Financial statements are reports issued by companies in order to convey information about their financial health and recent results. These statements are intended to convey the financial state of a business as clearly and accurately as possible for investors, prospective investors, analysts, and any other interested parties.
Broadly speaking, there are three main financial statements issued by companies to comply with GAAP (generally accepted accounting principles) — the income statement, balance sheet, and cash flow statement, with a fourth, the statement of retained earnings, added when preparing statements for lenders and investors.
1. Balance sheet
The balance sheet contains information about the company's liabilities, assets, and shareholders' equity, and is based on this accounting equation:
Shareholders’ Equity = Assets - Liabilities
Unlike the other two financial statements, a balance sheet shows these figures for a particular moment in time, typically the end of a quarter or fiscal year.
The balance sheet is the place to look if you want information about a company's cash and equivalents, long-term investments, accounts receivable, debts, number of shares outstanding, and retained earnings.
2. Income statement
The income statement shows the company's revenue, business expenses, and profitability for a particular reporting period, either annually or quarterly. An income statement is also known as a profit and loss statement.
From the income statement, you can find information such as the total sales, cost of goods sold, gross profit, operating profit, interest income, taxes paid, and net income/profit.
3. Cash flow statement
The cash flow statement shows how a company's liquid assets are increasing or decreasing over time. Positive cash flow indicates that more money is flowing in than out, and can be an indicator of improving financial strength and flexibility.
On the other hand, negative cash flow can potentially be an indicator of financial difficulty. The cash flow statement can tell you how much money a company is paying in dividends or share repurchases, spending on investments, and how much of a company's net income is actually flowing into the company.
4. Statement of retained earnings
Finally, the statement of retained earnings is designed to display any changes made in earnings during a specified period of time.
The statement of retained earnings begins with the prior period balance, adds in any net income as well as any dividends paid out to shareholders in order to arrive at the ending retained earnings balance.
The statement of retained earnings is usually provided to outside entities such as financial institutions and investors, and is not always part of the standard financial statement packet that is prepared.
The calculation for retained earnings is:
Beginning retained earnings + Net income - Dividends = Ending retained earnings
Why are financial statements important for small businesses
Whether you’re an experienced bookkeeper or still stumbling your way through accounting 101, financial statements are important. A company's financial statements can give you a much better idea of how a business is performing than by simply looking at its revenue and earnings.
Financial statements are also useful to current and potential investors as well as banking and other financial institutions, as they provide a window into the overall health and stability of your business. Here are a few more reasons why financial reports are important for small businesses:
1. They show what your business owns and owes
It’s important for small business owners to know at any given time, exactly what their business owns, what it owes, and how much equity they have in their business. That’s why a balance sheet is so important.
A balance sheet provides business owners, as well as creditors and potential investors with a breakdown of assets, liabilities, and equity, and can tell business owners how quickly customers pay their bills, how quickly inventory is moving, and how much money their business owes, not just immediately, but long term as well.
2. They provide owners with a snapshot of profitability
Perhaps the most useful financial statement, and easiest to understand, is the income statement. The income statement has a separate section for both revenue and expenses, including sales, cost of goods sold, operating expenses, and net profit.
And most importantly, it provides you with your net income. The income statement is useful for making informed business decisions, when seeking a business loan or additional investors, and when filing business taxes.
3. They display cash activity
A business cannot survive without cash. The cash flow statement provides business owners with details on incoming cash as well as outgoing cash, and can help you calculate important metrics such as operating cash flow.
And while it’s important to know what your business cash flow is, it’s even more important to know where your cash is coming from and where it’s going. That’s what a cash flow statement can tell you.
4. They tell you how much money you have left over
After your customers have paid their invoices and your business has paid suppliers and other vendors, you need to know how much money you have left over to invest back into the business, or to pay back to your investors in the form of dividends.
That’s why the statement of retained earnings is important. The statement of retained earnings indicates how much money a business has retained over a specified period of time.
How to prepare your small business financial statements
No matter what accounting method your business uses, you can create financial statements. Most business owners will find it much easier to prepare financial statements when using accounting software.
Of course, you can still prepare all of the necessary financial statements if you post in ledgers manually or record financial transactions using spreadsheet software, but both of those options are also more error prone, increasing the likelihood of inaccurate financial reporting.
It’s also more time consuming to perform closing entries for your business, which is done automatically by any accounting software application you may be using. If you’re looking to move to an automated accounting system, be sure to check out The Blueprint’s accounting software reviews.
Financial statements provide vital information about your business
The financial records of your business are important to you and your investors. When packaged together in the form of financial statements, they provide information on the health of your business.
Financial statements also provide you with the information you need to make informed decisions about your business, and they also provide lenders and investors with the financial data they need in order to invest in your business.