If you own a business or are thinking about starting a business, you need to understand the importance of creating financial statements. Financial statements provide an explanation of where the money came from, where it went, and where it is now. Without financial statements, you would have a hard time showing that your business is profitable to yourself or anyone else. Lenders, investors, suppliers, customers, employees, competitors, and government agencies all use financial statements to assess the credibility and strength of your company. There are three main financial statements: the balance sheet, income statement and statement of cash flows; let’s look at each one in more detail.

Balance Sheet

           The balance sheet shows what a company owns and what it owes at a fixed point in time, today for example. It is built around the Accounting Equation:

Assets = Liabilities + Equity

Assets are resources owned or controlled by a company that provide a probable future benefit, tangible items, like cash, buildings, equipment, and land. Accounts and/or loans receivable are also considered company assets.

Liabilities are obligations that will require probable future sacrifice, either by paying assets or by delivering services. Accounts payable, wages payable, taxes payable and long-term debt are all examples of liabilities. Unearned revenue is also a liability, for example in the airline industry when the airline collects money for your flight before you even get on the plane. They owe you a flight as a service for your payment.

Equity is the amount owners have invested in a company that it can use to buy assets. Equity can be capital – owner’s personal money put into the business or retained earnings - the amount of net income left over for the business after it has paid out dividends to its shareholders. 

As you can see from the accounting equation, assets equal liabilities plus equity; put another way liabilities and equity must equal assets.

Although the balance sheet is an effective financial reporting tool, there are some limitations: numbers in the balance sheet reflect the original costs, not current market values and some economic assets are not recorded on the balance sheet – things like brand value, and the balance sheet does not show the flows into and out of the accounts during the period.

Income Statement

           The income statement shows how much revenue a company earned over a specific time period (quarterly, semi-annually, annually). It shows the costs and expenses associated with earning that revenue. Revenue, the amount of assets created from the sale of goods or services, earned minus expenses, the amount of assets consumed through business operations, is the “bottom line” or a company’s net income, the net amount of assets generated in doing business. This net income tells you if your company is profitable or if you lost money over the given time period. Net income is the ONE number that summarizes the results of business operations at a company and is a measure of economic performance. 

Cash Flow Statement

           Cash flow statements report the amount of cash collected and cash paid by a company during a period of time; it’s a report of cash inflows and outflows. Cash flow statements are important because a company needs to have enough cash on hand to pay its expenses and purchase assets. While an income statement can tell you whether a company made a profit, a cash flow statement can tell you whether the company generated cash.

           There are three categories on a cash flow statement: operating activities, investing activities, and financing activities.

           Operating activities are items like revenues and wages or utilities, investing activities are items like buying land, buildings or equipment, and financing activities are things such as borrowing money or repaying loans.

           Although each type of financial statement is created separately, they are all related. Changes in assets and liabilities seen on the balance sheet are also reflected in the revenues and expenses on the income statement, and cash flows provide more information about the assets listed on the balance sheet. These financial statements tell the story of your business for you and your investors and are a vitally important tool in running your business.