Financial statements are records used to explain a company’s financial activities and performance at a specific point or over a period of time. By presenting information related to the business in a structured format, financial statements allow government agencies, accountants, partners and potential investors to gain insights into the company’s financial position.
Although they could be used for different purposes, most importantly, financial statements are crucial for self-analysis. By producing financial statements and building on that data, businesses can better understand their financial operations. The statements can show companies whether they are profitable right now, compare financials to past performance and predict the direction they are heading in.
Financial statement analysis informs future decisions, helping steer the business towards success. Laying out critical parameters related to the company shows where things are going well and where they aren’t. For example, perhaps too much capital is tied up in long term assets, potentially creating short term cash flow problems. Maybe a better way of managing accounts receivable is needed with new bill payment systems and procedures for authorizing funds.
Externally, financial statements are critical to show investors, analysts, creditors and regulators the business’s financial activity as well as its future earning potential. In fact, public companies are required to publish financial statements as part of an annual report to shareholders.
While other financial statements exist, the main three are a balance sheet, income statement and cash flow statement
Balance sheet: what you own and what you owe
A balance sheet provides a snapshot of the company on a specific date, listing its:
- Assets: profit-generating resources such as liquid assets (cash or cash equivalents), accounts receivable (money owed to you), physical assets (inventory or equipment) and non-physical assets (such as intellectual property).
- Liabilities: amounts owed to external parties, both short-term ( accounts payable or payroll) and long-term (startup costs or loans for example).
- Equity: the difference between the company’s assets and liabilities. Equity is what’s left if all of the company’s assets are liquidated and liabilities are paid.
Equity = Assets – Liabilities
Important metrics such as working capital, liquidity, profitability and debt-to-equity ratio can be calculated from a company’s balance sheet.
Internally, a balance sheet provides insight as to whether the company is succeeding or failing, allowing the company to change policy or focus on particular profit centers. Externally a balance sheet shows potential investors the company’s resources and how they were financed. Additionally, a balance sheet shows external auditors that the company is complying with the reporting laws it is subject to.
Income Statement: revenue made and how much it costs to make it
While the balance is a snapshot of the company, the income statement tracks revenue and expenses over a period of time. A typical time frame is usually a year (annual financial statements) or every three months (quarterly financial statements).
Businesses typically define revenue as:
- Operating – derived from selling products or services
- Non-operating – taken from from non-core activities such as interest, rental income, etc.
- Other – obtained from other activities such as asset sales, subsidiaries, etc.
Expenses include primary expenses incurred from the business’s core activity, such as:
- Cost of goods sold (COGS).
- Administrative expenses.
- Research and development.
They also include expenses connected to secondary activities such as interest paid.
Income statements lay out the profitability of the company’s activities in black and white, as well as the nature of its revenue and expenses (fixed vs variable). Income statements also make it easy to compare current performance to past performance and identify trends.
Cash flow statement: money in minus money out
Put simply, a cash flow statement is a document of the actual money coming into and out of a business. It removes any accounting principles to show only pure cash movement. We generally separate cash flow into three components:
- Operating activities: cash directly related to running the business’s daily activities and selling its products or services. In most examples, this is the primary source of money coming into the business.
- Investing activities: cash from long-term investments such as buying and selling assets.
- Financing activities: cash related to investors, banks, or paying shareholders.
Understanding financial statements
All three financial statements contain an interplay of information. Financial modeling relies on trends and analysis derived from each one of the statements. For example, a balance sheet and income statement connect through net income and the cash flow statement and balance sheet both have the same end cash balance.
Ratio analysis is a typical quantitative method for defining a company’s performance (profitability, liquidity, operational efficiency, etc.) by comparing critical metrics found from financial statements. These could be:
- Performance ratios – net profit margin, return on assets, return on equity, gross margin ratios, etc.
- Solvency ratios – current assets/current liabilities, leverage, operating cash flow/operating profit, etc.
- Investor Ratios – dividend yield, earnings per share, dividend payout ratio, etc.
While financial statements are essential sources of information, businesses must understand their limitations. Financial statements are in the eye of the beholder – they are open to interpretation and two investors may come to very different conclusions based on the same information.
Interested parties should always consider financial statements within a broader context. In isolation, financial statements struggle to tell the whole story. Instead, we should compare previous statements and those of similar companies.
The state of the business
Even with these limitations, financial statements remain the best tool for understanding the state of a business. This is because they offer a standardized and structured format to demonstrate a company’s performance over time or to compare different companies.
Generating financial statements is something every company should do, regardless of their size. Knowledge is power and greater understanding leads to greater decision making. We highly recommend you prepare your financial statements to gain a better understanding on what’s going on with your company’s finances.