Financial statements can sometimes seem like a puzzle, but crucial insights that can help business owners see their company from a different perspective may be hiding in the numbers.
You don’t need to be an expert on financial statements to run a successful business, but having a basic understanding of how they work can help you make better money-management decisions.
What are financial statements?
Financial statements are formal records of a company’s financial activities and performance over a period of time. “Apart from the legal requirements, financial statements can give us a huge amount of insight into business performance,” says Zoe Whitman FCCA, accountant and business coach at The 6 Figure Bookkeeper. “We can see anything from how profitable our business is, to how long it takes our debtors (customers) to pay us.”
Examples of financial statements include the balance sheet, income statement, cash flow statement, and statement of retained earnings.
Examples of financial statements
The core financial statements are:
- Balance sheet
- Income statement (also known as profit and loss statement)
- Cash flow statement
- Statement of retained earnings
Let’s see how each statement works.
The balance sheet
The balance sheet, is a snapshot of your company’s current financial position. It’s a list of everything your business owns (its assets), as well as everything it owes to others (its liabilities).
“The balance sheet is usually run on the last day of the period covered by the profit and loss report, and the two statements can be considered together to calculate ratios to give more information about the health and performance of the business,” says Whitman. When you subtract the liabilities from the assets, you’ll get the value that would be left over if you shut down and paid off the debts. This is also known as the shareholder’s equity.
By tracking this information, you can see the overall financial position of your business and whether it’s improving over time. One way to think about measuring financial success is to aim to increase your shareholder’s equity by either building up your assets and/or paying down your liabilities.
Balance sheet example
Here's a hypothetical example. Sarah is the owner of a construction business, whose balance sheet for the past three months is below.
Assets
- Trucks = £150,000
- Supplies = £50,000
- Construction equipment = £200,000
- Building = £400,000
Total Assets = £800,000
Liabilities
- Credit card debt = £30,000
- Unpaid vendor invoices = £50,000
- Truck and equipment loans = £230,000
- Mortgage on building = £350,000
Total Liabilities = £660,000
Shareholder’s equity = £800,000 - £660,000 = £140,000
The income statement
The second financial statement, the income statement, calculates your business profits over a set period of time. It’s also known as a profit & loss (P&L) statement, because it shows whether you made a profit or loss.
This will detail sales generated from business activities, along with the costs associated with creating that income. Whatever is left is your profit. If it’s a negative number, you have a loss, typically shown as a number in parentheses. For example (£1,000) is a loss of £1,000.
Income statement example
Let’s now look at Sarah’s income statement for the same period as above.
- Revenue = £100,000
- Operating Costs = (£50,000)
- Interest on Debt = (£7,000)
- Taxes = (£15,000)
- Profit = £28,000
Sarah’s business made a total profit of £28,000 over this three-month period.
The cash flow statement
Sixty per cent of small business owners say that cash flow has been a problem during the last 12 months [1]. By tracking your cash flow, you may be able to catch and react to potential issues earlier.
The cash flow statement is similar to the income statement, except it tracks your cash rather than profits. “Cash flow statements are vitally important to all organisations, but particularly small businesses where resources are often more limited,” says financial advisor and author of The Finance Playbook For Entrepreneurs, Asif Ahmed.
A statement of cash flow explores retrospectively how a business's cash balance has moved from one period to the next, and what has caused that movement. Inflows and outflows can be split out to give insight into how much cash has been received from customers, how much has been spent on investment activities, or received as loans or spent servicing debt.
Cash-flow statement example
It can be helpful to break your cash flow into three categories:
- Operating: Cash flow from the day-to-day management of your business.
- Investing: Cash flow from buying or selling long-term business assets, like equipment or real estate.
- Financing: Cash flow from lenders and investors.
Let’s look at Sarah’s cash flow statement for the same three-month period:
- Operating cash inflow = £75,000
- Operating cash outflow = (£50,000)
- Investment cash inflow = £0
- Investment cash outflow = (£10,000)
- Financing cash inflow = £0
- Financing cash outflow = (£20,000)
- Net cash flow = (£5,000)
Above you can see that, despite earning a £28,000 profit, Sarah’s business is actually at a net loss of £5,000 in cash flow. This exercise underscores the need to track the actual cash that is going in and out of your accounts each month.
The statement of retained earnings
Retained earnings are profits held by a company in order to pay off debts or invest in future projects, rather than distribute as dividends to shareholders. The statement of retained earnings details changes in the volume of retained earnings over a period of time. It is a good way to improve market and investor confidence in the business as it is a reliable reflection of the health of a business.
The statement of retained earnings is calculated by taking the balance of retained earnings from the previous period, then adding or subtracting the net income or loss. The last step is to subtract any dividends paid, if relevant.
Statement of retained earnings example
Let's have a look at an example statement for Sarah's business:
- Retained earnings from previous period = £10,000
- Net income = £28,000
- Dividends paid = (£5,000)
- Retained earnings = £33,000
How to create your own financial statements
There are a few options for creating your statements, depending on how complicated your finances are. Smaller businesses may choose to build them using spreadsheets. There are many useful free templates online to help you get started, including from the Corporate Finance Institute [2].
Accounting software is also an option. There are a number of programmes that not only make it easier to store and track your data, but also offer functions such as linking to your business checking account for automatic updates based on your transactions. For more help, you might consider hiring an accountant.
“A good accountant will not only produce end-of-year returns and reports, they will keep you up to date more regularly,” says Whitman.
“Annual returns can be filed so long after the year end that they're usually not particularly helpful for in-year decision making. Your accountant can help you set financial goals and ensure you have timely data to make business decisions as and when they come up.”
Whichever approach you use, aim to review your statements regularly. This applies even if you hire a professional to build them for you. You can use them to track performance and also plan for the future by forecasting potential opportunities and problems, like an upcoming cash-flow crunch.
Sources
[1] QuickBooks, Small business payments and cash flow in 2021 (Page 5)
[2] CFI, Financial Projection Template
