While there are many numbers involved in operating a business, three key financial statements can help unpack a ton of data in easy-to-digest formats.
Three core financial statements convey a business’s financial position, profitability, and cash flow, all of which are essential for internal business leaders and external stakeholders. Knowing your way around these statements not only helps you manage a business better, but it can help improve your personal investing acumen, too.
You don’t need to be a CPA to read these statements. Most financial statements are prepared following the same U.S. Generally Accepted Accounting Principles (GAAP) standards. After you learn to read one, you can read them all.
Types of Financial Statements
The three most important financial statements are balance sheets, income statements, and cash-flow statements. Each conveys a specific aspect of a company’s financial profile, but they are most helpful when reviewed together.
Two other financial statements, the statement of equity and the notes to the financial statements, round out the package. There are several more types of financial statements that can be helpful to consider.
What Companies Need Financial Statements?
Once they're operating, any and all businesses benefit from reviewing financial statements. They help company leaders analyze and monitor the business and provide a starting point for developing forecasts and financial plans.
Additionally, most lenders and investors request these documents before providing a loan or investment. They are also required by law for companies that issue public stock.
The Balance Sheet
The balance sheet shows a company’s financial position at a certain point in time by listing its assets, liabilities, and equity. It is often described as a snapshot because it’s prepared as of a specific date – typically the last day of a month, quarter, or fiscal year.
As its name implies, the balance sheet is balanced following the basic accounting equation: Assets = Liabilities + Equity.
Not surprisingly, the three words in that equation serve as the labels for the balance sheet’s three main sections:
Assets: economic resources that are controlled by the company and can provide future benefits, such as cash, inventory, or machinery
The asset section has two subsections: current assets and long-term assets.
Current assets are those expected to be converted to cash within a year, while long-term assets (sometimes called non-current assets) are expected to be held beyond 12 months.
For example, cash and inventory are current assets, while buildings and land are long-term assets. This designation is helpful when considering a company’s liquidity, a financial term that refers to how much cash a business can get its hands on quickly.
Liabilities: obligations to others outside the company
Liabilities are also shown as current and long-term. Current liabilities include trade payables and payroll, while loans expected to mature beyond 12 months, like a 30-year mortgage on a building, are long-term liabilities.
External stakeholders, such as bankers, look carefully at a company’s financial liabilities when considering new loans. Internal stakeholders should manage liabilities carefully because they are burdens on cash flow and reduce profitability.
Equity: the components of a company’s ownership and net worth
Contributed capital from owners, proceeds from outstanding stock, and accumulated profits are listed here, along with certain minority investments in other companies.
The equity section is used to calculate several ratios that are important to investors, such as return on equity.
The Income Statement
The income statement may be the most popular of the financial statements because it reports a company’s profitability. You may have heard it colloquially called the statement of operations, the profit-and-loss statement, or simply the P&L.
Unlike the balance sheet snapshot, the income statement shows the results of a company’s performance over a period of time. From top to bottom, revenue is listed first, then gains are added, and expenses and losses are subtracted, bringing you to the business’s net income or loss.
That format and flow is why a business’s revenue or sales is often called the top line and net income or loss is the bottom line.
The components of an income statement may be more familiar than those of a balance sheet:
Revenue: sales of goods and services to customers
This is the most important number in the financial statement package because it's what the business is all about.
Revenue can be presented as a single line or broken down by product or business unit. Revenue comparisons for different time periods are particularly helpful to analyze trends and context.
Ancillary inflows, such as interest income, are shown separately as other revenue.
Gains: positive impacts of incidental events (events outside of a company’s core operations)
Gains most often arise when assets are sold for more money than their carrying value on a company’s books. Examples include a company selling an old delivery van for more than its depreciated book value or being awarded a monetary settlement from litigation.
Gains increase profitability, but their contributions to profit are considered to have lower quality of earnings because they are outside of what the company is in business to do.
Expenses: the costs incurred to do business
There can be a wide variety of expenses on an income statement, such as raw material purchases, payroll, rent, travel, marketing, and depreciation, among others.
Cost of Goods Sold (COGS) is an important expense subtotal on an income statement, representing all the direct expenses to produce the products or services a company sells. Looking at COGS and gross margin (calculated as revenue – COGS) gives insight into how profitable a company’s core operations are.
Losses: the mirror image of gains – negative impacts from an incidental event
If a company is required to pay a settlement from a lawsuit or sells an asset for less than its carrying value, a loss is recorded. Losses reduce profitability.
Income statements can be prepared for any period, but are typically done for a month, quarter, or year. It’s common to show a current period’s results compared to the same period in the prior year and/or compared to the current year-to-date results.
For example, a quarterly income statement for the three months ended September 30, 2022 might be shown comparatively to the three months ended September 30, 2021, as well as the nine months ended September 30, 2022. The comparisons help readers spot trends and changes from one period to another.
For public companies, earnings per share is included under the net income line. This shows how much profit or loss a single share of stock would be entitled to if the company distributed all of that period’s earnings in dividends.
The Cash-Flow Statement
For many businesses, the cash-flow statement is the most important.
It shows whether the company’s actual cash balance is rising or falling over a period of time, along with all of the company’s sources and uses of cash. This is vital because the U.S. GAAP standards require that companies prepare their financial statements using accrual accounting, which counts revenue when it is earned (not when collected) and expenses when incurred (not when paid). But you can’t pay employees with revenue you don't have yet! So there are few things more critical to growing small or midsize businesses than cash flow.
The cash-flow statement buckets sources and uses of cash into three categories:
Cash Flow From Operations
This shows whether a company generates cash from its core operations, which is considered most important.
Sources of cash from operations include customer payments plus ancillary inflows, like interest income from investments. Uses of cash in this section include expenses like inventory purchases, salaries, utility payments, and all other payments made for the normal course of business.
This section of the cash-flow statement looks different than the other two because it acts more like a reconciliation of net income (from the income statement) and cash income. For most companies, this section should be cash positive, since it reflects the activity the company is in business to do.
Cash Flow From Investing Activities
This shows any buying and selling of capital assets or long-term investments.
For most companies, these are ancillary activities outside of day-to-day operating activity. Such activities might include selling equipment, land, stocks, bonds, and ownership interests of other companies.
On the other hand, purchases for things like long-term securities, warehouses, or vehicles are investing uses of cash. The activity in the investing section can give insight into how a company is setting itself up for the future.
For example, a company that is selling off its assets may not anticipate much opportunity for future growth, unlike a company that is spending on new equipment.
Cash Flow From Financing Activities
This shows how a company is funded. It reflects changes in the long-term liabilities and equity accounts from the company’s balance sheet.
Examples of financing sources of cash include proceeds of loans, capital contributions from owners or investors, and proceeds from selling stock in the company. Uses occur when a company repays loans, pays cash dividends, or repurchases its stock.
This section can help highlight a company’s underlying health, although it may not always be obvious. For example, a large source of cash from loan proceeds earmarked for product expansion may be viewed more positively than if the loan proceeds are merely propping up negative operating cash flow.
When the aggregate of the three sections increases cash, the company is cash positive. A net reduction in cash is cash negative. Companies can’t survive very long being cash negative. There's more to learn about cash-flow statements in order to maintain your business's financial health.
The balance sheet, income statement, and statement of cash flows are primary for assessing a company’s financial health, each in its own way. Learning how to read and interpret these key financial statements can help business leaders and investors feel more comfortable running and growing their businesses – and investing in others. Learn more about other types of financial statements here.
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