The Importance of Financial Statements
Financial statements are important to a business because they accomplish several purposes.
- They show the financial condition of the business and whether it’s making a profit or losing money.
- They are the source documents that a bank or investor will want to see before they commit to loan money to or invest in the business.
- These reports also consolidate and categorize the financial information used in federal and state filings and information returns.
- Owners and operators use the information to make determinations about such things as hirings and layoffs, when new marketing strategies are needed, when to discontinue or offer products or services or when to purchase new equipment.
There are three basic financial statements that bookkeeping systems deal with. These are reported to the business owner or operator at specified times.
- The Balance Sheet – which summarizes the Asset, Liability and Equity accounts
- The Income Statement – which summarizes income and expenses
- The Statement of Cashflows – which summarizes the sources and uses of cash from three areas of cash flows: operations, investing, and financing.
The Balance Sheet
The information about Assets, Liabilities and Equity are gathered from the general ledger and reported on the balance sheet. It’s called a balance sheet because the assets should always equal or “balance” the total of the liabilities plus the equity.
The purpose is to show how well the business is doing and at a certain point in time. Lenders and investors compare assets to liability and equity to determine whether to lend or invest. They want to see what a business owns and what it owes to others at that point in time.
The balance sheet is divided into two sections and each section must balance. The first section shows the business assets and the second section shows the liabilities and owner’s equity. The following formula is a simplistic example of what makes up the balance sheet.
Assets – Liabilities = Owner’s Equity
As assets increase, owner’s equity increases. If liabilities increase, owner’s equity will naturally decrease. If liabilities were incurred for the purchase of assets, then owner’s equity is not affected. When a business is first created, the amount of the owner’s personal investment is listed as equal monetary portions for assets and owner’ s equity. The investment of assets can vary depending on the business. Some asset examples might include:
The Income Statement (Profit and Loss Statement)
The information on this report deals with revenues and expenses. It’s purpose is to show the business profit or loss and is thus sometimes called the Profit and Loss Statement. The business owner/operator can use the income statement to evaluate where the business needs to concentrate it’s efforts to increase income or decrease expenses.
So the balance sheet and the income statement show the business from two different angles. Understanding the difference between the balance sheet and the income statement will help the beginner understand concepts like double entry bookkeeping which is just a manner of recording a transaction in a way that shows the transactions’ effect on the two different reports.
The Statement of Cash Flows
This report shows the amount and use of cash in the business. Usually, it’s broken down into three sections, cash flow from operations, from investing and from financing. Cash flow from operations is the “sweet darling” of many investors.
Cash flow is how much money came in from an activity and how much went out from a type of activity. Obviously, if there is a lot of cash flowing in and not so much flowing out, investors might view the business as a very worthy investment.
The Statement of Cash Flows – Cash Flow vs. Profits
The statement of cash flows, also known as the cash flow statement, reports the company’s ability to generate cash. The income statement might show that a company’s profitable, however profitability and cash flow don’t always coincide. For example if a business has a large portion of its revenues in accounts receivables with a slow turnover rate, it could have a detrimental effect on cash.
Another example of cash flow deficiency is when cash is used for the purpose of purchasing assets. Buying too much inventory is a good example of negative cash flow practices. Since cash and inventory is an asset, neither shows up on the income statement. Yet trading cash for inventory will naturally decrease the cash account but will not have an affect on profits.
Even if business owners can’t prepare a financial statement, they should at least understand what the reports tell about their business and how the information can be used to help their business succeed. To get a true picture of a company’s financial performance and stability, it’s important to analyze all three financial statements. If looking to purchase a business, it would be a mistake to look at profits alone. Net worth and cash flow strength are equally important attributes to the financial stability of a business.
Understanding financial statements starts with knowing what they tell about a business and how the information is used by owners, operators or investors.