What is the Purpose of Financial Statements?

What is the Purpose of Financial Statements?

Have you heard the term “financial statement?” If you’ve owned your own business for some time, we’re betting you have. While it’s part of the lingo of being a business owner, the value isn’t always understood. This handy tool not only gives you the best look at how your company is doing and will do in the future. It’s a vital part of creating plans for growth or even surviving a downturn in the economy.

There’s another reason to get comfy with a financial statement: funding. If you’re looking to get cash for your business, whether through private investment or a bank loan, you’ll need to have updated records that include at least the major financial statements. What are these statements? What do they have to offer? Here is the purpose of an accurate and up-to-date financial statement in a growing business:

3 Types of Financial Statements

When speaking of financial statements, it’s helpful to know that they can be one of three main types. Depending on what you’re hoping to learn, you could look at one – or all of them.

Balance Sheet

Some people also call this the “snapshot” statement. It’s the one that gives the most comprehensive view of your business and how it’s doing financially. It should show the money you owe (called “liabilities”) subtracted from the items you own of value (called “assets.”)

Liabilities can include credit card debt, unpaid loans, taxes owed, notes payable to your shareholders, and unpaid invoices to vendors. The assets include cash, invoices owed to you, your real estate, machinery, product inventory, and anything that could be liquidated.

What can you learn?

At a glance, the balance sheet can show you if your business is upside down and owes more than it owns. For a bank to approve you for a loan, they may want to see you in a better position. You can carefully monitor this financial statement and use your progress as a way to show banks you’re doing better and can be responsible for more debt. Flipping your balance sheet from negative to positive is something that can impress a lender!

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Profit/Loss

This statement is also called an “income statement,” because it can show whether you’re making money with your business or not. The date range for this report can be a few months or even a year, depending on what a bank or lender wants to see. The beauty of this report is that it doesn’t just show your sales against expenses; it can project future sales and expenses, too. If you’re on an upward trajectory with your business, you might be able to secure funding based on how much profit you’re expected to make down the road. This statement can make that point.

What can you learn?

Profit and loss statements are excellent tools to figure out if you can increase profits. 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 opportunities to increase profits even before you grow your revenue.

Cash Flow

This is a useful statement to see, at a glance, what money you have coming in and what you are spending in a given period. 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 all your money.) To know your cash flow, you’ll need to document:

  • Cash sales, interest on investments, invoices to customers that are in collections, and loans you’ve given to others (cash inflows)
  • Expenses you’ve paid out, including equipment, raw materials, money owed to vendors, and debt payments (cash outflow)

Subtract the cash outflows from the cash inflows to get your cash flow magic number! A positive number is excellent and will help get lenders to say “yes” to your loan application.

What can you learn?

In addition to knowing if a bank will find your situation favorable, you can get a very good idea of your collection practices. If your revenue and profits are stable (based on the other two financial statements we mentioned earlier), and you are showing negative cash flow, something isn’t right. Are you not being aggressive enough in your collection practices? Do you pay your bills in too timely a fashion? Balancing money going out with money coming in can often be a matter of timing. Work to get your cash flow in a more balanced cyclical pattern that won’t tie up your liquid cash too much and gets you paid faster each invoicing cycle.

How Often Should You Create Them?

What frequency should you be creating these reports? The answer is: it depends. Your articles of incorporation may state that you need to do reports at least annually; your tax guy might want to see them quarterly. Each type of report may not need to be done every single time, either.

While there’s no fast rule on how many of these reports you should do a year, today’s financial tech makes it easy to record data and use your connected financial accounts to create real-time reports at a moment’s notice. You’re better off having these reports updated often so that you can be alerted to any discrepancies or significant changes that can show you where your business needs improvement.

There’s also the matter of lenders. By having each type of report updated at least monthly, you’ll be in a better position to ask for credit when you need it. Financial statements are perhaps the most time-consuming portions of a loan application. Having them done in advance allows you to apply at any time, without waiting on your finance pro to pull all that paperwork for you. Prepared business owners should have access to these reports – as well as their credit score — at any time.

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