The Three Main Financial Statements
Financial statements are essential tools for business owners, lenders, and investors to gauge the financial health of a company. These statements offer vital data to make informed decisions on capital allocation for business growth. The three primary financial statements are the income statement, cash flow statement, and balance sheet. Together, they present a comprehensive overview of a company's financial status. This article examines each statement's significance, elucidating their individual roles and their collective importance in enabling stakeholders to gain insights into the company's performance and make sound financial judgments.
Why your business needs financial statements
Succeeding in business means being prepared for whatever the future may bring and being able to anticipate unforeseen events. Business owners must know how strong their enterprise is, whether it is growing at a sustainable rate and where they need to direct their efforts to encourage future growth and maximise the potential of the business.
Businesses also require investment from either investors or periodic influxes of cash from lenders. Without a reliable cash flow or enough investment, a business will not be able to acquire assets or produce goods or meet its debt obligations.
So, how does a smart business owner ensure that they are always informed of how their business has been performing, how it may perform in the future and how attractive it may be to lenders and investors? The answer lies in the three financial statements.
The three main financial statements provide a wide spectrum of data that covers either an entire fiscal year from January to December or an accounting cycle, such as the first quarter, for example. The accounting information contained in the income statement, the cash flow statement and the balance sheet can be analysed to show how much value is in a business, how much debt it is carrying and what the potential future profits may be.
The three main types of financial statements
As we have mentioned, there are three main types of financial statements. Usually, these are generated by an accountant or sometimes a business owner may create the statements themselves with the help of specialised business accounting software. A financial statement can be presented in paper form, as a Word document or as a pdf.
The three main financial statements are:
- The income statement: This statement details the revenue that the enterprise generated during the time period that the statement covers. The income statement will also provide details on what the business spent to generate its income.
- The cash flow statement: This statement provides information on the different ways the business generated cash and how it then used these funds during the time period that the statement covers. The cash flow statement also provides details on how the business intends to spend money and invest in itself in the future.
- The balance sheet: The balance sheet provides an overview of the financial health of the business as a whole. It details what assets the business holds, how much debt it is carrying and how much equityshareholders or the business owner have.
To properly manage the finances of a business, stakeholders should have a good understanding of what information these statements contain and how to analyse this information. Each one of the three main financial statements can be analysed on its own as well as in conjunction with the others.
The income statement
One of the first pieces of information a potential investor or lender may wish to see is a business’s income statement. The income statement provides information on the revenue that a business has generated during a specific time period. This may be an entire financial year or an accounting cycle.
The income statement shows the total amount of revenue generate via sales for the period that the statement covers. It subtracts the cost of goods sold (COGS) from this figure to arrive at the gross profit of the business. In other words, it subtracts what it cost the business to produce goods and services from how much revenue it sold the goods or services for to arrive at what the profits of the business were before tax. Income statements are used to assess and analyse the profitability of a business.
The cash flow statement
A cash flow statement provides details on how much cash went in and out of a business during a particular period. Usually, a cash flow statement is divided into different sections:
- Operating activities: Cash from daily business operations, including sales, expenses payments and the collection of any receivables
- Investing activities: Cash received and spent on long-term investments such as the sale of real estate, tools, equipment and so on.
- Financing activities: This includes cash paid and received for debt and equity
The cash flow statement can be prepared using either an accrual accounting method or a cash accounting method. With a cash accounting method, the inflow and outflow of revenue are calculated based on when they were received or paid. The accrual method is based on earned revenue or incurred costs regardless of if they have been paid or received.
The balance sheet
A balance sheet is a valuable document that shows all of a company’s assets, liabilities and equity through the period that it covers up to the reporting date. A balance sheet is used to demonstrate the actual value of a business.
Assets refer to anything that can be turned into cash. The assets list can include both current and fixed assets, such as cash or equipment, but not intangible assets such as branding or a company’s reputation.
Liabilities are the total the amount of money that a business owes either in debt or in accounts payable.
Shareholders’ or owner’s equity is the amount of money that investors and or owners have invested into the businesses. This also includes share capital from shareholders and retained earnings (money that was not paid out as dividends but was reinvested into the business).
Balance sheets are prepared using a particular formula known as the accounting equation:
Assets = Liabilities + Shareholders’ Equity
The total assets must be equal to the total number of liabilities plus shareholders’ (or owner’s) equity. If this is the case, then a business can be said to be in good financial health. If these figures do not balance, however, then a business may be considered to be carrying too much debt and may be considered too much of a high risk for investors or lenders.
Why the three financial statements are so important
These three financial statements can be created either on an annual basis or during a particular accounting cycle. As a group and individually, the three financial statements provide a clear picture of the financial health of a business and its potential for future growth. If a business is over-leveraged, meaning it has taken on too much debt, then these statements will reflect that. If a business has not generated enough cash within the last accounting period, these statements will reflect that. If a business is paying too much to have its goods produced, then the statements will provide this information.
All of the data contained within the three main financial statements enables business owners and stakeholders to determine the direction of the enterprise. By analysing the three financial statements, business owners can see exactly where the strengths and weaknesses of the business are. This also applies equally to lenders such as banks and financial institutions and investors. All three of the financial statements will be studied individually and together as a whole to determine if a business will be able to repay a loan or if it is a good risk for an investor.
Without proper accounting procedures, it is not possible to produce financial statements that meet the accepted standards. If your accounts are not in order, it will be more difficult for you to obtain loans or investment capital to grow your business.
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