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What are financial statements?
Financial statements refer to the record of a business’s finances that are recorded over a period of time. They contain essential financial information such as details of assets, liabilities, income, expenses, etc. Financial statements, in essence, are a formal, historical record of the business’ finances that business owners and finance executives can use to evaluate business health and performance. Financial data is presented in four fundamental sets collectively known as financial statements for evaluation. This can help you organize and categorize your financial statements to make data-driven decisions to drive financial growth. Following is the guide to 4 basic financial statements.
4 Basic Financial Statements
The balance sheet or statement of the financial position
The profit & loss account or an income statement
The cash flow statement or formerly the flow of funds statement
The statement of retained earnings or the statement of changes in comprehensive income
The Balance Sheet
The balance sheet contains data on the assets, liabilities, and shareholder equity of the business at the time of recording, or in other words, at any particular point in time, which usually is the year-end for business reporting purposes.
Assets
Assets refer to any valuable possessions owned by the business. This can include anything sold for money or used to earn money. Raw materials, machinery, real estate, etc., count as assets, and so does cash. Conceptual or intellectual property that does not have a physical form, such as a trademark or patent, also counts as an asset.
Liabilities
Liabilities are the debts a business owes, which may include rent, salaries, or loans payable by the company. Shareholder’s equity, also known as net worth, refers to the amount of money that would be left if the business sold all its assets and paid off all its liabilities.
Shareholder’s Equity
The residual of all the assets and liabilities belongs to the business’s shareholders, generally known as equity or shareholders’ equity. This includes the company’s capital, i.e., the funds injected by the owners, whether individuals, partners, or shareholders.
In a nutshell, the balance sheet shows data on assets, liabilities, and shareholder’s equity in the form of the accounting equation:
ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY
To sum up, the business’s total assets should equal the sum of its liabilities and shareholder’s equity. If the balance sheet shows otherwise, a discrepancy must be addressed. It displays a business’ ability to pay off its liabilities. Accountants, therefore, can use it to gauge its financial health. A healthy business generally contains more assets than its liabilities.
Business owners can implement some strategies to manage their balance sheet effectively. For instance, a CPG firm should monitor their consumers’ behavior: see what they usually buy and what they do not. This way, you can stock up on required products and discard the ones that your customers may not need. You can analyze cost-reduction areas and optimize your logistics and supply chain operations.
The Income Statement
The income statement contains data on the revenue and income earned and the costs and expenses incurred by the business over a specific period of time. Revenue is “the money generated from normal business operations, calculated as the average sales price times the number of units sold.” It is also called the “top line” of the income statement.
The expenses associated with the manufacture of the sold products, as well as the operations cost of the business, are then subtracted from the revenue, and these two, i.e., the cost of goods sold and expenses, are presented as line items on the face of the income statement. Any interest the business earned or paid over the specific time period is also subtracted, and the tax expense is deducted. Once all deductions have been accounted for, we arrive at the end of the business statement, which shows the “bottom line” or the net income or loss of the business.
Business owners can use the income statement of a business to evaluate its financial performance. It differs from the balance sheet as it shows the business’ profitability, which investors and financial analysts can use to judge the investing and future viability of the business.
Business owners can consider expanding market reach and improving their current marketing strategies to improve income statements. For instance, a CPG firm can target more areas to promote its products. Moreover, business owners can also consider outsourcing their accounting to get access to expert financial insight.
The cash flow statement
The cash flow statement tracks and records the cash movement through the business over a specific period. It shows all incoming and outgoing cash over a time period in the form of a statement. While the income statement represents the net profit earned by the business, the cash flow statement shows how much cash your business generated from investing, operating, and financing activities.
The purpose of the cash flow statement is not to provide a concrete dollar number for the cash available at a specific reporting time, although that can also be seen on the face of it, but rather to show the change in cash flow over some time. The cash flow statement is made using data from both the income statement and the balance sheet.
Business owners can improve their cash flow statements by implementing early cash collection policies. Decision-makers can implement these policies by enforcing credit policies or offering discounts for early payments. This can help reduce the average payment collection period and accelerate cash flow from receivables.
Click here to learn more about how to read a cash flow statement.
The Statement of Retained Earnings
Out of the four basic financial statements, the statement of retained earnings is usually the least used and is often combined with the income statement. Regardless, it is still valuable as it shows the changes in the business’s retained earnings. Retained earnings is a cumulative figure representing the portion of the net income retained so far by the business after paying off dividends to the shareholders. Companies focusing on growth may not pay dividends and instead plow back the money for expansion. It shows the business’ financial stability through a record of the saved net income over time.
Making Use of the Four Basic Financial Statements
After learning about the four basic financial statements, the next step is to turn the data inside them into useful information. A simple way to achieve this is by using financial ratios. Financial ratios are mathematical formulae that refine raw financial data into meaningful information. Our publication “7 Financial Ratios Every Small Business Owner Should Know“ provides a quick guide to using ratios for analyzing a company’s financial performance.
Business owners can also hire a dedicated accounting resource to help them evaluate their financial statements and provide insights into financial performance. This can help them identify areas where the business performed well and the areas that need improvement. A growing business must focus on leveraging its financial data to measure performance and make projections for the future. This may be an expensive move for small businesses, but it remains an effective way to drive business growth. Luckily, the rising popularity and success of outsourcing accounting means that small businesses can use these four financial statements, too.
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