Financial Statements 101: The Beginner’s Guide to Financial Reporting

Financial statements are written records containing information that provides insight into a company’s financial position and performance. In this article, we are going to take a look at the different types of financial statements, as well as how to prepare and interpret these documents.

Highlights/ Key Takeaways

• Financial statements are written records of a company’s financial health and overall business performance.
• The three main types of financial statements are the balance sheet, the cash flow statement, and the income statement. 
• Each type of financial statement contains different information, and reviewing all of them is necessary to obtain a full picture of a company’s financial situation.
• Publicly traded companies are required to disclose their financial statements to the general public.

Importance of Financial Statements

If you are wondering what is a financial statement, you should know that financial statements are written records prepared by companies that outline business activities and associated financial performance. Creditors, investors, and business owners review this financial data to analyze a company’s performance and estimate its earnings potential and future changes in its stock price.

How Do Creditors Use Financial Statements?

Financial statements of a company provide creditors with a comprehensive overview of the financial health of a business. They outline details like existing debt obligations, income, expenses, profit, and cash flow, - all of which can be used to determine the financial risk associated with extending debt to the business in question.

Varios ratios, such as Debt-to-Equity, Current Ratio, and Gross Profit Margin are used by creditors to help them in making a decision on whether to approve a business loan application and what rates and terms to offer.

How Do Investors Use Financial Statements?

Similarly, investors use statements of financial position to evaluate the financial viability of a company by reviewing its revenue, profit, debt, and expenses. Evaluating the same company metrics for different time periods can help to predict whether a company’s stock price will rise in the future, and, therefore, whether a company will make a good investment.

Experienced investors also compare a company’s financial statements with statements belonging to other companies within the same industry. The comparison can tell how well the company is performing against its competitors and peers. This, in turn, can help investors make informed investment decisions.

How Do Business Owners Use Financial Statements?

Business owners frequently analyze their company’s financial statements to get an insight into its overall financial health, performance, operations, and cash flow. This information helps them to understand their bottom lines, determine areas of weaknesses, and make smarter business decisions.

In addition, business owners must prepare accurate financial statements to ensure that tax authorities can easily asses their income and verify the accuracy of your tax returns.

The Three Types of Financial Statements

The three main types of financial statements are the balance sheet, the cash flow statement, and the income statement. Let us take a closer look at what each of these represents.

The Balance Sheet

The balance sheet is a type of financial statement that outlines a company’s assets, liabilities, and equity at a certain moment. In simple terms, the balance sheet is a snapshot of the amounts owned and owed by the company, as well as the amount invested by shareholders in that company.

Information Included

The three main components of a balance sheet are a company’s liabilities, assets, and shareholders’ equity. 

• Asset is a resource with monetary value that a corporation, an individual, or a country owns. Companies report their assets on the balance sheet as either current, fixed, financial, or intangible assets.
• Liabilities are debts that a person or a company owes to other parties. Some examples of business liabilities include credit card balances, accounts payable, payroll taxes, business loans, and more.
• Equity describes the value of the shareholders’ investment in the company. It can be calculated as the company’s assets minus its liabilities.

The basic equation underlying the balance sheet is:

Assets = Liabilities + Shareholders’ Equity

The formula indicates that in order for a company to pay for all of its assets, it must either borrow money (take on liabilities) or use the money invested into the company by shareholders (issue equity).

Balance Sheet Example

Let us take a look at a basic financial statement example:

Balance Sheet

Company ABC

As of December 31, 2022

Suppose Company ABC takes out a $5,000 loan from a bank, with a five-year term. This will increase ABC’s Assets (specifically, the Cash account) by $5,000. At the same time, ABC’s liabilities will increase by $5,000, keeping both sides of the equation balanced.

If Company ABC generates $6,000 by issuing shareholders’ equity, this will also lead to an increase on both sides of the equation: while the Equity value on the right side will rise by $6,000, so will the Assets value on the left.

If ABC generates revenues in excess of its expenses, they will appear on the Assets side as investments, cash, inventory, or other types of assets. The Shareholders’ Equity account on the right side will increase accordingly.

How It Is Used

The balance sheet helps to determine the level of financial risk and provides an important overview of a company’s ability to cover its operating expenses, including debt repayments and distributions. 

The balance sheet compiles how much a company owes and how much money it has borrowed within the same document. This makes it easy for financial analysts to quickly determine the company’s leverage and liquidity levels with simple financial ratios.

The Cash Flow Statement

The cash flow statement (CFS) is another type of financial statement, which outlines the movement of cash and cash equivalents (CCE) into and out of the company over a certain period of time. The cash flow statement is used in conjunction with the balance sheet and the income statement to get a full picture of a company’s financial performance.

Information Included

The main parts of the cash flow statement are:

• Cash flows from operations. Cash flows from operating activities on the CFS include any uses or sources of cash related to business activities. Simply speaking, these represent how much cash was spent and generated from delivering a company’s products or services. Some examples of cash flows from operations include interest payments, income tax payments, employee salaries, and more.
• Cash flows from investments. This type of cash flow outlines any uses and sources of cash related to purchases or sales of assets, payments related to mergers and acquisitions, and loans received from customers or made to vendors. In short, this part of the CFS outlines changes in cash associated with assets, equipment, and investments.
• Cash flows from financing. Cash flow from financing activities includes the cash paid out to shareholders along with the cash received from investors and banks. This includes payments for stock repurchases, dividends, and repayment of loan principal made by the company.

Cash Flow Statement Example

Here is an example of a basic cash flow statement:

Cash Flow Statement

Margaret’s Hair Salon

Month Ended January 31, 2023

How It Is Used

The cash flow statement is used to give an overview of the amounts of cash flowing in and out of a company during a specific time period. This cash flow can indicate the level of risk to potential investors, corporate management, and financial analysts.

• Positive cash flow demonstrates that a company’s liquid assets are growing, and the company is able to cover its debt obligations, reinvest in its business, pay expenses, and return money to stakeholders.
• Negative cash flow means that cash outflows exceed cash inflows. This can indicate that a company is not able to cover its expenses from sales alone and requires additional money from financing and investing. While negative cash flow may be acceptable for some time, it is not sustainable in the long run and indicates the risk of potential insolvency.

The Income Statement

The income statement, also known as the profit-and-loss (P&L) statement is the third main financial statement used to report a company’s financial performance over a certain period of time. The P&L statement summarizes the cumulative effect of a company’s gains, revenues, expenses, and losses over the reporting period. This summary is often shared as part of annual or quarterly reports.

Information Included

The income statement typically begins with the sales details and works down to calculate Net Income and Earnings Per Share. In a nutshell, it demonstrates how net revenue earned by the company is transformed into net earnings.

The P&L statement typically includes the following information:

• Revenue and Gains: how much money a business receives
• Expenses and Losses: how much money a business spends
• Costs of Goods Sold (COGS): costs associated with making the products sold as part of the business operations
• Gross Profit: total revenue minus the Costs of Goods Sold
• Operating Income: gross profit less operating expenses
• Income before Taxes: income operating income less non-operating expenses
• Net Income: income before taxes minus tax expenses
• Earnings per Share (EPS): net income divided by the total number of outstanding shares
• Depreciation: the loss in the value of fixed assets over time
• EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization

Mathematically, the income statement follows this equation:

Net Income = (Revenue + Gains) - (Expenses + Losses)

Income Statement Example

Below is an example of a standard income statement.

Income Statement

Company ABC

Year Ended December 31, 2022

Here, Company ABC’s total Revenue and Gains are calculated by adding the money received from sales and investment income. The Expenses and Losses value can be found by adding the money spent to cover the Cost of Sales, interest payments, loss on sale of equipment, and other types of expenses.

Finally, Net Income is calculated by subtracting the Expenses and Losses value from the Revenue and Gains value.

How It Is Used

The income statement provides the financial information necessary to determine a company’s profitability. It is a key document for managing business operations and working with investors, bankers, and other partners.

Below are a few examples of how the income statement can be used.

• Financial planning. Analyzing income statements is an important part of strategic planning, financial forecasts, and business budgeting. Quarterly or annual income statements can demonstrate how a company is performing and help to identify problem areas for efficient business planning.
• Business health analysis. Investors, lenders, and potential business partners may review a company’s income statements to understand the company’s position and financial health.
• Tax filings. Income statements are also used to assess annual tax filings.

Income Statement vs. Balance Sheet vs. Cash Flow Statement

While the three financial statements work in conjunction to describe the financial position of a company, there are a few differences between an income statement, a cash flow statement, and a balance sheet.

Let us take a closer look at the differences between the three financial statements.

Financial Statement Purpose

Each of the three main financial statements in accounting serves a specific purpose, - only combined, do they provide a comprehensive picture of a company’s financial health.

• An income statement determines how much money a business is making or losing during a certain period of time.
• A balance sheet displays a business’s financial position in regard to the volume of assets and liabilities it has.
• A cash flow statement tracks the movement of cash in and out of a business.

The main difference between an income statement vs. a cash flow statement is that the income statement, along with the balance sheet, will contain the information necessary to generate a cash flow statement.

What the Statement Measures

An income statement, a balance sheet, and a cash flow statement all measure similar areas of a company’s finances. However, there are a few subtle differences:

• An income statement measures a company’s revenue and expenses. From there, the profit or loss of the company can be calculated.
• A balance sheet measures a company’s liabilities and shareholders’ equity. The assets can be determined by subtracting the liabilities from the equity.
• A cash flow statement measures all cash movements in and out of a company. This information is used to identify how much the company spends on operating, investing, and financing activities.

Type of Items Included

All elements of financial statements can be classified as either cash (a company receives or gives cash) or non-cash (revenues or expenses that don’t involve cash transactions).

• An income statement uses both cash and non-cash items in calculations.
• A balance sheet also lists both cash and non-cash items.
• A cash flow statement deals with exclusively cash transactions and does not include non-cash items.

Preparing Financial Statements

Income statements, balance sheets, and cash flow statements are typically released on a quarterly or annual basis. These documents must be prepared in accordance with GAAP guidelines, or Generally Accepted Accounting Principles, - important rules that help to standardize financial reporting.

The four basic constraints that must be followed in accordance with GAAP include:

• Objectivity. The financial statements must include verifiable information and must be reviewed by an independent auditor.
• Materiality. The information included in the statements must be complete and carry value to outside parties.
• Consistency. Organizations must use the same accounting methods for every reporting period.
• Prudence. Accountants and auditors must use methods that minimize the possibility of overstating either income or assets.

Once a company’s management team prepares the financial statements, they must be reviewed by an independent auditor to ensure the accuracy and reliability of the information, as well as its compliance with GAAP guidelines.

Financial Statements and Financial Modeling

The information obtained from the three main types of financial statements can be effectively used in financial modeling. For example, a Three Statement Model is often used to link the income statement, the balance sheet, and the cash flow statement into a single dynamic financial model.

The model enables financial analysts to forecast a company’s future financial statements. Such forecasts are necessary to visualize how a company’s investing, operating, and financing decisions interact to affect the bottom line in the future. The model also allows visualizing how various activities of a firm work together and how it will perform under a range of different assumptions.

Understanding Financial Statements

To fully understand a company’s financial position, one must review and analyze its balance sheets, income statements, and cash flow statements in conjunction. Only when combined, the information from the three main financial statements can provide a full picture of a company’s overall financial health.

Financial statements are commonly used by company leadership, existing and potential investors, market analysts, lenders, and a company’s customers.

How to Read Financial Statements

When reading financial statements, it’s a good idea to refer to a company’s Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) for a company’s explanation of its financial performance. The MD&A is part of a public company’s 10-K, a report filed with the U.S. Securities and Exchange Commission (SEC).  

When trying to interpret the numbers yourself, it is important to understand what information to look for with each type of statement.

How to Read a Balance Sheet

When reviewing a balance sheet, find the most important information first: details on how a company is financed and the resources it has at its disposal. The balance sheet also contains the values necessary to evaluate a company’s capital structure and compute rates of return.

Note that alone, the balance sheet won’t provide information on a company’s trends, so you would still need to review cash flow and income statements to get a full picture of a company’s financial position.

How to Read a Cash Flow Statement

A cash flow statement will visualize what type of operations generate cash for a company. Based on how much cash is flowing into and out of the company during the accounting period, you will be able to evaluate a firm’s ability to operate in the short- and long term.

When reading a cash flow statement, keep in mind that cash flow is not exactly the same as profit. Profit refers to the amounts that remain with the company after all of a company’s expenses have been deducted from total revenues. Cash flow, on the other hand, simply refers to the cash amounts going in and out of the company.

How to Read an Income Statement

An income statement is often included in quarterly or annual reports and can be used to observe financial trends, review business activities related to revenues and expenses, and conduct comparisons over set periods to evaluate a company’s profitability.

A standard income statement will start with a Total Revenue value at the top, or the total amount of money a business takes in during a time period in question. The statement will then work down to calculate a company’s Net Income and Earnings per Share.

What Kinds of Companies Must Prepare Financial Statements?

All public companies in the United States are regulated by the Securities and Exchange Commission and are obligated to follow federal securities regulations that dictate when and how often they must issue financial statements. 

As such, all public companies are required to disclose financial statements as part of their quarterly reports. This provides important information to external stakeholders, such as a company’s investors, customers, and lenders.

Private companies, on the other hand, are not required to prepare and disclose financial statements.

What Kind of Tax Information Appears in Financial Statements?

Tax information must be included in all three types of financial statements, listed as expenses and liabilities. Different types of taxes are included in different financial documents:

• The balance sheet includes deferred income tax liabilities under Long-Term Liabilities. It also lists use tax and sale tax under Current Liabilities.
• The cash flow statement includes tax expenses under the Taxes Payable section. This includes both long-term and short-term tax liabilities.
• The balance sheet also indirectly outlines tax-related expenses. The statement will include pre-tax income and net income, which is obtained by subtracting tax payments from pre-tax income.

What Are the Limitations of Financial Statements?

Without a doubt, the three financial statements are valuable tools in evaluating the financial health of a company. However, reviewing the components of financial statements is not enough to find out everything about a company.

Some financial statement limitations include:

• A company’s intangible assets are not included on the balance sheet.
• The assets and liabilities on the balance sheet are not adjusted for inflation.
• All the transactions are recorded in historical costs. This means that the financial statements do not provide the current value of assets and liabilities.
• The financial statements are subject to fraud, meaning that the numbers and information could be misrepresented.
• Financial statements do not include non-financial factors, such as social, environment, and governance concerns related to a company’s operations.
• Financial statements are based on a specific time period, which makes them subject to seasonal fluctuations.

Final Word

Financial statements provide key details for understanding a company’s financial health. The balance sheet depicts a company’s liabilities, assets, and equity; the income statement details revenues and expenses; while the cash flow statement lists all the cash going in or out of the company. All of this information is essential to form a complete and well-rounded understanding of a company’s financial performance.