If you have owned your own small business for some time, we’re betting you have heard the term “financial statement.” While it’s part of the lingo of being a business owner, the value isn’t always understood. Financial statements can give you important insights into your company’s financial health. They are also a vital part of creating plans for growth or even surviving a downturn in the economy.
There’s another important purpose of financial statements: small business financing. If you’re looking to get funding for your business, whether through private investment or a bank loan, you’ll need to have updated accounting records so you can produce the financial statements lenders or investors want to see.
For those without an accounting background, financial statements might be intimidating. But with the right guidance, they’ll be a regular part of your business processes in no time. Learn why financial statements matter, the three main types, how to prepare them, and more in this article.
Why Are Financial Statements Important?
Your business prepares financial statements to track and record how well you’re performing financially. By putting together financial statements for your own small business, you’ll get a clearer picture of your company’s income, your company’s assets and liabilities, your operating expenses, and how efficiently you’re operating. You can check your performance over a period of time, like monthly, quarterly, or annually.
Financial statements can also give potential investors or stakeholders an idea of your company’s financial performance and financial position to help them decide your business’s valuation. The IRS also looks at financial statements when performing an audit of your business. Additionally, if you’re looking to apply for small business financing, lenders usually want to look at your financial statements.
3 Main Types of Financial Statements
There are a number of different types of financial statements that may be used in a small business, but three are known as the most important ones for typical small business owners. Depending on what you’re hoping to learn about your businesses’ financial position — or the type of financial modeling you want to do for planning purposes — you may want to look at one or more of the following:
- Balance sheet
- Income statement
- Cash flow statement
If you have a public business that is traded on the stock market, you’ll also need to complete a statement of changes, but this isn’t the case for most small businesses.
Let’s dive into each financial statement that’s common in small business.
The balance sheet gives a comprehensive view of your business’s financial position during a given period. The balance sheet shows what the business owes (called “liabilities”) subtracted from the items you own of value (called “business assets”).
The basic formula is:
Assets = Liabilities + Shareholder’s Equity
It’s called a balance sheet because both sides — assets vs. liabilities, plus owner’s equity — must equal one another (in other words, balance out.)
Assets are anything of value the business owns. Current assets include cash, invoices owed to your business (accounts receivable), marketable securities, and product inventory. Fixed assets typically include equipment, property, and buildings.
Liabilities are what you owe and can include credit card debt, unpaid loans, taxes owed, notes payable to shareholders, and unpaid invoices to vendors.
Shareholder equity (which is also sometimes called stockholder’s equity or owner’s equity) is the portion shareholders retain after debts have been paid. It essentially represents the net worth of the company. A related term you may see is “net assets” which describes the amount of retained earnings left in the business (and not distributed to shareholders.)
What you can learn from a balance sheet
At a glance, the balance sheet can help you understand your company’s financial position. It can also help you and other owners (shareholders) understand your personal financial positions in the business. After all, you want to make money (revenue) but as an owner you also want to build equity – and that means money left over after the bills have been paid.
This statement is also called a profit and loss statement and helps you understand whether your business is making a profit. (Gross profit indicates profit before expenses, while net profit is profit after expenses. Net profit is often used interchangeably with the term “net income”).
When preparing an income statement, you can choose a specific period: monthly, quarterly or annually, for example. However, monthly income statements are often extremely valuable for insights into your business’s financial progress. The beauty of this report is that it doesn’t just show your sales against expenses; it can project future sales and expenses, too.
What you can learn from an income statement
You have likely heard about the bottom line, which refers to the last line on your income statement. It shows your net profit.
A profit and loss statement is an excellent tool to figure out if you can increase profits (net income). Since they include everything in your cost of goods sold (such as raw materials, labor costs, and payroll taxes), it’s useful to play around with the numbers to see how lowering any one of these costs can increase your profits. If you’re not yet profitable, it can be easy to assume that you just need to sell more; the income statement can alert you to opportunities to increase profits even before you grow your revenue.
Cash flow statement
Cash flow statements are financial statements that help you understand the cash (and cash equivalents) flowing in and out of your business. It’s useful to see, at a glance, how much cash you have on hand at a given time. This is also the statement used most often to determine your cash burn rate. (Cash burn rate is essentially how fast you’re spending down your money.) “Net cash” is cash inflow minus cash outflows.
There are a couple of ways to calculate cash flow — the direct and indirect method. Most small businesses use the indirect method, which starts with the income statement and balance sheet.
It follows the formula:
Income Statement + Balance Sheet = Cash Flow Statement
The statement of cash flows will typically include three main types of cash flows:
- Operating activities (the nuts and bolts of your business activities and the bulk of where most businesses bring in revenue and spend money),
- Investing activities, and
- Financing activities
It can get a lot more complicated from there, which is why a solid bookkeeping system and a good relationship with an accountant can be very helpful.
What you can learn from a cash flow statement
Strong cash flow from operating activities and strong net cash compared to net income are likely to be viewed more favorably by lenders and investors. It can be helpful as you consider expanding your business. You’ll also gain insights into whether your business is shrinking, growing, or stagnant.
What Should Be Included in a Financial Statement?
The answer depends on which financial statement you’re preparing. A small business’s financial statements typically consist of a bundle of three different separate statements that work together — the balance sheet, the income statement, and the cash flow statement. To complete each of these, you’ll have to provide different line items relating to your business’s income and expenses. We detail what each financial statement requires above.
How Are Financial Statements Prepared?
You have a few choices in how to prepare financial statements for your business. First, you can create them yourself using a spreadsheet. The downside of this system is that it takes a lot of time and you need to understand complicated financial jargon and calculations. You’re also opening yourself up to potential data entry errors.
Another option is using a certified public accountant (CPA) to prepare these financial statements for you. You would send this financial expert your details and they would create the statements, ensuring they are accurate. This can be expensive, but you get one-on-one time with someone who can answer your questions.
Or you could use accounting software to gather your financial details — and most accounting software creates financial statements for you. It’s easy and can be a more affordable option than working with a CPA, although you may still have to spend a bit more time learning how to use the software.
How Often Should You Create Financial Statements?
It depends. Some business owners have their accountant create basic financial statements when they complete their tax returns. However, if you really want to stay on top of the financial health of your business, don’t wait until tax time. Instead it’s helpful to review them monthly or quarterly.
Technology can make it easy to record data and use your connected financial accounts to create real-time financial reports at a moment’s notice. As long as you keep up with your bookkeeping, you should be able to produce these reports with a few clicks in your accounting software. This is certainly a task you can delegate to your bookkeeper or accountant, but make sure you review and understand your numbers. While learning financial statement analysis was probably not on your list of reasons you wanted to start a business, this is your business and your money that’s at stake.
You’ll want to look for the following insights as you review your financials:
- Year-over-year changes in financial performance
- Changes in shareholder’s equity
- Unusually high expenses generally or in specific categories
- Significant increases or decreases in revenue
- Increases in outstanding invoices due
And just as monitoring your business credit can help you spot identity theft, monitoring your financial information may help you spot fraud in your business.
Do You Need Audited Financials?
Public companies need audited financials, but there are times when small businesses may need audited financial statements too; if, for example, they are seeking financing or want to sell the business. They may be required for government contracts and they can be key to uncovering fraud (including employee embezzlement) in the business.
Audited financial statements are prepared by an independent accountant who confirms the information is accurate and prepared following accounting standards.
What Are Accounting Standards?
Public companies (those listed on stock exchanges) must adhere to certain financial reporting and disclosure requirements, and will need to produce financial statements produced in accordance with recognized accounting standards.
When it comes to accounting standards, in the U.S. the Financial Accounting Standards Board (FASB) is an independent, private-sector, not-for-profit organization based in that establishes financial reporting and accounting standards for public and private companies and not-for-profit organizations that follow Generally Accepted Accounting Principles (GAAP). Internationally, the International Financial Reporting Standards are accounting standards issued by the IFRS Foundation, a not-for-profit, public-interest organization.
Can Accounting Software Be Used to Prepare Financial Statements?
Yes. You can create robust financial statements at the click of a button with most accounting software solutions. As long as the financial details you entered in the software are accurate, the accounting software should be able to create correct financial statements for you. Saving time on building out financial statements is one of many benefits of using an outside accounting solution rather than documenting everything yourself.
For more information on how accounting software can help your small business and to find the right option for you, see Nav’s accounting software resources.
Are You A Good Candidate for Financing?
Obtaining financing is one important purpose of financial statements. Not every lender will require them, but by keeping them updated you’ll be in a better position to apply for a small business loan when you need one.
If you want to get top small business loans, you’ll likely need to produce financial statements. Prepared business owners should have access to these reports — as well as their personal and business credit scores — at any time. Note that some lenders will also require personal financial statements for all owners with 20% or more equity in the business. But you don’t have to worry about scanning the fine print of loan qualifications. Use Nav to discover personalized funding recommendations based on your business details. Simply enter your information securely and we will recommend the options you’re most likely to qualify for in an instant.