What is a financial statement?
A financial statement is any document that records a company’s financial transactions, behaviors and performance. Data in financial statements guides business analysis and helps managers refine their strategy and business plan. Accurate financial reporting is essential for maintaining good standing with the government, seeking out support from investors and making other business deals.
Financial statements have several categories of information depending on the purpose of each report. Different types of reports provide specific metrics to guide budgeting decisions, track incoming funds or monitor outgoing costs.
Who reads financial statements?
Anyone in the financial sector should be able to read financial statements. Business owners and entrepreneurs in particular need to have a strong grasp of what financial statements mean. Even if you outsource your financials to a director of finance or have a team of accountants preparing your financial reports, you need to be able to interpret your business’s financial progress to set goals and implement appropriate strategies.
Types of financial statements
There are a few key types of financial statements that all entrepreneurs should know how to read.
Read more: Financial Management: Basics for Business Managers
Also known as a statement of financial position, a balance sheet lists all of your company’s assets and how they are distributed to make up a business’s overall net worth. It includes debts, liabilities, equipment, land and other company possessions. Reading a balance sheet gives you an idea of how your company can pay for its expenses and afford to continue operating. Balance sheets often have summarized information from previous financial reporting periods so you can assess your business’s growth and financial resources in comparison to past performance.
Business owners should regularly update their balance sheets to have an ongoing understanding of their company’s value and financial obligations. Balance sheets divide financial data by three types of accounts: assets, liabilities and shareholder equity.
Business assets are any cash or valuable goods and products that belong to your company. Assets increase your company’s value by reducing future expenses, generating revenue or boosting sales numbers. They include equipment, inventory, liquid cash and intellectual property. Examples of business assets on a balance sheet include:
- Accounts receivable
- Raw materials
- Cash accounts
- Real estate
- Prepaid insurance
A liability is a debt a company owes to another party. Liabilities on a balance sheet may include:
- Accounts payable
- Salaries owed
- Income tax
Related: Business Loan Rates: Key Considerations
On a balance sheet, shareholder equity is the difference between assets and liabilities. The equity section of a balance sheet lists the value of common stock, how much the owners withdrew as dividends and the business’s retained earnings. Retained earnings refer to the amount of revenue put back into the business to pay for business expenses and invest in growth instead of being paid to shareholders.
Tips for reading a balance sheet
When interpreting a balance sheet, compare numbers in each section to calculate ratios for analyzing financial stability. Look at the ratio of liabilities to assets at your company to get an idea of its value and performance. Having significantly more assets than liabilities indicates financial freedom and potential for growth. Other ways to analyze the balance sheet include:
- Debt-to-equity: Debt divided by equity, with a lower number indicating lower financial risk for investors.
- Working capital: Liabilities minus assets, positive numbers showing that you can afford to cover all expenses.
- Quick ratio: The quick ratio shows whether a company can pay off debts without selling their inventory. Calculate your business’s quick ratio by subtracting inventory from assets and dividing that number by liabilities.
Cash flow statements
A cash flow statement provides an overview of how a company raised and spent money over a certain period. Use the cash flow statement to ensure that your business is able to cover short term expenses and analyze where the money in your business account comes from. Most cash flow statements have the following three sections detailing different sources of income:
Operations activities are usually the largest portion of cash flow for small business owners. This section details the methods you use to make money and begins by listing a business’s net earnings then deducts expenses to reflect how profitable the company’s core services are.
Outside investments can also bring in cash flow to your business. This section shows how much interest you accrued from past investments and outlines how much money you spent on new investments. Review the investing section to see how your return-on-investment changes over time to better understand how to increase profits.
If you seek outside financing from a bank, angel investor or venture capitalist, this income will also appear on a cash flow statement. Dividends paid to stockholders and re-purchased company stock influence total earning from financing and may appear as a negative number in this section.
Tips for reading a cash flow statement
When reading a cash flow statement, look for a few key numbers: asset sales, income generated and investments in company growth. The decrease or increase in overall cash flow compared to past periods indicates your business’s ability to break even using liquid assets. Pay attention to how your company distributes income to different departments and projects.
An income statement, or profit and loss statement, compares overall gains and losses at a company, including both operating expenses and outside influences. Income statements include information from the cash flow statement and non-cash transactions like legal payouts, asset sales and depreciation. Businesses generate overall income statements on a regular basis such as monthly or quarterly.
Tips for reading an income statement
The most important number on an income statement is the net income after tax. Investors and banks use this figure to forecast the financial success of your business. Analyze your income statement by highlighting the numbers that make up the largest percentage of your net income and how to either limit related expenses or invest in areas of profitability.