How to understand end of year financial documents

Your personal finances are closely tied to your business's finances – when your business succeeds, so do you.

Your personal finances are closely tied to your business's finances – when your business succeeds, so do you.

The link between your personal and business finances

Many owners improve their business's chances of success by contributing personal resources in the form of loans and cash contributions.

It's crucial to develop a personal financial plan that you periodically review in conjunction with your business plan. There are a number of elements to a personal financial plan, from how you manage your investments and finance your mortgage – to education, retirement and estate planning.

If you operate a proven business, your financial statements from the last few years will show how well your business is doing. The more years of historical information you have available, the deeper the insight you'll give into your business's financial position and how it has changed over time.

Your key financial statements

Three financial statements will give a complete picture of your business. They are the:

  • Balance sheet – which describes what your business owns and owes at a specific point in time, usually at your business's year-end.
  • Income statement – that details revenues (sales), expenses and net income over a specified period of time, usually one year.
  • Cash flow projections – which forecast when money comes into your business, when you business pays money out, and helps you budget for both.

Whatever life stage your business is at, projected financial statements – or ‘pro forma’ statements – can help you work through various ‘what if’ scenarios, and allow you to plan where you want your business to go.

Review engagement statements

If you’re seeking financing for your business, some lenders or investors may require audited or review engagement statements prepared by an accredited accountant.

Review engagement statements are financial statements that have been reviewed by an independent accountant who determines whether they’re plausible within the framework of generally accepted accounting principles.

A review engagement is similar to an audit, except that no opinion is expressed on the statements.

Familiarizing yourself with the balance sheet

A balance sheet is a snapshot of your business' financial position – taken on a specific day. By drawing up balance sheets on the same day each year, you can track your business's progress over time.

Whether you're starting up or you run an established business, create projected balance sheets that reflect your business plan. That means estimating your assets, liabilities, and equity for the coming years.

A balance sheet is divided into three sections:

  • Assets – what your business owns.
  • Liabilities – what your business owes.
  • Equity – the difference between what your business owns and owes.

If you run a well-established business, include past balance sheets – ideally for the last three years.

If you're starting up, build your balance sheet by detailing assets and liabilities your business already has.

Getting your head around income statements

An income statement is a summary of your business's performance over a certain period of time, normally one year.

It starts with your business's revenues (also known as sales) and subtracts the expenses incurred to generate those revenues. The result is your business's net profit or loss.

If you run an established business, include income statements for your business – ideally for the last three years.

Regardless of the life stage of your business, create pro forma (or projected) income statements that reflect your business plan. This means estimating for the coming years your:

  • Sales.
  • Cost of goods of sold – for non-service businesses.
  • Expenses – including depreciation, interest, and income taxes.
  • Profit.

Projected income statements

If you are starting up, base your revenue and expense projections on what you've learned about your target customers, your competition, and your industry by writing your business plan. You’ll need to project:

  • Sales – your sales projections should be reasonable so take a conservative approach.
  • Cost of goods sold (for non-service businesses) – this should incorporate what you know about suppliers, their prices, and potential changes in costs.
  • Expenses – should be based on your plan and your educated understanding of what things cost.

Depreciation – in any year this can be very roughly estimated by dividing the amount spent on furniture, fixtures, equipment, and vehicles by the average number of years you expect your business will use such assets before replacing them.

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