared based on the following equation:

Assets = Liabilities + Owner’s Equity

This equation must always balance.

It will typically look like this:

The Assets section lists all the resources your firm owns that hold some current or future economic value. Common examples include cash, PP&E, vehicles, receivables, inventory, and land.

Assets can be subdivided into two categories from there: current assets and non-current assets.

Current assets are any assets you own that can be converted to cash within 12 months. Inventory and Accounts Receivable (A/R) are common examples.

Non-current assets are those assets that can’t be converted to cash as easily. Examples include equipment, real estate, and intangible assets like patents and trademarks. This sub-category is also known as fixed assets.

The Liabilities section of your Balance Sheet includes the amounts your business owes to other entities, such as financial institutions, suppliers, and employees.

As with assets, liabilities can be split into current and non-current subcategories.

Current liabilities refer to amounts owed within the year. Common examples are payroll, Accounts Payable (A/P), and short-term loans.

Non-current liabilities are the debts that will come due beyond a year from now. Examples include deferred tax or pension obligations, loans, and leases.

The Stockholder’s Equity (also known as Owner’s or Shareholder’s Equity) section captures the value of the business after liabilities are subtracted from the assets. Note that the net income from your P&L is transferred each year into your Balance Sheet as Retained Earnings.

Retained Earnings function as a running total of the business’s profitability since it opened. For this reason, you want to make sure that your P&L is in good shape before preparing the Balance Sheet.

The Cash Flow Statement

This final statement captures the movement of cash in and out of your business in three sections: cash from operating activities, cash from financing activities, and cash from investing activities. The reporting period for this statement is typically a year, but it can also be prepared on a quarterly, monthly, or any other cadence that suits your business.

While the P&L can tell you how you performed over a given period, profitability doesn’t always equate to liquidity. A big reason for this is accrual accounting.

In other words, revenue on the Income Statement is recorded when it’s earned rather than received. What results is a timing difference. The same is true with how expenses are recorded.

You may be tempted to check your bank balance or the Cash line item on the Balance Sheet and skip this statement altogether. Don’t do it, as neither of those shortcuts will tell you much about the source of your cash.

You need to know exactly where the money came from, where it went, and whether or not those events are normal and sustainable occurrences.

Because of this, knowing your cash flow statement from top to bottom is critical for avoiding cash crunches and allocating resources strategically.

Your Cash Flow Statement should look something like this:

Here’s how to read it.

The Cash from Operating Activities section includes all of the cash generated from the business’s day-to-day activities. This section accounts for inflows, such as revenue received, and outflows like COGS, rent, and utilities. This source of cash is the most meaningful for the health of the business, which is why it appears at the top.

When calculating your operating cash flow to prepare this statement, you have two options: The direct method and the indirect method.

The Direct Method

The direct method involves using only the transactions that affected cash during the period. What this means in practice is adding up all the cash collections from operations and then subtracting out the corresponding disbursements.

The Indirect Method

The indirect method is based on accrual accounting, which means recording revenues and expenses at the time they are incurred rather than received. Rather than sorting transactions as in the direct method to find the cash balances, you or your bookkeeper will start with net income and undo any adjustments made to this number from accruals.

In practice, this de-accruing process generally involves identifying non-cash expenses from the income statement like depreciation and amortization.

Cash from Investing Activities, as the name suggests, captures the inflows and outflows related to buying and selling investments—usually fixed assets. Common items in this section include machinery, equipment, real estate, land, and vehicles. That said, more liquid investments can and do appear in this section, such as stocks and bonds.

Cash from Financing Activities includes events like taking out loans and servicing debts. The cash you receive when taking a loan is an inflow in this section while your payments are reflected as outflows.

While this example doesn’t include it, the top of this statement will often report the amount of cash and cash equivalents that the company started the year with.

At a high level, here’s how the sample statement reads. The bottom of the operations section tells us that the company generated $2,012,000 from its main activities. The investing section tells us that $500,000 was then subtracted from operating cash to purchase equipment. The financing section then tells us that the company received a $10,000 inflow by obtaining financing. Note that there will be outflows in this section in future reporting periods as soon as the company begins making payments on this note.

The bottom line represents a net inflow for the year of $1,522,000.

Notice how I haven’t talked much about how to construct each of these statements manually. That’s because your accounting software should automate it for you. The strictly manual route, on top of taking up valuable time, leaves too much room for error.

Keeping everything housed within your accounting software also ensures that all of your critical business information is ready and accessible whenever you need to refer back to it. You just need to make sure your books are in good working order first.

Now, let’s move on to how you’ll interpret each of your statements to ensure that you’re always asking the right questions and know where your business is headed.

How to Interpret Financial Statements

Before diving into the individual statements again, I want to get on my soapbox for just a minute.

It can be tempting to get your reporting in order, look at the main buckets, and then leave it at that. I get it. I really do.

But taking the time to fully understand your finances will allow you to identify the right opportunities, manage risk, cut waste, and make strategic, forward-looking decisions. There’s no substitute for studying your numbers and referring back to them often.

Another note before we dive in:

The true picture of your business lies in studying the P&L, Balance Sheet, and Cash Flow Statement together.

How to Interpret the P&L

At a high level, the P&L shows you the cumulative impact of revenues, expenses, gains, and losses for a period as well as:

• General financial trends: Is there any seasonality to the business? Is the business generally growing? Are costs trending in the right direction? If expenses are growing, is that proportional to revenue growth? Why or why not?

• How well the company is doing: Is it profitable? How much does it cost to deliver the product or service? Is there excess cash to re-invest?

When studying your P&L, you’ll want to look for MoM and YoY variations. Overall, you’re looking for stability in your gross margins, general stability of the business, and an upward trend in revenue.

You can also use your P&L to calculate the following before moving on:

• Gross Profit Margin

• Operating Profit Margin

• Net Profit Margin

• Tax Efficiency

• Interest Coverage

You can put the P&L away once you have a clear understanding of where all the money is going.

How to Interpret the Balance Sheet

Aside from telling you the value of the company, the Balance Sheet offers you a concise view of the resources available relative to outstanding liabilities and investor obligations.

From the Balance Sheet, you can easily calculate how productive your assets are and assess liquidity. The Balance Sheet is also heavily used by prospective buyers and lenders to assess the company’s inherent level of risk and creditworthiness.

You can use your Balance Sheet to calculate the following before moving on:

• Asset Turnover

• Quick Ratio

• Receivables Turnover

• Days to Sales

• Debt to Asset Ratio

• Debt to Equity Ratio

How to Interpret the Cash Flow Statement

The Cash Flow Statement will tell you not only where all your cash went over a given period, but it will also help you assess how well the business operates over both the short- and long-term.

Your goal in studying the Cash Flow Statement is to zero in on the activities that generate the most cash and use that information to direct your strategic moves.

You’ll also want to check that your cash from operating income is routinely exceeding your net income. The reason is that consistently positive cash flow indicates not only present financial stability but also future growth potential.

With that said, positive cash flow and profitability are not the same. This is why you need to consider the Cash Flow Statement in conjunction with the P&L and Balance Sheet before concluding too much about the strength of the business.

You can use your Cash Flow Statement to calculate the following before moving on:

• EBITDA

• EBITDA per share, if applicable

Before we go on to discuss crafting a strategy based on these statements, here are a few more calculations you can make by considering all three statements in tandem:

• Return on Assets

• Return on Equity

• DuPont Analysis

Using Reporting to Drive Strategy

When taken together, your reporting should tell you:

• What the company owes and its ability to repay

• How much profit (or loss) was made for a given, month, quarter, or year —and what the overall trend is across periods

• Which investments will be required to grow the business

• Where you can make cuts without compromising quality

In the macro, these insights will in turn allow you to set a budget, learn from past mistakes, establish clear expectations with your team, and create a roadmap to reach operational and financial goals.

And day to day, here are 5 more ways that I recommend using your reporting to drive decision-making:

1. Quantifying the impact of your decisions

2. Cutting costs

3. Keeping the big picture in mind

4. Getting everyone on the same page

5. Motivating your team

Quantifying the Impact of Your Decisions

Whether you recently decided to upstaff to meet an upswing in demand, launch a new product, or increase ad spend, your P&L can tell you whether or not your decisions improved profitability. Check this by isolating the expenses for the period associated with your decision and the added revenue it brought in.

If these investments were productive, double down on them. Otherwise, learn from the mistake and re-allocate funds going forward.

Cutting Costs

Both the P&L and Cash Flow Statement can give you line-by-line visibility into where you can cut costs—especially when you’ve already had to quantify each expense’s relative impact on net income.

If something isn’t moving the needle, cut it within reason.

Keeping the Big Picture in Mind

Knowing the company’s overall financial position will not only keep you from getting too in the weeds, but it will also serve as a much-needed sanity check before you make any big decisions in any one area of the business.

Getting Everyone on the Same Page

Good reporting readily available to everyone not only empowers each team to do their best work individually, but it also ensures that everyone speaks the same language when setting priorities for the business. As a result, efforts don’t get duplicated, and everyone knows the why behind which decisions were made.

Motivating Your Team

Just as the P&L can help you measure the impact of your managerial decisions, showing individual contributors how their work translates to a healthy bottom line is an underrated piece of management advice.

Giving employees a sense of ownership not only increases trust but can also provide you with plenty of fresh ideas for improving the business.

There you have it. Everything you need to know about financial reporting.

Join me next week for a crash course in turnarounds. We’ll walk through how to put together a plan for your business and execute it flawlessly.

In the meantime, if you’re looking to get your reporting squared away and still need some help, feel free to reply to this message or shoot me a DM. I’m always happy to assist and read every reply.

Putting It All Together

Here are your top takeaways from this week’s post.

1. Once your books are in order, you’re ready to prepare your Income Statement, Balance Sheet, and Cash Flow Statement.

2. A true understanding of your business’s financial position only comes by studying the three statements in tandem. The P&L tells you how much you made in a given period while the Balance Sheet provides a snapshot of the company’s financial health more broadly. The Cash Flow statement tells you where the cash came from and where it went.

3. Making sure your P&L is correct comes before trying to prepare your Balance Sheet. The reason for this is that Net Income feeds directly into Retained Earnings.

4. Thanks to accrual accounting, profitability on the Income Statement and positive cash flow are not the same thing. So don’t skip the Cash Flow Statement.

5. Once you have your reporting in good shape, resist the urge to close it for the year. You will only benefit from clear reporting as much as you’re willing to refer back to and use it to guide your decision-making.

6. When you use your reporting to drive strategy, you can set a budget, learn from past mistakes, set expectations, and make meaningful progress toward your goals.

7. In the day-to-day of running your business, keeping your numbers top of mind allows you to quantify the impact, cut costs, support the big picture, get everyone on the same page, and motivate your team.

Hungry for More?

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2. Shoot me an email with your questions or requests for what you’d like me to write about next.

‘Til Next Time,

Connor