Beyond Compliance: Use Your Financial Statements to Improve Performance

Under U.S. Generally Accepted Accounting Principles, comprehensive financial statements include three reports: the balance sheet, income statement and statement of cash flows. Each report offers a different perspective on your business's financial health. When reviewed together — along with footnotes that provide important context behind the numbers — your financials can highlight cash flow pressures, operational inefficiencies, and emerging risks and opportunities. The key is knowing where to focus and how to use this information to support decision-making, strengthen performance and reduce risk.

The Balance Sheet

The balance sheet provides a snapshot of your business's financial position at a moment in time. One side shows the assets your business owns, such as cash, accounts receivable and inventory. The other side contains liabilities or claims on your business's assets. Examples include accrued expenses, accounts payable and equipment loans. Current assets (such as receivables) mature within a year, while long-term assets (such as plant and equipment) have longer useful lives. Similarly, current liabilities (such as payables) come due within a year, while long-term liabilities are payment obligations that extend beyond the current year or operating cycle.

Net worth or owners' equity appears below liabilities on the balance sheet. It represents the extent to which assets exceed liabilities. Because the balance sheet must balance, assets must equal liabilities plus net worth. If the value of your business's liabilities exceeds the value of its assets, its net worth will be negative.

When benchmarking financial results over time or against competitors, there are several balance sheet ratios worth monitoring. Examples include:

• ‍Change in accounts receivable vs. change in revenue. If receivables are growing faster than revenue, customers may be taking longer to pay. This might indicate that customers are experiencing financial difficulties or encountering quality issues with the products or services.‍
• Change in inventory vs. change in revenue. When inventory levels increase faster than revenue, it may indicate that sales aren't keeping pace with production. Stockpiling ties up your cash. Moreover, the longer inventory remains unsold, the greater the likelihood it'll become obsolete, damaged or stolen. Growing businesses often must invest in inventory and accounts receivable, so increases in these accounts don't always signal problems. However, sustained increases in inventory or receivables should typically correlate with rising revenue.‍
• Current ratio. The ratio of current assets to current liabilities is used to gauge short-term liquidity. If this ratio falls below 1, the business may struggle to pay bills as they come due. Some business analysts and lenders even view a current ratio below 2 as a potential red flag. But the optimal ratio varies depending on your industry, economic conditions and other factors.

The Income Statement

Your income statement — often called the profit and loss statement — shows revenue, expenses and profits earned (or losses incurred) over a given period. It helps answer a key question: Is the business operating efficiently and profitably?

A commonly used term when discussing the income statement is "gross profit," or the income earned after subtracting the cost of goods sold from revenue. Cost of goods sold refers to the direct costs incurred to produce, acquire, or deliver the products or services sold during a given period. These costs generally include expenses directly tied to revenue generation, such as materials, inventory, direct labor, and certain production or service-related overhead. Another important term is "net income," which is the income remaining after all expenses (including taxes) have been paid.

Also reflected on the income statement are sales, general and administrative expenses (SG&A). These expenses reflect functions, such as marketing or bookkeeping, that support a business's operations. The ratio of SG&A costs to revenue tends to be relatively stable within a given operating range. If these costs begin to rise as a percentage of revenue, it may be a sign of operational inefficiencies or slowing revenue growth.

You can use your income statement to identify areas of concern. For instance, a decline in the gross profit margin may indicate that production expenses are rising faster than revenue. Common causes include overstaffing or taking on too much low- or no-margin work. In today's business environment, many organizations are reporting lower gross margins due to rising labor and materials costs — unless they've been able to pass those cost increases on to customers through higher prices.

The Statement of Cash Flows

Cash flows are the engine behind smooth business operations. The statement of cash flows shows all cash inflows and outflows for your business. For many businesses, this statement explains why profits don't always translate into available cash.

Examples of cash inflows are selling products or services, borrowing money and issuing stock. Outflows may result from paying expenses, investing in capital equipment and repaying debt. Ideally, a business will derive enough cash from operations to cover its expenses. If not, it may need to borrow money or sell stock to survive.

The statement of cash flows shows changes in balance sheet items from one accounting period to the next. It's organized into cash flows from three primary sources:

1. Operations,
2. Investing activities, and
3. Financing activities.

Noncash investing and financing transactions are reported at the bottom of the statement of cash flows. These transactions don't involve direct cash exchanges. For example, a computer that's purchased directly with loan proceeds would be reported here.

Although the statement of cash flows may seem similar to an income statement, it focuses solely on cash. For instance, under accrual accounting, a product sale might appear on the income statement, even though the customer won't pay for it for another month. But the money from the sale won't appear as a cash inflow until it's collected. A business must continually generate cash to pay creditors, vendors and employees to remain financially healthy. That's why monitoring the statement of cash flows is so important.

Footnote Disclosures

Audited and reviewed financial statements are required to include footnote disclosures. In addition, businesses that issue compiled financial statements often voluntarily disclose information to support their numerical results. Footnotes provide greater detail to line items in the financial statements and explain business operations, risk factors and external market conditions. This information helps lenders and other stakeholders better understand your business's financial health.

To get the most out of your financial statement review, read the footnotes carefully. Here are some disclosure topics that your stakeholders may be monitoring:

• ‍Related-party transactions. Some businesses give preferential treatment to, or receive it from, related parties — individuals or entities with the ability to influence one another's financial transactions. Related-party transactions are often associated with small businesses, such as leasing space from a family member at below-market rates or paying above-market salaries. Larger organizations can also engage in these arrangements. It's important to evaluate whether such transactions are conducted at arm's length and whether they introduce additional risk.‍
• Accounting method changes. A business's choice of accounting methods can shape its financial results. Footnotes disclose changes in accounting methods, estimates, principles and practices if the change materially affects the business's financial statements. The disclosure should explain the reason for the change and its financial impact. While some changes are required (for example, due to regulatory updates), others may warrant closer scrutiny.‍
• Significant events. Footnotes should disclose events that could materially impact future earnings or business value, such as the loss of a major customer, uninsured disruptions or new regulatory requirements. Staying informed about these developments can help you anticipate potential challenges.‍
• Contingent liabilities. Footnotes may reveal contingencies, such as pending litigation, IRS inquiries or environmental claims. If significant, these items could affect future performance and value.‍
• ESG matters. Environmental, social and governance (ESG) issues can affect financial performance. While ESG reporting isn't mandatory for all U.S. companies, many businesses voluntarily disclose information on climate risks, resource use and workplace practices to demonstrate responsibility and strengthen stakeholder relationships.

Reviewing footnote disclosures can help you respond more effectively to stakeholder questions and anticipate potential challenges.

Better Information, Better Business Decisions

Your financial statements do more than report results — they can help you make better-informed, more timely business decisions. When you understand what each report reveals and how they work together, you're better equipped to manage cash flow, control costs and plan for growth. If you're not already getting this level of insight from your financials, it may be time for a closer look. Contact your accountant for help turning routine reporting into actionable insights.