How to Read Financial Statements

The financial statements your business generates provide the basis of future projections, insight into potential tax liabilities and your business’s progress over the years. It’s important to read them and to comprehend what they indicate, after all, they are the pulse of your business.

If you are serious about growing your business, then your accounting should be on a computerized software program that can produce a profit and loss, balance sheet and a general ledger. I’m talking about something more advanced than a spreadsheet program. The size of your business doesn’t matter, whether you have 10 transactions a month or 10,000, you should have systems in place to record your income and expenses, and provide you with important financial information.

Every transaction you make, whether it’s a sales invoice, a contribution of capital, or a payment for your office rent should be recorded in the general ledger and will end up on your financial statements.

Essentially, the profit and loss statement will show only your sales and deductible business expenses. The balance sheet shows the value of your assets: everything from how much you have in the bank, petty cash envelope or cash register to inventory, furniture, fixtures, and equipment among other things. It also shows the liabilities of the business that can include vendor bills payable, loans and credit cards payable. The difference between these two equals your equity position, which is the third element of the balance sheet.

Here is an overview of the profit and loss statement:

The Profit and Loss Statement

If you use QuickBooks for your accounting needs, then go to the top ruler bar and select Reports -> Company and Financial -> Profit and Loss.  Change the dates at the top of the report to correspond to last calendar year. If you can’t stand the idea of looking at a bunch of numbers, then select the graph option to bring up either a bar chart or a pie chart representation.

The first line item on the profit and loss statement is operating revenue, which reflects sales.  You may wish to break out sales by product or service type, this allows you to know how much is coming in from each source,  and what products or services need more promotion or possibly abandonment.  Be advised, just because a product represents a small percentage of sales, does not necessarily mean it should be abandoned.

Listed directly below sales are “returns and allowances.”  You or your bookkeeper may have this broken out to titles such as discounts, customer refunds, etc.  Keep an eye on this number:  If returns are high, then you should take a good look at your product or service to see what is wrong and correct the problem. Your reputation is reflected in this number. Reputations are hard to build and maintain, even harder to reestablish.

Cost of goods sold is comprised of the expenses that directly pertain to the sale of your product or service and allocated overhead. In a retail business, this includes the cost of the inventory sold during the accounting period and freight paid on delivery from the distributor or wholesaler.

You should adjust the inventory figure each accounting period, adding new purchases and subtracting inventory sold. The inventory figure is adjusted on the balance sheet to reflect ending inventory for the period.  The difference will be applied to cost of goods sold.  If you take a physical inventory monthly, the subtractions will be based on that figure and moved over to cost of goods on the income statement.

If you take inventory less frequently, this figure may be based on your markup.  For example: sales are $60,000.00 and you double the cost of your product when you sell it.  Therefore, cost of goods sold will be $30,000. At year end, take a physical inventory and adjust cost of goods sold and inventory on the financial statements. In other words when you make inventory purchases, post the transaction to inventory on the balance sheet not to cost of goods sold.

In manufacturing, cost of goods sold includes the cost of materials used in the creation of the product, production, labor, freight-in, and subcontracting of any phases of production.

For the construction industry, cost of goods sold includes materials, supplies, permits, production labor, and subcontractors. In a service industry, cost of goods sold includes the cost of direct labor and subcontractor labor.

The remaining expenses are essentially administrative costs necessary to the running of the business.  This includes sales expenses like advertising and sales commissions, vehicle expenses, and salaries and wages to employees who are not listed under cost of goods sold. For example: Your installer may be listed as direct labor under cost of goods sold, but your receptionist would be listed under salaries and wages simply because he does not work in a capacity pertaining to the creation of your product or service.  Insurance, rent, utilities, telephone, and shop supplies are also business expenses.

Note that any monies you put into the bank accounts from your personal funds should not be reflected on the profit and loss. Nor should any draws you take from the business or any personal expenses paid from business funds. These items affect your equity position and will be listed on the balance sheet.

If a number on the profit and loss seems out of whack, you can double click on that number to drill down to the detail comprising it. For example, sales seem higher than expected. Perhaps when you drill down you will find that a bank loan you took out was included in that number. It’s a simple matter to revise the transaction to reclassify it from sales to a liability account: bank loan payable.

“Other income” listed at the very bottom of the profit and loss includes items that are not sales and not part of normal day to day activities. For example, you received an insurance refund; this item should not be listed at the top as part of sales. But because it is part of the taxable picture, it must be included on the profit and loss statement.

Now check out your profit or loss - the difference between sales and expenses. This is essentially the number that will end up on your tax return. You can bring up a profit and loss that compares current year to prior year or years. Or using the selections on the ruler bar of the profit and loss screen, you can format it to give you monthly, quarterly, even daily summaries if you like to examine separate accounting periods. Check it out.  Next week: How to read a balance sheet

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.