[MUSIC PLAYING] Hi, Oscar from Bench here. And I'm going to tell you all about financial statements, how they work, and how you can use them to keep your small business on track. Basically, financial statements are reports that you get each month or each quarter that tell you how your business is performing financially. They're based on your books, so accurate financial statements are only possible when your bookkeeping is kept up-to-date.
It's worth it, though, as financial statements tell you exactly how you're spending money, how you're earning it, how much you owe other people, how much other people owe you, and how much cold, hard cash your business has to work with. When you have financial statements, you can make projections so you can predict how your business is going to perform in the future. You can find new ways to cut costs or to earn revenue. And you can file accurate tax forms without having to go back and dig through a bunch of old receipts.
Plus, if you're looking to take on investors or take out a loan, you are 100% going to need accurate financial statements. They're the best way to prove that your business is financially healthy. There are a few different types of financial statements, but there's three in particular that are essential, and every business uses them. Each one gives specific information for a specific period, usually a month.
Now, they are the balance sheets, which tells you what your business has and what it owes; your income statement, which tells you how you earned money and how you spent it; and then the cash flow statements, which tells you how much cash came into your business and how much cash went out of it. We'll look at each of these one at a time, but, first up, the balance sheet. Now, the balance sheet is split up into three sections-- you're got your assets, your liabilities, and your owner's equity.
Under assets, that's essentially anything that the business owns. So, cash in a bank account, that's an asset. Inventory, that's an asset. Real estate, equipment, intellectual property, supplies, stocks, bonds-- they're whole assets. Assets can also include money that someone else owes you. So if you've invoiced the customer for $500 and they haven't paid you yet, that $500 still shows up on the balance sheet as an asset.
Now, liabilities are the opposite of assets. So anything that costs your business money is a liability. Also, if you owe someone money, like a vendor, the amount that you owe will show up on the balance sheets under liabilities. Plus, if you have a loan that you're paying back or a credit card you're paying off, it'll also show up as a liability. Now, owner's equity basically explains who owns which piece of your business.
For instance, if you invested $5,000 to get your business up and running, that investment will show up under owner's equity. Your business is making a profit and any amount that you've set aside as kind of like a rainy-day fund for the business, that will show up as retained earnings under owner's equity. Now, those are both positive numbers. They add to the total equity in the business. There is one negative number that you may see in this section and that is owner draws.
So if you're paying yourself regularly using an owner draw, they'll show up as money coming out of your owner's equity. And that's because you're pulling that money out of the business for personal use. Let's take a look at an example. Imagine that you run a burger company. It's called Where's the Beef, and your balance sheet looks like this. So under assets, we have cash in the bank accounts. We also have accounts receivable.
This is the money that people owe you. We have the total value of your equipment and then, at the bottom, all the assets added up to give you a total. Next, liabilities-- so, accounts payable. That's the money that you owe other people like vendors. And long-term debt, that is any loans that you're paying back. So for instance here we have one for $2,000. Again, at the bottom we have a total figure for liabilities.
And then finally, owner's equity-- so capital that's the money that you invest into the business. Retained earnings-- that's any profits that you set aside as that kind of rainy-day fund. And then we have the negative number, drawings. So this is any amount that you've taken out the business to pay yourself during that reporting period. Once we've added up capital and retained earnings and we've taken away drawings, we'll have the total equity for the business.
Using all of this information, you can see how much value your business holds was taking into account what it owes. So balance sheets are really important to keep track of because you can then always ensure that your assets outweigh your liabilities. OK, next up, income statements. Now, if your balance sheet tells you how much your business has, your income statement tells you how you got it.
So at the top line of the income statement, that's where you have your sales revenue. That's all the money that came into your business during the period. And with each line after that on the income statement, expenses are taken away from that revenue figure until we get to your bottom line, your net profit. Now, the net profit is the money you get to keep after paying off all your business expenses. Now, the best way to understand this is again to look at an example.
So this time, let's say you have a coffee roasting company. And your income statement for the quarter looks like this. Now, at the top, we have the sales revenue, so $50,000 that came into your business during the quarter. And underneath we Have Costs Of Goods Sold, abbreviated to COGS. Now COGS is any money that you spent in making the product. So in this instance, we'll have the cost of raw coffee beans, the wages that you pay the people that roast them, packaging, and shipping.
Now, we break out COGS from other expenses on the income statement because, if you look at COGS versus revenue, you can get a good idea of how much you earn per unit you sell versus how much it costs to actually create that. Gross profit is revenue minus cost of goods sold, and it's the first of three subtotals that appear on the income statement.
And we'll get to the others later on. So now you take the $25,000 of gross profit, carry it down, and then you apply general expenses. And so these are all the day-to-day expenses outside of cost of goods sold. We have the total of $11,000. And then, below, we have a breakdown of each individual expense category. So rent, that's the cost of using your commercial space; equipment expense, that's the money that you spend on replacing or repairing equipment; marketing expense covers advertising; and merchant fees is the money that you pay to credit card processors every time a customer pays by card.
After all of these general expenses, you get to operating earnings. So operating earnings is gross profit minus general expenses, and it's the second of those subtotals that appear on the income statement. Operating earnings is all the money you get to keep out of your revenue after applying all of your internal expenses. So after operating earnings, we then apply external expenses. And this is the stuff that you can't really control.
For starters, we've got interest expense. That's payments that you're making on any money that you owe. And after taking that into account, we get to earnings before income tax. And this is the third and final subtotal on that income statement. Finally, we apply income taxes. So for this instance, it's $3,000 for the quarter. And that's the last expense that you'll see on the income statement.
Now, we've got to the bottom line, your net profit. So your net profit for the quarter is $8,000. Now, remember, the top line, the sales revenue, that was $50,000. And this is why income statements are really important. There are a whole bunch of different expenses that eat into your revenue each quarter. And income statements are the best way to keep an eagle-eye view on those expenses and see how they impact the amount of money you get to take home at the end of the day.
OK, the last financial statement that we're going to look at is the cash flow statement. Now, its job is to tell us all the cash that moved in and out of your business during the reporting period. Now, in order to do that, you reverse all of the transactions on your financial statements that weren't done in cash. For instance, if your income statement shows you that you earned $1,000 in revenue, but only $400 worth of that was in cash, the cash flow statement is going to show the other $600 is going back into your sales revenue account.
And if your income statement shows you is paying your suppliers $400 for inventory, but you've only actually paid $300 worth of invoices, the cash flow statement is going to put the remaining $100 back into the supplies cost accounts. OK, now let's take a look at an example, Here we have a cash flow statement for the month of January. We'll walk through it.
First, we have your net income. That's the bottom line from your income statement. Nothing weird here. Next we have a section called additions to cash. Now, these are expenses your business has incurred but hasn't paid cash for yet. So if you've got accounts payable of $20,000, but you've only paid for half the invoices, that $10,000 remaining is going to be listed here. It's being reversed from an expense and put back into your pocket as cash.
Next we have subtractions from cash. Now this is money that your income statement shows you as having earned. But in cases where you don't have the cash in hand yet, you need to subtract it from your net income. Again, it's reversing the transaction. So accounts receivable that haven't been paid yet by your customers get subtracted from your net income. You also subtract inventory.
So in this case, you took on $30,000 worth of inventory, but inventory items are on cash, so they get subtracted from your net total. After taking into account all these additions and subtractions, we get to net cash from operations. Now, this is all the cash that came into your business during the accounting period, in this case, $40,000. The next section is cash flow from investing.
So if you bought stock, you need to subtract the value from your total cash. Even if you invested $5,000, and it's still worth $5,000 or more, it's not cash anymore, so it gets subtracted. And finally, we have cash flow from financing, notes payable. So notes payable is money that you've taken out in the form of loans, in this case, $7,500.
Now, the bottom line from your cash flow statement is your total cash flow for the month. This is all the cash that came into your business, and it's the total cash that you have to work with. Now, it's really good to know this number. If you're basing your decisions off your income statement, you might think you've got $60,000 on hand to spend when, really, you've only got a little more than $40,000.
So your cash flow statement keeps you from coming up short when it's time to pay for expenses or invest in expanding your business. Financial statements are really powerful tools in running your business. And everyone from the smallest company to the largest corporations uses them. For instance, this is Disney's income statement 2019. Now, it's a little more complex than our example since it's broken down into quarters, but it's still the same info.
We've got total revenue, cost of goods sold, here it's called cost of revenue, and earnings before tax. It's just the numbers that obviously are a little bigger. Now, we've got a cash flow statement from Apple. Now, again, this statement covers five years, and the line items have slightly different names to the one we used in our example, but it's all the same information. For instance, we can see that Apple subtracted over $3 billion from its accounts receivable in 2015 to account for money that wasn't earned in cash.
And here we have a balance sheet from Tesla. And again, we're looking at billions of dollars, but it's all the same line items that are there-- cash, receivables, and liabilities. So even if you're not Elon Musk, financial statements still have a really big role to play in running your small business. Hopefully this has been a helpful intro into financial statements. If you have any questions, please feel free to let us know in the comments.
