Financial statements have a certain formality about them.
They contain official numbers and signify official business.
They’re also not commonly used by the majority of people.
In fact, unless you work in business or finance, you may not have seen a financial statement.
But if you run a business, financial statements are among the most important documents.
They provide a record of all the activities performed by a business or entity, and are usually required by accountants, investors, and government agencies.
As far as statements go, financial ones say a lot.
So this post explains the basics of financial statements, the four main types of statements, and the many benefits they offer for anyone who does business.
What Is a Financial Statement?
Financial statements are a summary of a business’s or entity’s finances, usually prepared for every fiscal year.
By collecting and organizing all the year’s transactions into precise numbers, these statements reveal key metrics about how a business is faring.
More specifically, financial statements can be used to determine a business’s cash flow, to assess its ability to pay expenses and debts, to track the financial results of significant business changes, and much more.
Financial statements provide all the important financial information needed by business owners, investors, and other decision makers.
For this reason, they must be clear and accurate, and are generally presented in a standardized format.
The 4 Types of Financial Statements
There are four main types of financial statements — balance sheets, income statements, cash flow statements, and statements of shareholders’ equity.
Each one presents a different view of a business’s finances, but they all share information and should be taken alongside one another to create a complete picture of its current financial state.
(This state naturally changes with every transaction.
Therefore, it’s important to check the date the financial statement was created and to draft new statements every year.)
An income statement, also called a profit and loss statement or a P&L statement, accounts for all revenues and expenses (or profits and losses) during a particular period of time.
This can be a month, quarter, or year, depending on the business, and this time period should be stated at the top of the sheet.
Income statements can be prepared using two methods — the single step income statement and the multi-step income statement.
No matter which you use, the goal is to list all the revenue or income from sales (usually as cash and account receivables), as well as the expenses (inventory, rent, advertising, etc.) made during the time period.
The basic formula is as follows:
Revenues – Expenses = Net Income or Net Loss
By adding all the revenue and subtracting all the expenses, the income statement arrives at the net income or “bottom line.”
The net income is used in the other financial statements, and therefore, an income statement is the first one that you should prepare.
The statement of shareholders’ equity, also known as a statement of retained earnings, is prepared next.
Shareholders’ equity, or owner’s equity, includes all the assets left after a business has paid all its liabilities and debts.
Retained earnings are part of shareholders’ equity, as they are the net income after a business has paid its dividends.
The statement of shareholders’ equity explains any changes in the net worth of a company during a particular accounting period, usually between two balance sheet dates.
This period should be stated at the top of the sheet.
To create this statement, you take the beginning retained earnings, add the net income or subtract the net loss (which is taken from the income statement), and then subtract any dividends to arrive at the ending retained earnings.
The accounting equation for this statement is:
Beginning retained earnings + Net income – Dividends = Ending retained earnings
Statements of shareholders’ equity are mostly used for external purposes, like when showing financial reports to investors or creditors.
They reveal the financial condition of a business, and therefore, the financial condition of any investments made in the business.
You can write statements of shareholders’ equity as their own statement or add them to the end of another financial statement (usually the balance sheet or income statement).
A balance sheet is the one financial statement that reports for a specific date, rather than a period of time.
The date should be stated on the top of the balance sheet.
It presents a business’s financial position on a particular day and is often referred to as a statement of financial position.
Included in the balance sheet are what the business owns (assets), what it owes (liabilities), and the amount invested by shareholders (equity). The basic formula for this sheet is:
Assets = Liabilities + Shareholders’ Equity
Balance sheets list assets in the left-hand column, and liabilities and shareholders’ equity in the right-hand column.
Assets are also listed first, usually in order of liquidity, or how quickly they can be converted to cash (i.e., current assets before long-term assets).
Next come liabilities, listed in the order in which they will be paid (i.e., current liabilities before long-term liabilities).
And finally, it includes the shareholders’ equity, which is taken from the previous statement.
When you finish the balance sheet, you’ll have a snapshot of how your business is doing financially at a particular point in time.
Cash Flow Statement
A cash flow statement, or statement of cash flow, is a summary of all the cash and cash equivalents that flow into and out of a business.
There are three main ways cash flows through a business — operating activities, investing activities, and financing activities.
Operating activities generate cash from sales of goods and services, and incur expenses from inventory, salary, rent, and the like.
Investing activities usually include loans, company mergers or acquisitions, or the sale or purchase of long-term assets.
Financing activities mainly deal with investors and creditors, such as when cash is invested into a business or dividends are paid to shareholders.
Cash flow statements only list cash and cash equivalents.
Unlike the other financial statements that factor sales credit or depreciation into the net income, cash flow statements do not take these into account.
You can create cash flow statements using either the direct cash flow method or the indirect cash flow method.
While the direct method is more accurate, most big businesses and accountants prefer to use the indirect method as it draws figures from other financial statements (for example, the net income), and is therefore more consistent and easier to prepare.
The purpose of a cash flow statement is to show how well as business handles its cash.
Whether a cash inflow or outflow, each transaction should be made in efforts to grow the business.
By seeing how much money a business has on hand — or its working capital — you can determine its financial health and projected growth.
The Benefits of Financial Statements
A business isn’t always expected to issue all four financial statements.
But at the bare minimum, it should have an income statement and balance sheet.
Larger scale businesses and those looking for investors, however, should prepare complete financial statements.
When taken together, they can help investors decide whether a business is worth investing in, assist creditors in determining whether they should open a line of credit for the business, and aid government agencies in analyzing the business’s tax situation.
They can also help business owners assess their own financial performance in more concrete terms.
Financial statements can be compared to those made in previous years, as well as with other businesses in the same industry.
Financial statements contain all the numbers needed to calculate a business’s liquidity, profitability, and activity levels.
The Limitations of Financial Statements
Financial statements generally take a lot of information into account, which span an entire quarter or year.
As such, aside from the balance sheet, financial statements don’t really indicate how a business is doing at the present moment — only how they’ve been doing in the past.
They also don’t provide much detail about the actual numbers.
Line items, such as sales revenues or cost of goods sold, are very vague and quite easy to leave unchecked.
In addition, there may be certain items that can be easily skipped over or skewed during accounting.
It’s all too easy for someone to inflate profits or not report liabilities in the right period.
Even the slightest manipulation can lead to a very inaccurate presentation of the business.
Overall, financial statements only account for what can be written on paper.
They don’t include qualitative indicators of a company’s success, such as brand strength, industry network, or employee happiness.
Although these aren’t expressed in monetary terms, they all contribute to the success of a business.
Making a Statement
Financial statements are essential for building any successful business.
Even if they’re just for internal purposes, clear financial statements and the ability to read them can give all business owners a better view of their operations and aid in their decision making.
Start with the two basic financial statements — the income statement and the balance sheet — and see just how useful they are in helping you understand your business.