To read financial statements, start with the income statement to see whether the business made a profit, then the balance sheet to see what it owns and owes on the last day of the month, then the cash flow statement to see why cash went up or down. Compare each line with last month, work out a few ratios, and finish by writing down what you will do differently.
That is the whole method. The rest of this page shows how to apply it to small business financial statements each month: what to look for on each statement, which ratios to track, the red flags that matter, and what a useful monthly financial report contains. If you would rather receive statements that already come with this reading done, see our financial reporting services.
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The three statements and what each answers
Every small business should get three statements each month. Each answers one question.
| Statement | Covers | The question it answers |
|---|---|---|
| Income statement (profit and loss, P&L) | A period, such as the month | Did we make money, and where did it go? |
| Balance sheet | One date, the last day of the month | What do we own, what do we owe, and what is left for the owners? |
| Cash flow statement | A period | Why did our cash balance change? |
The U.S. Securities and Exchange Commission’s Beginners’ Guide to Financial Statements defines all three in plain language. If you want the definitions and types first, our post on what a financial statement is covers them. This page is about reading them.
Before reading any numbers, check that the books are closed (bank and card accounts reconciled, nothing left uncategorized), that you know whether the statements are on a cash or accrual basis, and that the statements tie: net income should match the change in owner’s equity after draws, and the ending cash on the cash flow statement should match the cash on the balance sheet.
How to read an income statement
The income statement runs from revenue at the top to net income at the bottom, taking costs away in steps. Read it in this order:
- Net revenue. Gross sales less returns, refunds and discounts. Did it grow, and from which product or channel?
- Cost of goods sold and gross profit. Gross profit is net revenue less the direct cost of what you sold. Divide it by net revenue to get gross margin. A drop of a point or two deserves a question.
- Operating expenses. Find the three largest lines and see whether any grew faster than revenue.
- Operating income. What the core business earns before interest and taxes.
- Net income. The bottom line.
Read every line as a percentage of net revenue as well as in dollars. “Marketing was $22,500” tells you little. “Marketing was 25% of revenue, up from 23%” tells you where to look. Ask for three months side by side so you see the trend rather than one month.
Free guide
How to Read Your Financial Statements: A Monthly Guide for Small Business Owners
A monthly routine for reading your statements, with a worked example.
How to read a balance sheet
The balance sheet always balances: assets equal liabilities plus equity. The most useful split on it is between current items, which the SEC describes as assets a business expects to turn into cash within a year and obligations it expects to pay within a year, and everything else.
Assets to watch
- Cash. Does it match the bank, and how many months of costs does it cover?
- Accounts receivable. Money owed to you, including payouts from payment processors or marketplaces that have not landed. If it grows faster than revenue, you are being paid more slowly. Our guide to accounts receivable financing covers what to do when receivables tie up too much cash.
- Inventory. For any business that holds stock, the line that most often swallows cash.
Liabilities to watch
- Accounts payable and credit card balances. If they grow month after month, suppliers and card issuers are funding the business.
- Sales tax payable. Tax collected from customers that belongs to the states. It is cash you hold but cannot spend.
- Deferred revenue. Money taken for preorders, gift cards or subscriptions not yet delivered. Our post on deferred revenue explains how it is recorded.
- Loans. The part due within 12 months sits in current liabilities.
Equity
Owner’s equity rises with profit and falls with owner draws. If it is falling while the business reports a profit, the owners are drawing more than the business earns.
How to read a cash flow statement
The cash flow statement explains the change in cash. It has three sections: operating activities, investing activities (buying or selling equipment and other long-term assets) and financing activities (loans, repayments and money owners put in or take out).
Start at the top of the operating section. It begins with net income and adjusts it for non-cash items, such as adding back depreciation, and for changes in working capital. An increase in inventory or receivables uses cash and shows as a negative number. An increase in payables or deferred revenue supplies cash and shows as a positive one.
Then compare cash from operations with net income. Over a few months they should move together. If the business is profitable month after month and cash from operations stays negative, find the line that is absorbing the cash. Our post on the cash flow statement walks through each section.
Why profit and cash are different
Two reasons. The first is timing. Under accrual accounting, income is recorded when it is earned and expenses when they are incurred; under the cash method, when money moves, as the IRS sets out in Publication 538. The second is classification: buying inventory, repaying loan principal and taking owner draws all use cash without appearing as expenses.
The Small Business Administration notes that private companies aren’t required to follow GAAP, the accrual-based standard the Financial Accounting Standards Board maintains. Accrual statements are still the clearer guide to how the business performed, because they match income and costs to the month they belong to. Our post on cash vs accrual accounting explains the choice and how each changes the statements.
Five ratios every small business owner should track
| Ratio | Formula | What a change tells you |
|---|---|---|
| Gross margin | Gross profit ÷ net revenue | Falling: costs, discounts or product mix moved against you |
| Operating margin | Operating income ÷ net revenue | Falling: running costs are growing faster than sales |
| Current ratio | Current assets ÷ current liabilities | Below 1.0: bills due within a year exceed what will turn into cash |
| Days sales outstanding | Accounts receivable ÷ monthly net revenue × days in the month | Rising: you are being paid more slowly |
| Cash runway | Cash ÷ average monthly net cash outflow | Fewer months: time to cut spending or arrange funding |
Businesses that hold stock should add inventory days: inventory ÷ cost of goods sold for the month × days in the month. Track every ratio the same way each month and compare it with last month and the same month last year. The direction matters more than the level, because what counts as healthy depends on what you sell.
Red flags in small business financial statements
- Revenue up, profit down. Check gross margin and the fastest-growing expense lines.
- Profit with negative operating cash flow for two months or more. Cash is tied up in inventory or receivables.
- Card balances and payables rising every month. The business is borrowing from suppliers and card issuers.
- Owner draws above net income. Equity is shrinking.
- Large uncategorized balances. The books are not closed, so the month is not final.
- Sales tax payable growing with no filing. Tax collected but not paid.
Each is a reason to ask a question, not proof of a problem.
What a monthly financial report should include
A monthly financial report for a small business is the three statements plus one summary page you read first. That page should hold:
- Net revenue, gross profit, net income and ending cash, against last month and last year
- Three sentences on what happened, why, and what changes next month
- A ratio table for the last three months
- The five largest expense lines as a share of revenue
- A cash bridge from opening to closing cash
- What is owed to you and what you owe in the next 30 days
- Open questions and up to three decisions, each with a date
Keep the layout the same each month so trends are easy to see. If you report to a board or investors, our guide to a board-ready financial report covers that format.
What the full guide adds
This page shows how to read financial statements. The free guide gives you the working material: a 30-minute monthly review routine, line-by-line reading tables for each statement, the ratio table with formulas and how to read each one, a worked example of one month at a small online store with a full income statement, balance sheet, cash flow and ratios (illustrative numbers), a 12-row red flags table, 12 questions to ask your bookkeeper or accountant each month, a one-page monthly report template and a review checklist.
Frequently asked questions
How do you read financial statements for beginners?
Read the income statement first to see whether the business made a profit, then the balance sheet to see what it owns and owes, then the cash flow statement to see why cash changed. Compare every figure with the month before, and turn the key ones into ratios such as gross margin and the current ratio.
What order should you read financial statements in?
Most owners read the income statement, then the balance sheet, then the cash flow statement. The cash flow statement links the other two: it starts from net income and explains the change in cash shown on the balance sheet.
What are the three main financial statements for a small business?
The income statement (profit and loss), the balance sheet and the cash flow statement. Together they show performance over the month, the position on its last day, and the movement of cash.
How often should a small business review its financial statements?
Every month, once the books are closed, usually within the first two weeks of the next month. A monthly review catches cash and margin problems while there is still time to act.
Why is my business profitable but short of cash?
Profit and cash differ. Cash can go into inventory, unpaid customer invoices, loan principal and owner draws, none of which reduce profit. The cash flow statement shows which of these used the cash.
What ratios should a small business owner track?
Gross margin, operating margin, the current ratio, days sales outstanding and cash runway cover most businesses. Add inventory days if you hold stock.
What is the difference between a balance sheet and an income statement?
The income statement covers a period and shows revenue, costs and profit. The balance sheet is a snapshot on one date and shows assets, liabilities and equity. Net income from the income statement feeds into equity on the balance sheet.
Free guide
How to Read Your Financial Statements: A Monthly Guide for Small Business Owners
A monthly routine for reading your statements, with a worked example.
Ben has a strong expertise in combining data and strategic thinking to help businesses that are in the process of growth, plan smarter, grow faster and make better business decisions. He has experience in economic research and managing operations, providing him with a broad & rounded analytical perspective from many angles. Curiosity is coupled with logical reasoning. Therefore he enjoys tackling complex issues and converting analysis/insights into action.