How to Use Financial Statements to Make Better Business Decisions
Financial statements are the heartbeat of any business, yet many entrepreneurs and small business owners overlook their importance. Whether you're planning to hire new employees, invest in equipment, or simply ensure your business stays profitable, your financial statements provide critical insights to guide your decisions. In this blog post, we’ll dive into the key financial statements you need to understand—Income Statement, Balance Sheet, and Cash Flow Statement—and show you how to use them to make better business decisions that drive growth and sustainability.
1. The Income Statement: Understanding Profitability
Think of your income statement like a report card for your business—it shows how well your company is performing financially over a specific period. Are you making money, or is your business losing steam?
The Income Statement (also known as a Profit and Loss Statement) shows your revenues, expenses, and profits over a certain period—usually monthly, quarterly, or yearly. This statement answers the critical question: Is my business profitable?
Key sections to focus on:
Revenue: Your total sales or earnings during the period. Keep an eye on whether revenue is growing or stagnating.
Cost of Goods Sold (COGS): The direct costs associated with producing your product or service. If this number is too high, it can eat into your profits.
Gross Profit: The difference between revenue and COGS. This tells you how efficiently your business is producing or delivering its services.
Operating Expenses: These include rent, utilities, salaries, and other overhead costs. Regularly reviewing these expenses helps you spot opportunities for cost-cutting.
Net Profit: This is your bottom line—what’s left after all expenses are deducted from revenue.
How to Use It:
Identify profitability trends: Compare income statements over time to see if your business is becoming more or less profitable. This can help you decide whether to raise prices, cut costs, or invest in new revenue-generating activities.
Control costs: Use the income statement to monitor your expenses. Are certain costs rising faster than expected? Regular reviews allow you to cut unnecessary expenses and protect your margins.
Make pricing decisions: If your COGS is climbing, it may be time to adjust pricing. Your income statement helps you make informed pricing decisions without risking profitability.
Action Tip:
Review your income statement monthly. If your profits are falling, dig deeper into the reasons. Look for areas where costs are rising or where revenue is declining and take corrective action.
2. The Balance Sheet: Evaluating Financial Health
The balance sheet is like a snapshot of your business’s financial health at a particular moment in time. Imagine it as a picture of what your business owns, owes, and the value it has built over time.
The Balance Sheet provides a comprehensive view of your assets (what you own), liabilities (what you owe), and equity (your net worth). It is divided into three sections:
Assets: These are the things your business owns, including cash, inventory, equipment, and accounts receivable. Assets are typically divided into current assets (e.g., cash and inventory) and long-term assets (e.g., property and equipment).
Liabilities: This section covers what your business owes—debts, loans, accounts payable, and other obligations. Like assets, liabilities are split into current liabilities (due within the year) and long-term liabilities (due in more than a year).
Equity: This is the net value of your business—what’s left over after liabilities are subtracted from assets. It represents the ownership interest of the business’s shareholders or owners.
How to Use It:
Measure liquidity: Your balance sheet shows whether your business has enough assets to cover its liabilities. A good rule of thumb is to aim for a current ratio (current assets/current liabilities) of at least 1. This means your business can comfortably meet its short-term obligations.
Manage debt: By comparing your total liabilities to your equity (also known as the debt-to-equity ratio), you can assess whether your business is carrying too much debt. If your liabilities are too high, it may be time to focus on paying down loans or renegotiating terms.
Plan for growth: Strong equity signals financial stability, which is important if you’re seeking investors or planning to expand. A healthy balance sheet can help you secure better financing options and negotiate from a position of strength.
Action Tip:
Compare your balance sheet from different time periods (monthly, quarterly, or annually) to spot trends. Are assets growing faster than liabilities? If liabilities are growing too quickly, consider strategies to reduce debt or improve cash flow.
3. The Cash Flow Statement: Keeping an Eye on Cash Flow
Ever heard the saying "cash is king"? It couldn’t be more true in business. Your cash flow statement is your secret weapon for ensuring your business has the cash it needs to thrive.
The Cash Flow Statement tells you how cash moves in and out of your business over a specific period. It’s divided into three sections:
Operating Activities: This shows the cash generated or used by your core business operations. Ideally, this should be positive, meaning your business is generating enough cash from day-to-day operations.
Investing Activities: Cash spent on investments in the business, such as purchasing equipment or property, is shown here. Negative cash flow from investing activities isn’t necessarily bad—it could mean you’re growing.
Financing Activities: This section shows cash received from or paid to investors and lenders. If you’ve taken out a loan or repaid debt, this will be reflected here.
How to Use It:
Monitor cash flow trends: Even if your business is profitable, poor cash flow management can cause serious problems. Use the cash flow statement to ensure your business has enough cash to cover day-to-day expenses.
Spot cash shortages: Regularly reviewing your cash flow can help you spot potential shortfalls before they happen. If your operating activities are consistently generating negative cash flow, it’s time to reevaluate your spending or collection processes.
Plan for growth or expansion: Positive cash flow gives you more flexibility to invest in new opportunities or growth strategies. If you’re consistently generating cash, it may be time to reinvest in the business.
Action Tip:
Review your cash flow statement monthly and compare it to your projections. If cash flow is tight, consider adjusting payment terms with customers or delaying non-essential expenses to improve your cash position.
4. Using Financial Ratios for Deeper Insights
Financial statements on their own can be overwhelming. But when you start using financial ratios, it’s like turning a blurry image into high-definition—you can see exactly what’s working and what needs attention.
Financial ratios help you analyze your financial statements in greater detail. They provide insights into liquidity, profitability, and efficiency, helping you assess the overall performance of your business.
Key ratios to consider:
Gross Margin Ratio: (Gross profit/revenue) x 100. This tells you how much profit you're making for every dollar of revenue. A higher ratio means more efficient cost management.
Current Ratio: Current assets/current liabilities. This shows whether you have enough current assets to cover your current liabilities.
Debt-to-Equity Ratio: Total liabilities/total equity. A high ratio indicates that your business is heavily reliant on debt to finance its operations, which could be risky.
Return on Equity (ROE): Net income/shareholder equity. This measures how efficiently you’re using your equity to generate profits.
How to Use It:
Benchmark against industry standards: Compare your ratios to those of competitors or industry benchmarks. This gives you an idea of how your business is performing relative to others in your field.
Track over time: Regularly track your financial ratios to spot trends and make informed decisions. Are you becoming more or less efficient? Are you relying too much on debt?
Action Tip:
Use accounting software to automatically calculate key financial ratios and incorporate them into your regular financial reviews. Understanding these ratios will help you make more informed, data-driven business decisions.
5. Making Better Decisions Based on Financial Data
Think of your financial statements like the dashboard of your car. Without them, you wouldn’t know how fast you’re going, how much fuel you have left, or whether there’s an issue under the hood.
Now that you understand how to interpret your financial statements, the next step is using that information to make smarter decisions. Whether it’s budgeting, cutting costs, or planning for growth, your financial data gives you the insights you need to act confidently.
Steps to take:
Review financials regularly: Don’t wait until the end of the year to look at your financial statements. Make it a habit to review them monthly or quarterly.
Set measurable goals: Use your financial data to set realistic, measurable goals. For example, if your gross margin is below industry averages, aim to improve it by cutting costs or increasing prices.
Monitor progress: Use your financial statements as a tool to track progress toward your goals. This will help you adjust course if needed and stay on top of any emerging issues.
Financial statements are a powerful tool for making better business decisions, but only if you know how to interpret them. By understanding your income statement, balance sheet, and cash flow statement, and leveraging financial ratios, you can ensure your business is on the right track. Start using these insights to guide your budgeting, cost management, and growth strategies, and watch your business thrive.
Need help understanding your financial statements? At CoStar Accounting, we specialize in helping small businesses turn financial data into actionable insights. Contact us today for a free consultation!