What is the Purpose of Financial Statements?

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. 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, they can be intimidating though. So, here we’ll provide an overview of these important documents. 

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 most 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 Sheets
  • Income Statement
  • Cash Flow Statement

Let’s dive into each one: 

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Balance Sheets

The balance sheet gives a comprehensive view of your businesses’ financial position at a particular point in time. 

The balance sheet shows what the business owes (called “liabilities”) subtracted from the items you own of value (called “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.”)

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 monies owed 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 can you learn?

At a glance, the balance sheet can help you understand the financial position of your business. It can also help you and other owners (shareholders) understand your personal financial positions in the business. After all, you want to make money (revenues) but as an owner you also want to build equity – and that means money left over after the bills have been paid.

Income Statement 

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 the time period: monthly, quarterly or annual, for example. However, monthly income statements are often extremely valuable for insights into your businesses’ 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 can you learn?

You’ve heard the statement: “What’s the bottom line?” The bottom line on your income statement is 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 opportunities to increase profits even before you grow your revenue.

Cash Flow Statement

A cash flow statement is what it appears to be: a financial statement that helps 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: 

  1. Operating activities (the nuts and bolts of your business activities and the bulk of where most businesses bring in revenue and spend money), 
  2. Investing activities and 
  3. 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 Can You Learn?

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. 

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Pro tip: What you don’t know can kill your business

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How Often Should You Create Financial Statements?

What frequency should you be creating these reports? The answer is: it depends. Some business owners have their accountant create basic financial statements when they complete their tax returns; but 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. 

What insights might you look for 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. 

Ty – should we add an accounting partner call out? 

Are You A Good Candidate for Financing?  

Remember when we said that 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 tier financing such as a bank line of credit or SBA loan, 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 owner’s with 20% or more equity in the 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 organisation.

This article was originally written on May 23, 2019 and updated on June 24, 2020.

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ABOUT AUTHOR

Gerri Detweiler

Education Director for Nav

Credit expert Gerri Detweiler is Education Director for Nav. She has more than three decades of experience in consumer credit education, has been interviewed in more than 3500 news stories, and answered over 10,000 credit questions online. Her articles have been widely syndicated on sites such as MSN, Forbes, and MarketWatch. She is the author or coauthor of five books, including Finance Your Own Business: Get on the Financing Fast Track. She has testified before Congress on consumer credit legislation.

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