How to Read Financial Statements as a Business Owner

Want to finally make sense of financial statements? In this video, Steve breaks down the income statement, balance sheet, and cash flow statement in a way that’s clear, practical, and actually useful.

Whether you're leading a business, learning finance, or just trying to understand what the numbers are really saying, this video shows you how it all connects. You’ll learn how to track performance, spot red flags, and make smarter financial decisions with confidence.

It’s a must-watch for any business owner who wants to lead with clarity.

TRANSCRIPT:

Hey, it's Steve. In this video, I'm gonna walk you through the three financial statements you need to know in business and show you how they flow together from a CFO's perspective. Let's go ahead and kick things off by talking about the income statement.

Now, I'm going to abbreviate things in this video and keep it really high level because I'm not here to turn you into a nerd where you're wearing a green shade in the back office doing debits and credits and celebrating every time your trial balance ticks and ties. Instead, I wanna show you how money flows within an organization specifically through the income statement, balance sheet and statement of cash flows. So let's start off with the income statement and we have revenue for starters.

Revenue also known as the top line or sales represents the amount of income a company generates from selling its products and services to customers. Underneath revenue, we have COGS, also known as cost of goods sold or cost of revenue. These are all the costs associated with delivering products and services to the end user.

I'm not talking about literally Amazon style driving a truck and dropping off products to customers. No, instead I'm talking about direct materials, labor cost, equipment cost, not the cost of the equipment, but the maintenance that goes into the equipment that's used in the production and delivery of these products and services, subcontractors and other direct or indirect costs associated with getting the product into the hands of customers. These costs are up here in cost of goods sold.

What I see with a lot of organizations is that they'll have expenses that should be up in COGS, but they're down below in operating expenses or in their overhead. And if this happens, then they are likely misrepresenting the next line item, which is gross margin. So you have to be really careful when you're looking at a company's income statement and ensure that the costs associated with delivering those products and services are hitting COGS up above, not down below in overhead.

Okay, so we have gross margin, also known as gross profit. You'll notice here in this video, there are a lot of synonyms with financial statements. I'll say gross margin, gross profit, cost of goods sold, cost of revenue, sales, revenue.

All these terms pretty much mean the same thing in their own context, so don't let that confuse you, but I wanna use these different terms so you're familiar because every company may do things slightly different within the bounds of GAAP. Now, GAAP stands for Generally Accepted Accounting Principles, or IFRS, International Financial Reporting Standards, if you are outside of the US. But there are standards that are in place, but just know there are nuances with the reporting.

So, like I said, I'm gonna keep things really high level so you can understand how things flow, but they may look slightly different within your organization or from company to company. All right, so going back here, we have gross margin, also known as gross profit. This represents the amount of money a company earns after pricing its products and services and selling them to customers, and then accounting for all the costs associated with producing and delivering that product or service to the end user.

Okay, that's gross margin, but we're not done here. We have to account for overhead, also known as OPEX, which is short for Operating Expenses. If you wanna sound cool, you can say OPEX, or commonly referred to as SG&A, which stands for Selling General and Administrative Expenses.

So we have this line item here underneath gross margin, and when we take gross margin minus OPEX, we end up with operating profit or operating income. Now, it's important to note that operating profit is calculated by taking revenue minus cost of goods sold and operating expenses to arrive at a number that represents how much money a business is earning in the course of its normal operations, hence the word operating. That's really important to understand because there are other things below this in other income and expense that are not associated with normal operating activities.

For example, you may have interest income, and unless you're a bank, you're not in the business of earning interest. So therefore, it's gonna come down here and hit other income. You may have other items such as a gain on a sale of an asset that hits other income, but essentially, it's just other items that are not a part of normal operations.

That's what I want you to understand here. On the expense side, you may have interest expense, you may have a loss on a sale of a piece of equipment, and other items not associated with normal operations. Once we take out other interest and expense, we arrive at net income.

Now, here's a nuance. If you're a sole proprietor or an LLC or an S-corp, then you're treated as a disregarded entity and not subject to corporate tax. So therefore, your net income flows through on your K-1 to your personal tax return if you are an investor in this type of business.

In other words, a company that is a DBA or an LLC or an S-corp, they don't pay income taxes and therefore, we just stop here at net income. Now, if you're a C-corporation, you have corporate taxes that you have to pay and therefore, you may see taxes on the face of the financials. But for most companies, especially small to mid-sized businesses, they're just gonna stop here at net income and this is gonna flow through to owners of the business or investors of the business on a K-1.

Now, here's another nuance to understand with the income statement. You may be wondering where is depreciation in amortization? Now, I'll get into this here but when you buy a piece of equipment and if it's expected to provide future benefits for the organization and it has a useful life greater than one year and it meets a certain threshold and that threshold varies from company to company, it may be between $2,500 or $5,000, for example, then you're gonna capitalize the purchase of that asset. In other words, you're not going to expense the whole thing on the income statement in a given year.

That's where depreciation and amortization comes in. So let's say I buy a truck for $50,000. I'm not gonna record the cost of the truck up here and cost of goods sold or an operating expenses.

That would misstate my financial statements. Instead, I'm gonna record it on the balance sheet because it's gonna provide future economic benefits, has a useful life greater than one year and it exceeds the general threshold and therefore it's capitalized on the balance sheet and each year I record an expense under depreciation. The only difference between depreciation and amortization is you depreciate tangible assets and you amortize intangible assets.

So you may be wondering where does that hit on the financial statements? Some organizations record depreciation amortization up above in cost of goods sold. Others may record it down here in op-ex while others may record it in other expense down below the line. So it just depends on every business.

Once again, you have to follow generally accepted accounting principles but there is some flexibility of where it hits on the financial statements. So I just wanted to point that out here because it varies from company to company and if you look at the financial reports of businesses, you'll see exactly what I'm talking about. But that is how the income statement works.

There's a song that's associated with the income statement. I'm not ready to embarrass myself. You're gonna have to wait because I have to explain the balance sheet and then I'll sing it for you, I promise.

I know you're really excited about that but let's go through the balance sheet next and I'll start showing you how all these financial statements flow together. All right, so with the balance sheet, there's a formula. Assets equal liabilities plus equity.

That's how a balance sheet is organized and that's how it balances. So we will start off with assets. Now under assets, we have current assets and we have non-current assets.

I'll just abbreviate here as NCA. Anytime you hear the word current, just think of current assets or current liabilities that are expected to be settled within a 12-month period. That's all that refers to.

Now under current assets, we have accounts such as cash. Okay, that's just cash and cash equivalents sitting in the bank. Next, we have accounts receivable.

This is the amount of money that customers owe the company. We have inventory, we have prepaids and then there's some other current assets that may be included down below but these are the main accounts that are included typically up in current assets. Now non-current assets may involve investments and other types of items but mostly it's gonna include PP&E which stands for property, plant and equipment.

So remember that example I just gave to you about the truck? So if I buy a truck, it's gonna be recorded under property, plant and equipment as a non-current asset because it's not expected to be settled within that 12-month timeframe. It's a long-term asset of the business so it goes here in this section. So you have PP&E and then this is offset by accumulated depreciation and amortization underneath here and if we add these all together, we end up with total assets.

Like I said, I'm keeping things really high level. There may be some other items or nuances here but generally, this is how it is organized. Next we have liabilities.

Under liabilities, the same type of structure as above. We have current liabilities and then we have non-current liabilities. Under current liabilities, the main accounts are accounts payable, AP.

This is the amount of money an organization owes its trade vendors and then there may be some accruals for payroll or payroll taxes or sales taxes or other items that fall underneath here. Maybe you have some credit cards under current liabilities that may all fall into this section but then next, we have non-current liabilities and remember, these are liabilities that are expected to be settled in one year or longer. So let's just say you have a loan on that truck, a five-year loan.

The current portion that is due this year is recorded up here in current liabilities but the rest of the balance is recorded down below in non-current liabilities. Add these together and we have total liabilities. Now the next section is equity.

And this is where some people get really confused but I'll just keep it really simple for you. First, we have capital. This is the amount of cash that flows into the business or flows out of a business.

So let's say you have a company and you raise capital from investors. So investors are like, hey, we're gonna put money into your business. It's gonna hit here under the capital section within equity.

Now, if you take money out of your business through distributions or dividends, it's gonna flow out of your capital balance. So we have this and then we have retained earnings and this represents accumulated profits that the company earns over its lifetime, including, here I'll just put accumulated earnings plus current year net income falls under this retained earnings section. So we have capital and we have retained earnings which includes accumulated earnings and current year net income.

We add all this together and we end up with total equity. All right, now let me add some color to this diagram. We have assets equal liabilities plus equity.

And this is the structure of the balance sheet. Pretty easy to understand when you break it down into these three main sections. And hopefully you're starting to see how things are structured on these financial statements because these two financial statements are really important but they're not the most important financial statement which we're about to get into here in just one minute.

Now, did you know that the income statement fell in love with the balance sheet? I know, it's kind of crazy. You probably didn't know that two financial statements could fall in love with each other, but they did. And I'm gonna draw just a little heart symbol here so you remember.

But the income statement loves the balance sheet, they got together and they had a baby and that baby is called the statement of cash flows. In fact, this could be called my baby because this is my favorite financial statement of all financial statements because it will tell you how cash is flowing through an organization and cash flow is the most important thing to pay attention to. Did you know that 70% of companies that go bankrupt are profitable when they close their doors? They have profit right here, but they run out of cash.

So I'm gonna show you how that can happen. So let's go ahead and jump in here to the statement of cash flows. Now, for starters, the statement of cash flow begins with net income.

So we have net income from the income statement flows over here and that's where we start. Then we have to make adjustments for non-cash items because remember, we're trying to get to cash flow so there's some adjustments we need to make. For example, we have depreciation and amortization.

Now remember, this is just a way to record the depletion of assets over their useful life. So we record these expenses on the income statement, especially for tax purposes, but these accounts don't represent true cash outflow. So we have to add back depreciation and amortization.

We have changes in working capital. I abbreviate there. That does not stand for water closet, okay? So we take changes in working capital.

And what I mean by that is on the balance sheet, if we take the difference between current assets and current liabilities from one period to the next, we're gonna have changes in cash, all right? So you can't just pull a balance sheet at one given point in time and look at the difference between current assets and current liabilities and record that over here. Instead, we need to account for the change in working capital from one period to the next. That's really important to understand.

But here's what happens in a business, and this is really important to understand as it pertains to working capital. Let's go back to accounts receivable. This represents the amount of money that is due to a company from its customers.

Now, let's say you have $1,000 in accounts receivable in a given period. And then in the next period, the balance goes to $2,000. So it's at $1,000 in one period, and then it climbs to $2,000.

Do you have more cash or less cash? And if you said you have less cash, you are correct. Because think about it. You have $1,000 in this balance.

Now it climbs to $2,000. It just means that customers are holding on to your money. Now remember, when you sell the product, you record revenue here.

So it's hitting the income statement and it's flowing down here to net income, which is showing up over here on the statement of cash flows. But net income is not the same thing as cash because we have customers who owe us money in accounts receivable. And therefore, if we don't make adjustments for those fluctuating balances, we're gonna misrepresent the amount of cash we actually have, and that's how changes in working capital works.

If you wanna learn more about this, I have two episodes on my podcast called Boosting Your Financial IQ. You can check that out where I walk you through working capital in more detail. This is really critical, but I could do a whole nother video on how this works.

So I'm gonna just keep it really high level, like I said, and just understand when you have fluctuations in current assets and when your current assets go up, it means you're gonna have less cash, with your current liabilities, when your balance goes up, you're gonna have more cash because, for example, with accounts payable, your balance increases. It means you owe your trade vendors more money. You're holding onto their cash.

You already accounted for that either in cost of goods sold or op-ex, and it's in your net income number, but you're sitting on more cash. So therefore, your working capital is increasing. All right, so that's enough about working capital.

I just wanna explain that so you understand that we arrive at cash from operating activities. So once again, you take net income, you make adjustments for non-cash activities, you account for changes in working capital, and you end up with cash flow from operating activities. That's the first section on the statement of cash flows.

In the next section, under investing activities, we have cap-ex, which is short for capital expenditures. Don't get this confused because this is not the same thing as op-ex, operating expenses on the income statement, but this represents the amount of money that flows out of the company when you're making investments in your property, plant, and equipment. This is not the same number as your property, plant, and equipment balance on the balance sheet because this is the accumulated balance over time.

On the statement of cash flows, we're just showing the cash outflow for a given period, not the accumulated balance. So really important to understand. We may have investments in other items here, so I'll just put other investments, and we add these together, and we have cash from investing activities.

That's the second section. And then finally, we have financing activities, and this represents the amount of money that flows into the company or out of the company for debt and equity. So let's just say you take on a loan.

You're gonna get cash coming into the business from that loan, from that long-term debt, or from that line of credit, or whatever you're pulling on. That's gonna flow in under financing activities. You pay off that debt.

It's gonna flow out of financing activities. Same thing with equity. You get investors, they put money into a business.

You're gonna have money flowing into financing activities, and then you pay distributions or dividends. It's gonna flow out. So you add up cash from operating activities, cash from investing activities, and cash from financing activities.

When we add these three sections together, we end up with a change in cash. We add our beginning cash, and we arrive at ending cash. This is how a statement of cash flow works.

Like the balance sheet, there are three sections, operating, investing, and financing. We end up with change in cash, account for the beginning cash, and we arrive at ending cash. Okay, here's the cool part.

I'm gonna show you how these financial statements all flow together, and then I'm gonna give you some bonus pointers here. Now, if this makes sense to you, can I get a yes in the comments box below? Because this will help me to understand whether or not you're tracking and whether or not this video is making sense. If it's not making sense, tell me where you're getting hung up on this video, because then I can make additional content to help you along the way.

But understanding the language of business, which is finance, is really critical. And this has been the game changer for me throughout my career. When I educated myself on the language of money, and when I started to understand how numbers worked within businesses, everything changed, because then I knew which value drivers to pull in the business in order to maximize firm value.

So that's really, really important. Now, let me tie everything together here real quick. Net income, as I mentioned before, flows right here onto the statement of cash flows.

So that's how the income statement connects to the statement of cash flows. Remember we talked about the adjustments of non-cash depreciation, amortization, and other items. That's coming from the income statement as well.

It could be coming from this area right here, other income or expense. It could be captured up here in OpEx, just depending where you record these non-cash adjustments. But those are gonna flow from the income statement.

Working capital, the change in working capital is coming from the change in current assets and current liabilities from one period to the next. Cap-X is coming from the change in your property, plant, and equipment from one period to the next. And here's where it's interesting.

Here's a little bonus tip for you. I've interviewed a lot of CFOs and controllers, and I will often ask them, where do you find Cap-X on the financial statements? And to my surprise, most of them cannot answer this question. So I want you to get this right.

Now, if you ever interview with me, bam, you're gonna nail this. But Cap-X is found on the statement of cash flows under investing activities. Sure, you can calculate it by taking the change in PP&E, but there's other things that you have to account for, like the gain or loss in a sale of a piece of equipment or depreciation or amortization.

We're not gonna go there. Just go to the statement of cash flows, and that's where you'll find Cap-X real easy. All right, so that's how these items fit together.

But also, net income, current year net income, ties to the balance sheet down here in retained earnings. So that's important to understand because if you ever wanna check the income statement against the balance sheet and see if everything is working together and it's all legit, that's how you can connect the two as well. Now, here's the song.

I know you've been waiting in great anticipation, and I'm ready to completely embarrass myself, so here it goes. The income statement is a flow through, always starts with revenue. Cost of goods sold in SG&A, and you end up with profit at the end of the day.

And the reason why I say it's a flow through is because all these accounts flow through to net income, and then it's settled on the balance sheet under current year net income. That's how it flows through. The balance sheet has a song too.

These are songs that I just made up because I'm wacky and I'm just crazy with this stuff, but it does help people to remember them, even myself, so that's why I like to sing them, even though my voice is absolutely terrible and I'm embarrassing myself. You just can't see with the lighting, but my face is bright red. I am so ashamed right now.

No, I'm just kidding. But here, the balance sheet, we have the balance sheet is dear to me, assets, liabilities, and equity, in order by liquidity, and it ties to net income with rigidity. All right, that song, not as cool as the income statement song, but nonetheless, hopefully, that helps you to understand how this all flows.

And one important thing to mention that I said in my song that I didn't mention earlier is that most of these accounts, according to Gap, are in order by liquidity. So you'll list out cash or accounts receivable and all these other items in order by the most liquid at top down to the least liquid down below. That's why cash is always the first item on a balance sheet because it's the most liquid.

All right, so that's how everything flows together. Now, are you ready for some bonus content? If so, can you type in bonus in the comments box below? That will help me to understand whether or not you're still awake, you're alive, and you're engaged. Now, as a CFO, I've worked with financial statements for a lot of years.

I've spent a big chunk of my life that I'll never get back in financial models and in Excel. And I've also done a lot of talking and teaching regarding these financial statements. So let me just give you a few pointers here.

Okay, we talked about operating profit. A lot of times, organizations will incentivize their leaders and they do it on this line item right here, operating profit, because depreciation and amortization is usually recorded down below the line here or it's subtracted out. And you don't wanna skew things because you could definitely change up different accounting practices or make other adjustments which can mess up profit and then it skews the true economic reality of a business.

So if you're ever incentivizing people or you're creating a bonus pool in your company, I would recommend doing it on some function of operating profit here because this is the true economic reality of your business, operating profit. All right, now, what about EBITDA? Have you ever heard of that term which stands for earnings before interest, tax, depreciation, and amortization? You may wonder, is operating profit the same as EBITDA? Kind of. It all depends on where depreciation and amortization sit.

If you record depreciation and amortization in other income or expense, then yes, essentially, you have EBITDA up above because remember, interest, income, and expense is already excluded and taxes aren't involved in this number down below here. So essentially, EBITDA can be this, but for some organizations, if you record depreciation and amortization in OPEX or cost of goods sold, then all you have to do is take operating profit and add back depreciation and amortization from these sections above, and bam, there you have EBITDA. All right, what about free cash flow? This is probably the most important metric in business, but it's the most ignored, unfortunately.

Free cash flow can be calculated really simply by taking cash from operating activities right up here. So I'll just put cash from operating activities minus CAPEX right here. If you subtract out CAPEX, then you end up with free cash flow.

Okay, this is really important to calculate and compute in an organization, and that's just a really simple way of doing it. Go to the statement of cash flows, take your cash from operating activities, subtract out CAPEX, you end up with free cash flow. This is the amount of cash a company has to give back to capital providers, so in other words, to pay off its debt, or to provide returns to its equity investors, or reinvest back in the business.

So that's why this number is really important, because you could have net income, you could have EBITDA, and you could still go bust, but you will be successful if you consistently generate free cash flow. So that's something else that's really important to understand. You can do it the long way here by taking net income, adding back non-cash items, accounting for changes in working capital, and subtracting out CAPEX, but why do that the long way if you could do it right here off the statement of cash flows? All right, let's wrap here, because we covered a lot regarding these financial statements.

If you are confused or overwhelmed, it's okay. You can come back and watch this video as many times as you want. And look, it takes a lot of practice for this to really resonate.

But once you understand the language of business, which is finance, and how money flows through these three financial statements, you're gonna be so much more confident. Look, when I started out in business, I was running a multimillion dollar company, and I had no clue how to read an income statement. So it doesn't matter where you are on your journey, just take the time and invest it in boosting your financial IQ.

Because like I said, it will make all the difference in the world, and it will help you to live a better financial life. Okay, don't forget to subscribe, and be sure to share this video with others so we can help spread the word on financial literacy. And also, if you have other ideas, or you just wanna provide some feedback on this video, be sure to drop it in the comments box below.

And until next episode, take care of yourself. Cheers.