Business owners are commonly and rightfully urged to generate financial statements regularly in compliance with Generally Accepted Accounting Principles (GAAP). One reason is that external users of financial statements, such as lenders and investors, place greater trust in financial reporting under GAAP's rigorous standards.
But that’s not the only reason. GAAP-compliant financial statements can reveal details of your company’s financial performance that you and your leadership team may otherwise not notice until a major problem has developed.
Let’s begin with the income statement (also known as the profit and loss statement). It provides an overview of revenue, expenses, and earnings over a given period.
Many business owners focus only on earnings in the income statement, which is understandable. You presumably went into business to make money. However, though revenue and profit trends are certainly important, they aren’t the only metrics that matter.
For example, high-growth companies may report healthy top and bottom lines but not have enough cash on hand to pay their bills. So, be sure to look beyond your income statement.
The second key part of GAAP-compliant financial statements is the balance sheet (also known as the statement of financial position). It provides a snapshot of your company’s financial health by tallying assets, liabilities, and equity.
For instance, intangible assets—such as patents, customer lists, and goodwill—can provide significant value to businesses. However, internally developed intangibles aren’t reported on the balance sheet; they are reported only when they’ve been acquired externally.
Similarly, owners’ equity (or net worth) is the extent to which the book value of assets exceeds liabilities. If liabilities exceed assets, net worth will be negative. However, book value may not necessarily reflect market value. Some companies provide the details of owners’ equity in a separate statement called the statement of retained earnings. It covers sales or repurchases of stock, dividend payments, and changes caused by reported profits or losses.
Ultimately, your balance sheet can tell you a lot about what you’ve got, what you owe, and how much equity you truly have in your company. But it doesn’t tell you everything, so it’s important to read the balance sheet in the context of the other two parts of your financial statements.
The third key part of GAAP-compliant financial statements is the statement of cash flows. True to the name, it shows all the cash flowing in and out of your business. Cash inflows aren’t necessarily limited to sales; they can also include loans and stock sales. Outflows typically result from paying expenses, investing in capital equipment, and repaying debt.
Typically, statements of cash flow are organized into three categories: operating, investing, and financing activities. The bottom of the statement shows the net change in cash during the period.
Read your statement of cash flows closely as soon as it’s available. It essentially tells you how much liquidity your business had during the reporting period. A sudden slowdown in cash flow can quickly lead to a crisis if you aren’t generating enough cash to pay creditors, vendors, and employees.
In the day-to-day commotion of running a company, it can be easy to think of your financial statements solely as paperwork for the purposes of obtaining loans or other capital infusions. But these documents paint a detailed picture of the financial performance of your business. Use them wisely. For help generating GAAP-compliant financial statements or just understanding them better, contact us.
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