Understanding your financial statements

Where should you start?

For a U.S. small business, three views are useful: a balance sheet shows financial position on a particular date; an income statement shows results over a period; and cash flow shows when money comes in and goes out. The examples below are fictional and in U.S. dollars.

Balance sheet · Income statement and net income · Cash flow and accounting methods · Tax records

1. Balance sheet

A balance sheet is a snapshot on a particular date. It lists assets the business owns or controls, liabilities it owes, and the owners’ equity left after liabilities. The basic equation is Assets = Liabilities + Owner’s Equity.

For example, on December 31, a shop has $12,000 in the bank and $8,000 in inventory, for $20,000 in assets. It owes suppliers $5,000 and has a $7,000 loan balance, for $12,000 in liabilities. Owner’s equity is $8,000: $20,000 = $12,000 + $8,000.

Check the date, then review cash, amounts customers owe, supplier bills, and loan balances. Equity is not the same as cash in the bank; assets can also include inventory and equipment.

2. Income statement and net income

The income statement, also called a profit and loss statement or P&L, shows revenue and expenses over a period, such as January 1 through December 31. It helps answer how much the business earned, spent, and ultimately gained or lost.

Suppose annual sales revenue is $100,000 and the cost of goods sold is $40,000, leaving gross profit of $60,000. After $45,000 of operating expenses such as rent and wages, and assuming no other income, expenses, or income tax, net income is $15,000.

$100,000 revenue − $40,000 cost of goods sold = $60,000 gross profit
$60,000 gross profit − $45,000 other expenses = $15,000 net income

Net income is revenue less related expenses for the period. If expenses exceed revenue, the result is a net loss. Actual statements may include interest, other income and expenses, and income taxes. Net income is not sales, and it may differ from the change in cash or taxable income; tax treatment depends on the circumstances.

3. Cash flow: profit is not the same as cash

Cash flow tracks when money actually moves. If you complete a $5,000 service and invoice the customer, but they pay next month, accrual accounting may recognize the revenue this month while the cash arrives next month. A profitable business can still be short of cash to pay bills.

Watch accounts receivable (amounts customers have yet to pay) and accounts payable (amounts the business owes suppliers). Loan proceeds are generally not sales revenue; repayment of loan principal is generally not an income statement expense, although interest may be an expense.

4. Two common accounting methods

Cash basis: Generally records income when received and expenses when paid. Accrual basis: Generally records revenue when earned and expenses when incurred, even when payment happens at another time. Rules and tax choices can be more complex; confirm your business’s method with your accountant and compare periods using a consistent basis.

5. What can you do each month?

• Keep invoices, receipts, and bank and credit card statements; separate business and personal spending.
• Reconcile bank and credit card records and review unpaid customer invoices and bills.
• Compare revenue, major expenses, and cash balances with prior periods, and ask about unusual changes.
• Discuss large equipment purchases, loans, owner withdrawals, and tax treatment with your accountant; these are not necessarily all current-period expenses.

6. How long should you keep tax records?

Keep copies of filed returns and the documents that support income, deductions, and credits, such as Forms W-2 and 1099, invoices, receipts, bank statements, and payroll records. The right retention period depends on the record and your circumstances.

• Generally 3 years: For federal income tax, keep supporting records for 3 years after filing when no longer period applies. A return filed early is treated as filed on its due date. For a refund claim filed after the return, keep records for 3 years after the original return was filed or 2 years after the tax was paid, whichever is later.
• 6 or 7 years in some cases: The IRS says 6 years if income that should have been reported is omitted and exceeds 25% of the gross income reported; keep records for 7 years if claiming a loss from worthless securities or a bad debt deduction.
• Payroll taxes: Keep employment tax records at least 4 years after the tax is due or paid, whichever is later.
• Property and equipment: Keep purchase, improvement, and depreciation records until the limitations period expires for the year you dispose of the property; records of exchanged property may need to be kept longer.
• No return or a fraudulent return: The IRS says to keep records indefinitely.

State rules, an open audit, insurance, creditors, or other needs may require longer retention. Store records securely, including readable electronic copies and backups. Before discarding documents, ask your accountant about your situation. See IRS record-retention guidance ↗