127: How to Read These 3 Essential Financial Statements

Are you making the same costly mistakes in your business without even knowing it? In this episode of "Boosting Your Financial IQ," we dive deep into the three essential financial statements every business owner must know: the income statement, balance sheet, and statement of cash flows. Learn how to leverage these tools to drive profitability, assess financial health, and maximize firm value. Ready to elevate your financial literacy? Visit BYFIQ.com and join our Financial Pro Mastery Program for more in-depth training.

Here's how to get started with Boosting Your Financial IQ:

• Step 1:  Test your financial IQ for FREE
• Step 2: Download the FREE app
• Step 3:  Take the Fundamentals of Finance course

Disclaimer:
BYFIQ, LLC is a wholly owned entity of Coltivar Group, LLC. The views expressed here are those of the individual Coltivar Group, LLC (“Coltivar”) personnel quoted and are not the views of Coltivar or its affiliates. Certain information contained in here has been obtained from third-party sources. While taken from sources believed to be reliable, Coltivar has not independently verified such information and makes no representations about the enduring accuracy of the information or its appropriateness for a given situation.

This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only, and do not constitute an investment recommendation or offer to provide investment advisory services. The Company is not registered or licensed by any governing body in any jurisdiction to give investing advice or provide investment recommendations. The Company is not affiliated with, nor does it receive compensation from, any specific security. Please see https://www.byfiq.com/terms-and-privacy-policy for additional important information.

Get the free BYFIQ app and Starter Course here:  https://www.byfiq.com/app

Transcript

Speaker 1: 0:15

You don't want to spend years and years in your company just making the same mistakes over and over again, or just doing something that is costing a ton of money and you have no idea. This podcast, boosting your Financial IQ, is about business, financial literacy, strategies for profitability and the principles taught at byfiqcom. My hope is that you'll apply the lessons learned and that we can work together soon in my mastery program. Enjoy the show and don't forget to subscribe. Let's talk about the three financial statements that you need to know in business the income statement, the balance sheet and the statement of cash flows and then how to leverage these financial statements to drive greater firm value in your company. Let's start with the income statement. All right, the income statement is the most commonly known financial statement that exists out there in business, but guess what? It's incomplete. It's a good starting point because it will help you to understand how much revenue your business is generating, how much you are incurring in cost of goods sold in order to produce that revenue, to deliver on that revenue. And then you have operating expenses. You get down to profit, operating profit. You have to account for other income, other expense, to finally arrive at net income, and this financial statement will tell you whether or not the company can make profit. Right, but it's incomplete for a variety of reasons. I'm going to get into that here in just a minute, but let me just give you a little bit further breakdown on the income statement.

Speaker 1: 1:41

So we have revenue. Like I said, that's also known as your top line or your sales. That represents all the income that your company is generating from selling its products and services. Then you have cost of goods sold. Remember, these are all the costs associated with delivering your products and services to the customers, and it may include things such as material cost, direct labor, subcontractors if you engage with those types and other indirect and direct costs associated with producing that product or service, for example, merchant fees. Some companies will put merchant fees down in operating expenses. I believe that merchant fees should be up above in cost of goods sold because, think about it, you wouldn't. I believe that merchant fees should be up above in cost of goods sold because, think about it, you wouldn't be incurring merchant fees in other words, fees every time a customer pays with a credit card if you weren't selling products and services. So I don't believe that it's an operating expense. I believe it's cost of goods sold. Also with labor. A big mistake that I see with companies is that they will pay employees and they'll just have one labor line item on their income statement and oftentimes it's in operating expenses. Well, you have to separate out employees that are directly related to producing products and services. You have to put them up in cost of goods sold. Then everybody else goes down below in operating expenses.

Speaker 1: 2:59

So having a clear understanding of your cost of goods sold is important, because you're going to want to take your revenue minus cost of goods sold to arrive at gross profit. Now gross profit will tell you how much money is the business making by pricing its products and services, selling them out there in the market, incurring costs in the process, and then they'll tell you, like I said, what's left over. But that's not the end all be all. Gross profit is just the amount of money a company makes before it's overhead. But we have to account for overhead. So in overhead you have general and administrative expenses, sales and marketing expenses, maybe occupancy expenses like utilities or rent, professional fees, insurance and other miscellaneous taxes like property taxes or sales taxes, et cetera. So that's how OPEX is formed. From those accounts and if you take gross margin and you subtract out OPEX, you end up with operating profit and then, like I said, you have to account for other income and expense and then subtract those out and you arrive at net income. So the income statement is great. And when I'm working with companies, oftentimes their general managers are responsible for the income statement or maybe it's a P&L leader, a profit and loss leader, but they're ultimately driving performance from a revenue standpoint. They're watching their costs get sold. They're trying to maximize their gross profit while keeping operating expenses low so they can squeak out a profit at the end of the day. So the income statement is great, like I said, and companies will then build budgets based on the income statement.

Speaker 1: 4:39

I'm not a big fan of budgets because I think they're really constraining right. They're broken. If you are creating a budget to drive better performance, in other words, if you're using it as this, like carrot and stick, where you say, okay, if you follow this budget, I will pay you this P&L leader or team, that's not super effective. Instead, I believe in forecast, where you're trying to be more predictive in the future and you're driving continuous improvement. So there's some nuances there. I'm not going to get into the nuances between a budget and a forecast. But I'm definitely a forecast guy because I want companies to not play games with the numbers and try to create this like performance contract that's implicit in the budgeting process. Instead, I want companies to create a forecast so they can understand not just how much revenue and costs they're incurring along the way and profit, but ultimately how much free cash flow is going to be available month over month on a rolling basis. That's a forecast. It's rolling right. So you're constantly adding on a month, taking off a month. Adding on a month, taking on a rolling basis that's a forecast. It's rolling right. So you're constantly adding on a month, taking off a month, adding on a month, taking off a month All right, so that's the income statement.

Speaker 1: 5:47

Let's talk about the balance sheet. The balance sheet is organized in three main sections assets, liabilities and equity. Within assets and liabilities, they're broken down into current and non-current assets and liabilities. So the word current just means within 12 months. So with assets, it represents items that can be converted into cash or that are liquid within a 12-month time frame. With liabilities, it represents items that are due and payable within a 12-month time frame. So with assets and liabilities, just remember that there's two sections current and non-current, and I'll get into each here in more detail. But taking a step back, the balance sheet ultimately helps you to understand the financial health of a business as it pertains to their assets, liabilities and equity.

Speaker 1: 6:37

Let's get into assets, all right. So we'll talk about the current section first. Within current assets, they're in order by liquidity, so the most current assets'll talk about the current section first. Within current assets, they're in order by liquidity, so the most current assets are typically going to be reported first, according to GAAP at least. All right, so within current assets, cash is the most liquid.

Speaker 1: 6:57

So you have your checking accounts, your savings accounts, all your cash and cash equivalents listed first. Then you may have accounts receivable next. This represents the amount of money that customers owe you. So when you go out there and you do work and you send an invoice to a customer, you record that revenue because you perform the work. But if the customer hasn't paid you yet, you have to record that as a balance in your accounts receivable, so that's accounts receivable. Then you have inventory inventory that's being held and you're looking to sell, right, so there's a value there.

Speaker 1: 7:27

Then you have prepaids oftentimes, and if you think about prepaids like this. Let's say you take on an insurance policy. Well, the company may say hey look, we want you to pay six months of the premium upfront. Well, that's not an expense you could just record all at once on the income statement. Because of the matching principle, you want to match revenue and expenses in the period in which they incur. So instead you have to take that amount, record it as a prepaid and then you're going to release it month over month over month as the time goes on.

Speaker 1: 7:58

That's a prepaid and that's considered a current asset. All right, so those are your current assets. And then you have non-current assets, which primarily consist of property, plant and equipment. So when you go out there and you buy an asset that has a useful life greater than one year and it exceeds a threshold let's just say $2,500, then you're gonna capitalize it and record it as an asset on the balance sheet. So PP&E may include things like a vehicle, machinery equipment, a building, all the assets related to running the business. So that's PP&E. They're non-current because you're not going to convert them into cash within a 12-month timeframe and therefore they sit below the current section. All right. A business may also have other assets, such as investments in other companies, but essentially that's the bulk of assets.

Speaker 1: 8:49

If we move on to liabilities, the same kind of thing, remember, current liabilities are going to include things such as accounts payable, that's the amount of money that a company owes its trade vendors. It may have payroll liabilities, like taxes, that it needs to submit to the appropriate authorities, but it hasn't done that yet, so it's a liability on the books. Maybe they sell gift cards. That's a liability to the company. That would sit there in that section as well. So I'll have all these current liabilities and then non-current liabilities essentially equals the long-term debt of the company, right? That's usually what's in non-current liabilities. But also there's a little caveat here, because if you have long-term debt, you have to break out the current portion of that debt into short-term and that's recorded in current liabilities, right? So you have current liabilities, long-term liabilities. That makes up liabilities. And then you have equity.

Speaker 1: 9:43

Now, equity doesn't have to be that complicated, but I remember in school my mind was always like blown. I was like whoa, what is equity? This gets really complicated. Maybe that's just me, but let me just keep it really simple.

Speaker 1: 9:55

Equity is the amount of money that is put into the business right to start it up, or it's just capital that's raised over time and retain earnings. So capital the first one. Think about it. You start a business, you put a hundred grand in. That's not revenue to the business, instead it's equity. It just goes in as capital to the business and it just sits there until there's some type of liquidity event. Or if a business goes out there and raises more capital, then that's going to go in under the equity section. Now, when it comes to retained earnings, that is made up of the beginning balance of retained earnings, all the earnings that have been accumulating over the life of the business plus the current period net income. So that's going into retained earnings, less any distributions or dividends paid to give you an ending retained earnings balance. And that's it right. And that's how the balance sheet ties back to the income statement, because net income is going into equity and that is coming off that statement and the two connect together.

Speaker 1: 10:55

But here's what's interesting the balance sheet can have a lot of hidden little demons in it if you're not paying attention, if you're just paying attention to the income statement and you're not comparing the profit to your invested capital, which is computed from the balance sheet, you may think, hey, we're making returns that are great, but in fact your return on invested capital may be really, really low. So you have to understand that. Also, there may be liabilities or assets accumulating on the balance sheet and if you're not careful, they could put you out of business. So think about working capital current assets minus current liabilities. If you're not paying attention to this, your accounts receivable may be climbing, which means your customers are sitting on all your cash from all the services you provided them, and if you're not collecting that fast enough, guess what? You're going to run out of cash. So you have to pay attention to the balance sheet and that's why, whenever I'm working with a company, it's always the income statement and the balance sheet, at a minimum.

Speaker 1: 11:52

Now let's move on to the most important financial statement, which is the statement of cash flows. Now, the reason why I love the statement of cash flows is because it's broken down into three core sections operating activities, investing activities and financing activities. Let's start with the first one. In order to get down to operating cash, you have to start with net income from the income statement and then account for non-cash line items like depreciation and amortization, and then also take into account changes in working capital and then you arrive at cash from operating activities.

Speaker 1: 12:27

Now the next section in investing activities, this represents all the cash that goes in or out of the business from just investments. Now, one of the big investments in a business is this capital expenditures, capex for short. So when companies buy property, plant and equipment, it shows up as CapEx, capital expenditures and that's in investing activities. So if you take your cash from operating activities, less CapEx, you will arrive at free cash flow, which is one of my favorite measures in a business. But that's where these two sections come together to give you free cashflow, which is one of my favorite measures in a business. But that's where these two sections come together to give you free cashflow. But just remember, in investing activities you may take cash and invest in another business or subsidiary. You're going to have those flows, inflows, outflows in that section as well.

Speaker 1: 13:13

In the last section, financing activities, this is where you account for inflows from debt and outflows for debt when you're paying down debt, and inflows and outflows from equity. Let's say you raise capital or you return capital to your equity providers. So that's the financing activity section. So you take all these three sections. Add up all the changes and then you take your beginning cash account for these changes in cash and then you arrive at ending cash at the end of the period. Guess what? That ending cash ties back to the balance sheet and that's how the income statement and the balance sheet have a baby together and it's called a statement of cash flows. You're blending the income statement and the balance sheet, all the accounts together, to arrive at the statement of cash flows. That's why I love the statement of cash flows, because it has everything you need to know in one financial statement and then, if you need the detail, you can go to the respective financial statements, the income statement and the balance sheet. All right, it's kind of a lot, but in business I like to leverage all these financial statements.

Speaker 1: 14:20

If I want to know how is a company performing from a profitability standpoint or how much is it generating in sales, I'll go to the income statement. If I want to compute invested capital and return on that invested capital, I'm going to combine profit from the income statement with that from the balance sheet. Maybe I want to look at the liquidity of the business that's on the balance sheet, or how much leverage. Look at the liquidity of the business. That's on the balance sheet. Or how much leverage does the company have? Is it taking on too much debt? That's on the balance sheet. Or if I want to evaluate what are the returns on equity, I have to look at profits from the income statement and combine that with the equity which is found on the balance sheet. And then the statement of cash flows helps me to determine free cash flow of the business and that, ultimately, is the driver of intrinsic value and firm value in a company. The statement of cash flows helps me to understand where's cash coming into the business and where is it flowing out of the business in those three sections operating, investing and financing. So those are the three financial statements that exist out there.

Speaker 1: 15:20

If your head is about to explode and you're like, oh my gosh, slow down, steve, I want to learn more. At byfiqcom I have a course you could take. It's called the Fundamentals of Finance. I'm standing in front of a whiteboard. No, it's not a boring Zoom lesson, right, it's actually. It's a pretty engaging course. I think so, but you can check that out. I also have this program called financial pro, but there are other YouTubes, there's podcasts, there's all these resources out there.

Speaker 1: 15:50

The key is is just to get started somewhere. I don't care if you use me or if you use somebody else for your content, but just build the skills. Learn how to read these financial statements, because it will make all the difference in the world in your business. And, trust me, you don't want to spend years and years in your company just making the same mistakes over and over again or just doing something that is costing a ton of money and you have no idea. I've gone into businesses before where I made one little adjustment to their pricing or to their cost and it created millions of dollars of profit just by adjusting one thing, and the owners of the business would always say to me they're like what the heck? Where were you before? And it's like yeah, I know, I hear you, but you can do the same exact thing in your company and you will be an absolute powerhouse. All right, that's a wrap. That's all I wanted to cover in today's episode. Until next time, take care of yourself. Cheers.