Let’s start with the fundamentals. What is a financial statement?
A financial statement represents the financial position and activities of a business. They are created by an accountant using the daily financial data recorded by a bookkeeper. A financial statement helps a business see where money is being spent. It tells you where it is coming in and whether the business is in profit or losing money.
By analysing a financial statement, an accountant can work alongside a business owner to help them better understand how their business functions, where it can improve and identify what the business can do to maintain growth.
In total, there are four main financial statements. These are:
- Income Statements
- Balance Sheets
- Statements of shareholders’ equity
- Cash Flow Statements
This guide will help you understand why each of these financial statements are important and specifically what each one represents.
Income Statement
This is pretty much exactly what it sounds like! An income statement (also known as a profit and loss statement) details the revenue, expenses and subsequent profits/losses achieved during the relevant financial period. Because of its nature, an income statement is considered one of the most important financial documents.
An income statement can tell you a lot about the activity of your business and whether you are operating on good business practices. It can tell you if you need investment, where you need to cut expenses and where you may qualify for tax deductions.
Think of an income statement like a ladder. The top rung is the revenue you made from each customer across the accounting period. As you step down the ladder, you subtract any expenses or costs sustained during this period. Once you get to the last rung – or the bottom line – you see your company’s net income.
These expenses could be many things – operating costs, manufacturing, income tax, to name a few – and it’s important that their value is accurate. That way, the bottom line is an accurate representation of the net profit or losses sustained by the company during the financial period.
Balance Sheets
Balance sheets cover pretty much everything the income statement doesn’t. Where the income statement details revenue and expenses, a balance sheet covers the other three of the five main accounts in the general ledger: assets, liabilities and equity.
At its core, the balance sheet will show the following formula:
ASSETS = LIABILITIES + SHAREHOLDERS EQUITY
The total assets owned by a company should equal the sum of their liabilities and the shareholder’s equity. Balance sheets tend to represent this information in a structured way – the assets are listed on the left-hand side of the sheet, whilst the liabilities and shareholder’s equity is listed on the right.
Like the income statement, the balance sheet has a bottom line; although with a balance sheet, you will see two sums at the bottom of each column. The bottom line for the left-hand side tells you the total sum of assets, whilst the right-hand side should tell you the total sum of the liabilities and the shareholder’s equity. These two totals should equal one another!
A balance sheet is a valuable financial document for any business – it can show you, or potential investors, the financial position of your company, how stable it is and how you finance business activity.
Statement of Shareholder’s Equity
A statement of shareholder’s equity is exactly as it sounds – a section of the balance sheet reflecting how the value of the business has changed over the accounting period. This is important for shareholders to understand how the business is growing.
When shareholder’s equity increases over the accounting period, it demonstrates that the business is succeeding in its attempt to increase income. On the other hand, if the statement of shareholder’s equity demonstrates a decrease, it should encourage a strategic rethink of your business activity.
Cash Flow Statement
Luckily this financial statement is, again, exactly what it sounds like! A cash flow statement shows all the cash transactions coming in and going out of your business.
Cash flow statements tend to be made up of the following three areas: operating activities; investing activities; and financing activities.
Operating activities refer to the activities of the business that generate revenue like product sales, commissions, or invoices from supplies.
Investing activities are made up of payments that are spent in order to purchase long-term assets. They also include income from sales.
Financing activities are those which affect the equity of the business like the sale of company shares.
Cash flow statements aren’t necessarily as important as income statements; however, they can show you things other statements can’t. Cash flow statements are considered the most transparent as it indicates the daily operation of the business. It also can be helpful in understanding the divergence of profits and net cash flow.
The bottom line
Financial statements, then, can have a real impact on the success of your business. The data they show can help inform whether your business is sustainable, whether it is growing and if it needs investment. This can be vital to the survival of a small business and the their importance should not be understated.
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