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Understanding Financial Statements

Financial statements are only valuable if you are able to understand and interpret the information they contain. Unless you have a background in accounting, understanding your business' financial statements can be like trying to understand a foreign language.

Although financial statements can be formatted in a variety of ways, most business owners generally rely on four key statements to measure the condition of their business:

Income Statements

The income statement measures your company's income and expenses over a given period of time such as a year, a quarter or a month. In many ways, these statements represent your business' ability to function profitably. They highlight trends in sales and expenses that may require you to adjust the way you are doing business. When expenses are subtracted from income on the income statement, the result is either net income or net loss — a.k.a your company's bottom line.

Balance Sheets

The balance sheet tracks your businesses assets and liabilities. It is called a balance sheet because it is based on an equation that must balance in order to be valid: assets = liabilities + owner equity. Unlike the income statement, the balance sheet does not measure your business over a period of time. Instead, it is a snapshot of your business at a given point in time. By comparing balance sheets from month-to-month or year-to-year, you can begin to measure your business' growth in quantifiable terms.

Statements of Capital

The statement of capital measures changes in your company's capital situation over a period of time. In other words, the capital statement places a dollar value on how much your ownership of the company is worth. These statements are typically completed at the end of an accounting cycle to determine how much money the business has earned for the owner throughout the year. That amount — the net income — can be used however the owner sees fit. It may be reinvested into the company or it may be withdrawn for personal use.

Cash Flow Statements

The cash flow statement measures the actual cash running in and out of your business over a specific period of time. This can be extremely valuable because it helps you track the sources the cash is coming from: From operating activities, from investing activities, from financing activities or from changes in investment values. You may be flush with cash, but if it is all coming from loans then you may be in trouble. Properly interpreted, the cash flow statement will give you the information you need to make the necessary adjustments.

There are a multitude of other issues involved with understanding your financial statements, e.g. cash vs. accrual, underlying assumptions, etc. Your best bet is to sit down with your accountant and ask him to explain anything you don't understand. No question is off-limits. The important thing is that you have a solid grasp of what the financial statements mean for you and your company.