Financial statements are the reports summarizing vital information about the financial state of your business. There are three types of financial statements that give you, and others with interest in the financial affairs (investors) a clear picture of the company’s’ financial health. These include: the balance sheet, income statement, and cash flow statement.
In this article, we’re going to break down the importance and functionality of these three statements, which should be prepared in this order:
1. The Balance Sheet
The balance sheet is a current snapshot of where your business financials stand. It breaks down assets and liabilities at a particular point in time.
The frequency in which a balance sheet is prepared depends on your business. Some businesses may require daily or monthly reports, while some may require quarterly statements. For example, banks move lots of money around, so they prepare a balance sheet every day. Alternatively, an individual freelancer may only prepare a balance sheet once per quarter.
Generally speaking, balance sheets are broken up into three categories: assets, liability, and equity.
Investors and creditors can utilize the balance sheet to understand how companies are funding capital assets and operations.
Assets: anything the business owns of value
Assets consist of things like money in a checking account, money being transferred between accounts, or larger things such as equipment, properties, etc.
Liabilities: debts the business owes
Liabilities consist of things like loans, mortgages, and accrued expenses such as taxes, utilities, and even wages owed to employees of the company.
Equity: the value after subtracting liabilities from assets
Equity may also be retained revenue, meaning the money the company has earned to date. It’s important to remember, equity is only the ‘book value’ of the business, not the market value (if you are considering selling the business.)
2. The Income Statement
The income statement, sometimes referred to as a profit and loss statement, shows how profitable a business was during a specific period of time. The income statement shows the revenue you brought in and the expenses you paid out.
The income statement can be used to see if companies are operating efficiently and producing enough profit to fund their current operations and growth.
The income statement has four key focuses – revenue, expenses, gains, and losses.
Revenues and Gains
The revenues and gains may be reported in a slightly different manner depending on regional regulatory requirements, though it should include:
Operating revenue is realized though the primary activities of a company. For product-based businesses, this would likely result from the sale of a product. For service-based businesses, this would refer to revenues earned through the fees charged to a consumer in exchange for services provided
Non-operating revenue is realized through secondary, non-core business activities. This could include things like interest earned on business capital sitting in the bank or rental income from a business property.
Gains, also sometimes referred to as ‘other income’, recognizes earnings from other activities, like the sale of assets.
Expenses and Losses
Expenses factor in the costs for a business to continue operation and retain a profit. The IRS allows some of these expenses to be a tax write-off.
Primary Activity Expenses
The expenses incurred during the course of operations are considered primary activity expenses. This includes things like the cost of goods sold (COGS), selling, general and administrative expenses, as well as things like research and development, or depreciation. Salaries and wages, commissions paid, and utility expenses like internet and electricity are also typically included in primary activity expenses.
Secondary Activity Expenses
Expenses that aren’t linked to non-core business activities are considered secondary activity expenses. This would include things like interest paid on a loan.
Losses as Expenses
Losses as expenses are costs associated with loss-making sales of assets, or lawsuit expenses.
The Formula for the income statement is:
Net Income = (Revenue + Gains) – (Expenses + Losses)
3. The Cash Flow Statement
The cash flow statement shows how much cash entered and left the business over a specific period of time. Also sometimes called statement of cash flows, these statements are usually prepared for companies that use the accrual method of accounting, rather than cash basis. The reason is, under accrual based accounting, a company’s income statement might include revenue that the company has performed work for, but has not yet received payment for.
This statement measures how well a company manages its cash position. This refers to how well the company generates revenue to pay its debt obligations and fund its operations. This statement serves as a compliment to the balance sheet and income statement.
The cash flow statement is generally comprised of the following parts:
Cash Flows from Operations.
This includes the income and expenses that occur during the normal course of business.
Cash Flow from Investment Activities.
This includes the money you invest in things like new equipment for the business.
Cash Flow from Financing Activities.
This includes money the owner invested in the business, as well as money coming in or going out of the business from loan activities.
Disclosure of noncash activities.
This is sometimes included in the cash flow statement when prepared under the generally accepted accounting principles, or GAAP.
The cash flow statement is a valuable statement that displays the strength and profitability of a company. This statement can help determine if a company has enough liquidity to cover expenses. For investors, this statement showcases a company’s financial health, since generally speaking, the more cash available for operations, the better.
Why These Financial Statements Matter
By analyzing the figures reported on these statements, you are able to see trends, possible inefficiencies, and opportunities to optimize your company’s financial performance. By collecting the data and ensuring proper preparation of these statements, you can learn to rely on the data to help you make smarter business decisions.
How We Can Help
We understand that you didn’t likely start your business to learn how to do accounting, so that’s where we come in. At Robert B. Fisher, CPA, PC, we work with you to understand your business goals so we can provide the best accounting services to help you achieve them.