The Four Key Financial Statements Business Owners Should Understand
March 14, 2017
Making Sense of Four Key Financial Statements
Financial statements aren’t just for accountants. All business owners and executives should have a basic understanding of what information certain financial statements contain and why they are important to your business.As the Securities and Exchange Commission (SEC) states in its “Beginners’ Guide to Financial Statement” publication, “If you can read a nutrition label or a baseball box score, you can learn to read basic financial statements.” While balance sheets and cash flow charts may seem daunting, they can be understood with a bit of knowledge.
Financial Statements 101
While financial statements can take several different forms, the general goal is to provide information about the financial position and performance of a business entity. A wide variety of interested parties, including investors, lenders, creditors, business partners, shareholders, and regulators, use the information provided in your financial statements to make decisions about your company. For instance, a venture capital firm may use the statements to determine whether your company is a worthy investment. Similarly, banks use the information to determine whether a business is credit-worthy.
Understanding the Lingo
To read a financial statement, you must first understand some basic terms. The Financial Accounting Standards Board (FASB) provides the following definitions of several key building blocks of financial statements, among others:
- Assets: probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
- Equity: The residual interest in the assets of an entity that remains after deducting its liabilities. In a business entity, equity is the ownership interest.
- Expenses: Outflows or other uses of assets or incurring of liabilities during a period from delivering or producing goods or rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operation.
- Gains: Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owner.
- Liabilities: Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
- Losses: Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.
- Revenues: Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.
Types of Financial Statements
Below is a brief overview of the four most common types of financial statements:
- Balance Sheet
A balance sheet provides a snapshot of a company’s assets, liabilities, and shareholders’ equity at a certain date, typically the end of the reporting period. The basic premise is that a company’s assets must equal, or “balance,” the sum of its liabilities and shareholders’ equity. Traditionally, companies list their assets on the left side of the balance sheet, while the liabilities and shareholders’ equity are on the right. In other cases, the assets are at the top, followed by liabilities, with shareholders’ equity at the bottom.
- Income Statement
An income statement summarizes a company’s revenues, gains, expenses, and losses. The so-called “bottom line” is the net income or net loss for the specific time frame. To borrow an analogy from the SEC, “think of [income statements] as a set of stairs. You start at the top with the total amount of sales made during the accounting period. Then you go down one step at a time. At each step, you make a deduction for certain costs or other operating expenses associated with earning the revenue. At the bottom of the stairs, after deducting all of the expenses, you learn how much the company actually earned or lost during the accounting period.”
- Cash Flow Statement
A cash flow statement captures a business’s inflows and outflows of cash and shows whether the company has cash on hand. The report is typically divided into three sections: 1. operating activities; 2. investing activities; and 3. financing activities.
- Statement of Changes in Owners’ Equity/Stockholders’ Equity
The report reconciles the start of the period equity of an enterprise with its ending balance. It specifically details changes in a company’s share capital, accumulated reserves, and retained earnings over the reporting period to show changes in the owners’ interest in the businesses from one reporting period to the next.
When reading any financial statement, it is imperative to look at the footnotes. They often contain valuable information, including the accounting policies and practices used to generate the financial information.
Do you have any questions regarding your business’ financial statements? Would you like to discuss the matter further? If so, please contact me, Robert Marsico, at 201-806-3364.