Introduction: Financial Statements Are Your Report Card
Financial statements tell the story of your business.
They show:
- How much you’re making (Income Statement)
- What you own and owe (Balance Sheet)
- Where cash is actually going (Cash Flow Statement)
Most business owners don’t understand these. They just look at bank balance.
But bank balance is misleading. You might have $100,000 in bank but owe $150,000 in bills next month.
Understanding financial statements prevents surprises.
Part 1: Income Statement Deep Dive
What It Shows:
Income Statement (P&L) shows profitability over time period (month/quarter/year).
Formula: Revenue – Expenses = Profit
Real Example: Service Business
ABC Consulting – Income Statement for Year 2024
Revenue:
- Consulting services: $450,000
- Training workshops: $75,000
- Product sales: $25,000
- Total Revenue: $550,000
Cost of Goods Sold (COGS):
- Contractor payments (fulfilling services): $100,000
- Materials for workshops: $15,000
- Total COGS: $115,000
Gross Profit: $435,000 (79% gross margin)
Operating Expenses:
- Salaries (2 employees): $120,000
- Payroll taxes: $18,000
- Office rent: $36,000
- Marketing: $55,000
- Software/subscriptions: $12,000
- Professional services: $24,000
- Insurance: $18,000
- Utilities: $9,600
- Office supplies: $4,800
- Miscellaneous: $12,000
- Total Operating Expenses: $309,400
Operating Profit: $125,600 (23% operating margin)
Other Expenses:
- Interest on loan: $6,400
- Total Other Expenses: $6,400
Net Profit: $119,200 (22% net margin)
Analysis:
- 22% profit margin is healthy (most service businesses target 15-25%)
- Gross margin 79% is excellent (means high profit per customer)
- Operating expenses are 56% of revenue (reasonable for service business)
- Owner is building substantial business value
Part 2: Balance Sheet Deep Dive
What It Shows:
Balance Sheet (as of specific date) shows financial position.
Shows: What you own, what you owe, what’s left.
Real Example:
ABC Consulting – Balance Sheet as of December 31, 2024
ASSETS:
- Cash: $85,000
- Accounts Receivable: $35,000
- Equipment: $30,000
- Office furniture: $15,000
- Total Assets: $165,000
LIABILITIES:
- Accounts Payable: $8,000
- Credit card balance: $5,000
- Bank loan (vehicle): $40,000
- Total Liabilities: $53,000
EQUITY:
- Owner’s investment: $50,000
- Retained earnings (profits): $62,000
- Total Equity: $112,000
Verification: $165,000 = $53,000 + $112,000 ✓
Analysis:
- $165,000 total assets (what business owns)
- $53,000 total debt (what business owes)
- $112,000 owner equity (net worth in business)
- Strong financial position (2x more assets than debt)
- Healthy liquidity ($85,000 cash to cover $8,000 current payables)
Part 3: Cash Flow Statement Deep Dive
What It Shows:
Cash Flow Statement shows actual cash moving in and out.
Different from profit (which includes non-cash items).
Real Example: Consulting Business Monthly Cash Flow
ABC Consulting – Cash Flow Statement for January 2024
Cash Inflows:
- Revenue collected from customers: $40,000
- Loan proceeds: $0
- Owner investment: $0
- Total Cash In: $40,000
Cash Outflows:
- Contractor payments: $8,000
- Payroll: $12,000
- Rent: $3,000
- Marketing: $4,000
- Software: $1,000
- Insurance: $1,500
- Supplies: $400
- Loan payment: $2,000
- Total Cash Out: $31,900
Net Cash Flow: +$8,100
Ending Cash Balance: $85,000 (beginning) + $8,100 = $93,100
Analysis:
- Positive cash flow (good)
- Collecting revenue well ($40,000 on $45,000+ revenue = 89% collection)
- Expenses under control
- Cash position healthy and growing
Cash Flow Red Flag Example:
If instead:
- Revenue collected: $20,000 (customers slow to pay)
- Expenses: $31,900 (same)
- Net cash flow: -$11,900
- Ending cash: $73,100
This would be concerning. Cash declining monthly. If continues, company runs out of cash in ~6 months.
Warning sign: You’re profitable on paper but running out of cash.
Part 4: Interpreting Financial Ratios
Profitability Ratios
Gross Profit Margin = Gross Profit ÷ Revenue
Shows how much profit on actual products/services before operating expenses.
Example: $435,000 ÷ $550,000 = 79%
Means: For every $1 of revenue, 79 cents is profit before overhead.
Benchmark: Service businesses 60-80%, product businesses 40-60%
Net Profit Margin = Net Profit ÷ Revenue
Shows bottom-line profitability after all expenses.
Example: $119,200 ÷ $550,000 = 22%
Means: For every $1 of revenue, 22 cents is actual profit.
Benchmark: Most businesses 5-15%, excellent businesses 15-25%
Liquidity Ratios
Current Ratio = Current Assets ÷ Current Liabilities
Shows ability to pay short-term obligations.
Example: $120,000 current assets ÷ $13,000 current liabilities = 9.2
Means: You could pay all current bills 9.2 times over.
Benchmark: 1.5-3 is healthy, 9.2 is very healthy
Return on Assets (ROA) = Net Profit ÷ Total Assets
Shows how efficiently you use assets to generate profit.
Example: $119,200 ÷ $165,000 = 72%
Means: Every $1 of assets generates 72 cents in annual profit.
Benchmark: 5-10% is good, 10%+ is excellent