The goal of any business is to make money. And without financial reports, it's nearly impossible to understand the financial health of your business.
Are you spending too much on marketing initiatives? Do you need additional funding to keep the business afloat? All of these answers lie within your financial reports.
Whether you're a new business owner or are looking to take your business to the next level, understanding how to use financial reports effectively can make all the difference.
Are you ready to learn more?
Let's dive in.
Types of financial reports
Before we get carried away, let's quickly review three main types of financial reports businesses use to keep track of their finances: the balance sheet, income statement, and cash flow statement.
The balance sheet gives you a quick snapshot of your company's finances at a specific time. It lists your assets, liabilities, and equity.
The balance sheet formula is: Assets = Liabilities + Shareholders Equity
Assets are what your company owns, such as cash, accounts receivable, and inventory, while liabilities are what your company owes, such as loans or accounts payable.
Equity represents the difference between assets and liabilities and shows how much of the company's value is owned by shareholders.
The income statement, commonly known as the profit and loss statement, shows your company's revenue, expenses, and net income over a specific period — usually a month or a year.
This report is important for understanding how much money your company is making and how much it's spending to generate that revenue.
Cash flow statement
The cash flow statement shows how much cash flows in and out of your company during a specific period. It tracks cash inflows and outflows from operating, investing, and financing activities.
This report is important because it indicates whether or not your company has enough cash to pay your bills and invest in future growth.
How to analyze financial reports
Now that we've covered the three main financial reports, it's important to learn how to read and interpret each of these reports. That way, you can make informed decisions about your business.
For example, your balance sheet may show that you're holding a lot of inventory but not enough cash to cover accounts payable, indicating a potential problem with managing cash flow.
On the other hand, an income statement showing a large revenue increase may be a good sign for your business.
But suppose your expenses have also increased significantly after switching to a new payroll company or spending more on marketing initiatives. In that case, it could indicate that you need to adjust your spending to maintain profitability.
How did we come to these conclusions? Here are three common methods of financial analysis:
The vertical analysis compares line items on your financial statements to a base amount, usually total revenue or assets.
This analysis is expressed as a percentage and is useful for identifying trends or changes in your company's financial performance over time.
For example, a vertical analysis of an income statement may show that the cost of goods sold as a percentage of total revenue has been increasing over time, indicating a potential issue with cost control.
With horizontal analysis, you compare financial statements from different periods to identify trends and changes over time.
Horizontal analysis can help to identify areas where a business is improving or declining.
Think about it like using various types of business analytics to help grow your business.
You can use predictive, descriptive, and prescriptive analytics to learn about your company's finances, identify trends, and decide what to change to improve business.
Ratio analysis focuses on calculating and comparing ratios to measure different aspects of your company's financial performance, such as profitability, liquidity, and solvency.
Ratios are often expressed as a percentage and can be compared to industry benchmarks to evaluate your company's performance relative to your peers.
For example, a ratio analysis of your company's liquidity might show that your current ratio is below the industry average, indicating that you may have difficulty meeting short-term obligations.
And like personal discretionary income, business owners need to calculate SDE, or a seller's discretionary income, to determine how much money they can take out of their business to pay themselves.
These ratios can also help measure the success of your business and its attractiveness to investors.
If your eyes just rolled to the back of your head, don't worry. There are several tools and techniques to help you analyze financial reports effectively:
- Financial modeling - creating a mathematical representation of your company's financial situation and projecting future outcomes based on different assumptions.
- Trend analysis - comparing data from multiple periods to identify patterns and changes over time.
- Benchmarking - comparing your company's financial performance to industry averages or competitors.
- Variance analysis - comparing actual financial results to budgeted or expected results to identify areas where performance is better or worse than expected.
Analyzing financial reports is important because it allows you to find the areas of strength and weakness in your business's financial performance.
You can then share these results with your teams to improve your weaknesses. For instance, you can use one of the best notion widgets like Plus to share your financial data and insights with your team — which updates in real-time.
No more lags or stale presentations. You'll always have access to the most accurate data. And one wrong or outdated figure can be very costly.
Using financial reports to make informed decisions
When you understand where your company is thriving and needs improvement, you can make informed decisions about allocating resources and setting goals and objectives.
That way, when planning for the next month, quarter, or year, you can make the most accurate decisions to keep your business running smoothly.
Budgeting and forecasting
Financial reports help you create a realistic budget and forecast for your business.
By analyzing historical financial data, you can identify trends and patterns to help you make accurate predictions about your future financial performance.
For example, suppose your financial reports show that revenue has increased steadily over the past few quarters. In that case, you might invest in new marketing campaigns to continue that growth trajectory.
On the other hand, if your financial reports show that expenses have been increasing faster than revenue, you might need to cut costs to stay within your budget.
That's why we're seeing major tech layoffs in late 2022 and into 2023.
Investment and financing decisions
Financial reports can also help you make informed decisions about investments and financing.
When you spend time in the weeds of your financial reports, you can identify areas where you might need to invest in growing your business.
For instance, you can start investing money in innovative techniques or technology to cut costs or increase output. Or even purchase rival companies or side ventures.
No matter how much money you're willing to put into anything, you need to know if and when you can. Otherwise, it could backfire and bankrupt your company. And that's the last thing you want.
And if you're considering applying for a loan or raising capital, having your financial reports at your disposal can help you make a strong case for why your business is a good investment.
For example, suppose your financial reports show that your company has consistently high profitability margins. In that case, you can use that information to find buyers for your business and convince them they wouldn't take on much risk during the takeover.
Identify areas for improvement
Financial reports can also help you identify areas where your business is struggling.
You can identify red flags like expenses that are too high or underperforming revenue streams.
For instance, if your financial reports show that your business is spending too much on employee salaries, you might implement a cost-saving plan that includes reducing salaries or cutting back on other expenses — like capping overtime meal spending on company credit cards.
The more accurate financial information you have about your business, the better you can handle any risks it might face. Keeping track of your finances will help you grow your business and keep liability risks at a minimum.
Some business structures, like LLCs, offer liability protection from the beginning, but this protection might be removed if you fail to manage your business properly.
One of the best ways to manage your business' finances correctly is by opening a separate business bank account to keep track of all your cash inflows and outflows.
Separating your personal account from your business bank account gives you a clearer picture of all the moving parts. The red flags will clearly stand out using this methodology.
Set realistic goals and objectives
Finally, financial reports can help you set realistic goals and objectives for your business.
By understanding your financial performance and analyzing your data, you can set achievable targets for revenue growth, expense reduction, or profitability margins.
Suppose your financial reports show that your business has been consistently growing at 10% per year.
You might set a goal to increase that growth rate to 15% over the next year. In comparison, a growth rate of 50% seems aggressive based on past performance — although not impossible.
This type of goal-setting is important because it helps you focus your efforts and make measurable progress toward your overall business objectives.
Best practices for using financial reports
To wrap everything up in a nice bow, here are some best practices for using financial reports to grow your business:
- Conduct annual internal and external audits to ensure the accuracy of your financial data and maintain transparency with stakeholders.
- Use financial reports to communicate and collaborate within your organization, sharing them with key stakeholders such as investors or department heads to ensure everyone is on the same page.
- Leverage technology to streamline the process of generating financial reports and analyzing data using tools such as accounting, payment, or data visualization software.
- Evaluate and adjust your reporting and analysis processes to ensure they're meeting the needs of your business and driving growth.
Accuracy is the name of the game.
Financial reports are a powerful tool for understanding your business's financial performance and helping you make informed decisions.
By analyzing your financial data, you can identify areas for improvement, set realistic goals, and make strategic investment decisions to help your business thrive.
Of course, using financial reports effectively requires some effort and dedication. You'll need to establish regular reporting schedules, seek professional assistance (if needed), and avoid common mistakes that could take your business under.
But by following these best practices and adjusting your reporting and analysis processes, you can use financial reports to drive growth and improve your bottom line tenfold.
So, what are you waiting for? Start using financial reports to drive growth in your business today.
Johannes Larsson is the founder and CEO of Financer.com, an SEO geek, and an affiliate marketing expert. In his blog he shares his expertise in SEO, affiliate marketing, and finance with a wealth of resources for digital entrepreneurs.
*This blog post is intended for informational purposes only and is not intended as financial advice.
**Melio does not provide legal, tax or accounting advice, and you should consult with a professional advisor before making any financial decisions.