How to Use Business Financial Statements

If you’re a business owner, it’s imperative that you understand the importance of financial statements and know how to use them.

The ability to understand and utilize financial statements will help you monitor your business’s cash flow, profitability, assets, liabilities, and overall financial performance.

This, in turn, will allow you to make better financial decisions with regard to your business so that you can facilitate business growth without taking on an unsustainable amount of debt.

What are Business Financial Statements?

The purpose of a business financial statement is to convey a company’s financial performance and condition over a specific period of time (quarterly, semi-annually, or annually). There are four main types of financial statements that all companies are required to maintain:

Balance Sheet
Cash Flow Statement
Income Statement
Statement of Changes in Equity (for publicly traded companies only).

To ensure that these reports are consistent and easy to understand, the Securities and Exchange Commission (SEC) requires that all financial statements should adhere to certain widely-accepted accounting standards.

These might include the Generally Accepted Accounting Principles (GAAP) for US-based companies or the International Financial Reporting Standards (IFRS) for multinational firms.

The primary purpose of business financial statements is to ensure that potential investors, lenders, tax authorities, and other stakeholders always have a way to assess the current financial status of the company so that they can make informed decisions.

Business Financial Statements vs. Financial Reporting

The words ‘financial statement’ and ‘financial report’ are often used interchangeably, but there are certain differences between the two concepts. While every financial statement is a type of financial report, not all financial reports are financial statements.

Financial reports gather all the relevant financial information about a company in order to pass it on to the stakeholders and decision-makers associated with that company. This may include management decisions, supplementary financial disclosures, and detailed analyses of revenue and expenditure geared towards providing a comprehensive understanding of the business’s operations and financial results. Financial reports are, in general, broader in scope (and less rigid in structure) than financial statements.

Financial statements, on the other hand, are formal documents designed to provide a structured overview of the current financial condition of the company. These documents – including the income statement, cash flow statement, and balance sheet – are created following specific accounting standards and principles. They’re typically used by external decision-makers like potential investors and tax authorities to decide how to associate with the business.

What are the Elements of a Financial Statement?

Different companies may structure their financial statements in slightly different ways, but almost all for-profit entities will have these five key elements in their financial statements. These elements are:

Assets: These are the financial resources owned by the company, such as land, buildings, and equipment (fixed assets) and cash, accounts receivable, and inventory (current assets).
Liabilities: These include long-term and short-term debts that the business owes to another entity or individual, such as mortgages, wages payable, and accounts payable.
Revenue: This is the total income generated by the business (through sales or services rendered) over a specific period of time, such as a quarter or a year.
Expenses: Business expenses are the costs that a company incurs in the course of its day-to-day operations, such as the cost of interest or utilities over a specific period of time.
Equity: This is the amount of money that the owners invested into the business or any retained earnings being reinvested into the business.

Main Types of Financial Statements

As mentioned above, there are four main types of financial statements that any for-profit entity must create. In this section, we’ll take a deeper look and try to understand the purpose of each of the statements.

Balance Sheets

This is a financial statement that can provide you with a snapshot of a firm’s financial position during a specific period of time. It outlines the company’s assets, liabilities, and shareholder equity at a given time, which can help analysts evaluate the capital structure of the business and the potential rates of return (ROI) for investors.

A balance sheet can be used to gain an accurate understanding of what a business owns and what it owes, as well as how much investment it has received from shareholders. Along with other financial statements, this can help you calculate financial ratios or conduct a fundamental analysis of the company’s finances.

You can use a balance sheet to uncover the relationship between the company’s resources (assets + shareholder equity) and obligations (liabilities). In turn, this will help you get a clear picture of the business’s liquidity, solvency, and overall financial health, which are important factors when trying to determine whether or not you should invest in a particular company.

Income Statements

Also known as a profit and loss statement, this is one of the major financial reports used to measure a company’s financial performance during an accounting period. It shows you the various sources from which the company generated income during that accounting period, as well as the sources of expenditure. It also shows whether the company made a net profit or loss during that period.

The purpose of an income statement is two-fold:

It helps the business owner figure out the best strategy for increasing profits – either by decreasing expenditure, increasing revenue, or both.
It helps stakeholders analyze the effectiveness of the strategies the business has implemented so far and whether the existing strategies should be continued or if they need to try something new to increase profitability.

In short, an income statement is a tool that you can use to analyze the efficiency of a company’s operations, its performance relative to competitors, and underperforming sectors within the company, as well as gauge its ability to generate consistent profits.

Cash Flow Statements

A cash flow statement is used to track an organization’s cash flow, which makes it an essential tool for financial management within the business. It enables the business owner to monitor incoming and outgoing money, including the sources of such income and expenditure. This helps the business owner to regulate business operations with the aim of maintaining a positive cash flow.

In order to succeed, a business must ensure that it always has sufficient cash on hand to meet its obligations, but not so much that all its money is sitting idle in a bank account instead of generating returns. A cash flow statement facilitates this by:

Giving clear information about expenditures, including payments made to creditors, cost of inventory and equipment, office or factory rent, etc.
Making it easy for business owners to see where the company might be able to generate extra cash, such as by purchasing equipment at a discount or collecting receivables from customers earlier than expected.
Giving a clear picture of the available cash balance so that the business owner can take the steps to always maintain the optimum balance necessary for the smooth running of the business.
Enabling business owners to make effective decisions based on cash flow by helping them analyze incoming and outgoing cash transactions and foresee short-term cash deficits for upcoming payments.

Statements of Shareholders’ Equity

This is a financial document that tracks changes in the shareholders’ ownership interest in a company, typically from the beginning of a given year to its end. The shareholders’ equity in a company can be calculated by subtracting its total liabilities from its total assets.

Shareholders’ equity can change due to various types of transactions, such as stock-based compensation offered to employees, revaluation of company assets, repurchasing of shares or issuing of new shares, etc. The statement of shareholders’ equity will help you understand the impact of such changes on the company’s overall financial position.

The Importance of Business Financial Statements

The SEC mandates that all companies should file their financial statements (particularly the balance sheet and income statement) on a quarterly and annual basis.

All companies must follow certain universal principles or guidelines when creating their financial statements so that regulators and investors can easily analyze the statements and compare the financial performance of different companies. This helps regulators efficiently monitor the markets and ensure that all businesses are playing by the same rules.

Investors, on the other hand, can use financial statements to gain crucial information about a company’s profitability, revenue, expenses, debt load, and solvency.

Careful analysis of the financial statements of a business can provide valuable insights into its growth prospects, financial health, and risk levels – which are needed for making sound investment decisions.

Limitations of Business Financial Statements

While financial statements can be very useful when analyzing the current conditions and future prospects of a business, they do have certain limitations, which we’ll discuss in this section.

Historical Costs: Financial statements are created on the basis of historical costs, meaning that if the values of a company’s assets and liabilities change over time, this is typically not reflected in its balance sheet unless there has been a recent revaluation.
Subjectivity: Financial statements can be quite subjective, relying on the personal judgments and best estimates of the people preparing them. The standards used for determining the value of assets and liabilities, amortization of assets, and the depreciation methods used can all have a profound impact on the results.
Incomplete Information: Financial statements may provide an incomplete picture of a company’s financial position because they don’t take into account intangible assets like brand image, company reputation, local community support, etc. These factors could have a huge impact on future profitability and growth, so neglecting them may paint a misleading picture of the real value of a business.

How to Read and Better Understand Business Financial Statements

The ability to read and understand financial statements will help you make better decisions – both as a business owner and an investor. So, let’s take a look at the three major types of business financial statements and how you can gain a better understanding of them.

Reading a Balance Sheet

Balance sheets can be broken up into three broad categories – assets, liabilities, and shareholders’ equity.

Assets include real estate, equipment, patents, inventory, and any other valuable item that your business might own. Liabilities are the debts that the business owes to other individuals or entities. The shareholders’ equity is essentially the amount of money that would be left if all the company’s assets were sold and all its debts paid off.

From the balance sheet, you can figure out the liquidity of the business using the current ratio, which is current assets divided by current liabilities. For a balance sheet to make sense, the value of the assets section should be equal to the combined value of the company’s liabilities and shareholders’ equity.

Understanding Income Statements

The income statement can help you figure out how much money your business has earned and how much it has spent over a given period, enabling you to calculate your net profit or loss. Most income statements will have the following sections:

Total revenue: Total amount of money the business has earned over a given period.
Cost of revenue: Also known as cost of goods sold, this is the amount of money it takes to produce the product or service your business sells.
Gross profit: This is calculated by subtracting the cost of revenue from your total revenue.
Operating expenses: These include the cost of utilities, rent, wages, and other day-to-day expenses associated with running a business.
Non-operating expenses: These include taxes, interest payments, and any other expenses not directly incurred for running the business.
Net income: This is calculated by subtracting all expenses from the total revenue.
Depreciation: This represents the rate at which your fixed assets lose their value over time.
Earnings per share: This is calculated by dividing the net income by the total number of outstanding shares.

In essence, the income statement shows you how efficiently your business is generating a profit (and whether or not you’re spending too much money on production costs and overheads).

Reading Cashflow Statements

This document lets you know what the cash situation of your business is and whether or not you have enough cash or cash equivalents to pay all your bills over the next accounting period.

A cash flow statement can be broken down into three sections. These are:

Cash from operating activities: This is the cash generated from core business activities like selling a product or a service.
Cash from investing activities: This is the cash flow generated from buying and selling assets with cash, including real estate, vehicles, and equipment.
Cash from financing activities: This is the cash generated from equity financing, money invested by the business owner, as well as loans.

A cash flow statement can help you understand what types of activities generate cash for your business, so you can take that into account when making business decisions in the future.

How to Use Financial Statements to Build Your Business

Business financial statements are essential for growth since they provide you with the detailed and accurate financial information you need (as the business owner) to effectively plan your taxes, attract investments, and lower your borrowing risk.

Accurate and easy-to-analyze financial statements can also help you make better business decisions and avoid costly mistakes. In addition, you can use current financial statements to project future scenarios and plan accordingly – such as anticipating taxes and managing cash flow for debt servicing.

Such informed decision-making will help you build a more successful future for your business.