Even though it’s not the most glamorous aspect of owning a small business, regularly reviewing your company’s financial data is essential to its success. You may identify your company’s financial situation at a certain point in time and throughout a specific period of time by keeping accurate financial accounts.

The creation of your company’s financial statement involves the usage of data from both your general ledger and accounting journal. Your financial statements are made up of an income statement, a statement of retained earnings, a balance sheet, and a statement of cash flows. Additionally, the prior statement’s data is used to create the following one.

Income Statement

The income statement, also known as a profit and loss statement, is important because it shows the overall profitability of your company for the time period in question. Information on sales revenue and expenses from both your accounting journals and the general ledger are used to prepare the income statement. It shows revenue from primary income sources, such as sales of the company’s products, and secondary sources, like if the company sublets a portion of its business premises.

The income statement also shows the business’s expenses for the time period, including its primary expenses, expenses from secondary activities, and, finally, losses from any activity, including current depreciation. One thing to note about the depreciation shown on the income statement is that it only accounts for depreciation over the time period in question, not the total depreciation of an item from the time the asset was acquired.  

The bottom line of the income statement is net income or profit. Net income is either retained by the firm for growth or paid out as dividends to the firm’s owners and investors, depending on the company’s dividend policy. 

Statement of Retained Earnings

The statement of retained earnings is the second financial statement you must prepare in the accounting cycle. Net profit or loss must be calculated before the statement of retained earnings can be prepared.

After you arrive at your profit or loss figure from the income statement, you can prepare this statement to see what your total retained earnings are to date and how much you’ll pay out to your investors in dividends, if any. This statement shows the distribution of profits that are retained by the company and which are distributed as dividends. 

As the name suggests, the amount of retained earnings is the profit retained by the firm for growth, as distinguished from earnings that are distributed to shareholders as dividends or to other investors as the distributed share of profits.   

Balance Sheet

No financial statement would be possible without the balance sheet. The balance sheet is the financial statement that tracks the firm’s financial position at a given point in time, typically the last day of the accounting cycle. It’s a statement showing what your business owns (assets) and what it owes (liabilities). Your assets must equal your liabilities plus your equity or owner’s investment. You have used your liabilities and equity to purchase your assets. The balance sheet shows your firm’s financial position with regard to assets and liabilities/equity at a set point in time. 

Entries on a balance sheet come from the general ledger, and the format mirrors the accounting equation. Assets, liabilities, and owners’ equity on the last day of the accounting cycle are stated.  

A note about depreciation: In contrast to the depreciation shown on the income statement, the depreciation shown on the balance sheet — which is a snapshot of the company at the end of the accounting cycle — is the total accumulated depreciation from the day the item was acquired to the present. 

Statement of Cash Flows

Even if your company is turning a profit, it may be falling short because you don’t have adequate cash flow. The cash flow statement compares two time periods of financial data and shows how cash has changed in the revenue, expense, asset, liability, and equity accounts during these time periods. 

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The statement of cash flows must be prepared last because it takes information from all three previously prepared financial statements. The statement divides the cash flows into operating cash flows, investment cash flows, and financing cash flows. The final result is the net change in cash flows for a particular time period and gives the owner a very comprehensive picture of the cash position of the firm. 

The statement of cash flows shows the firm’s financial position on a cash basis rather than an accrual basis. The cash basis provides a record of revenue actually received, from the firm’s customers in most cases. The accrual basis shows and records the revenue when it was earned. If a firm has extended billing terms, such as 30 days net, 60 days 1 percent, these two methods can produce substantially different results.

Financial statements provide investors with information about a company’s financial position, helping to ensure corporate transparency and accountability. Understanding how to interpret key financial reports, such as a balance sheet and cash flow statement, helps investors assess a company’s financial health before making an investment. Investors can also use information disclosed in the financial statements to calculate ratios for making comparisons against previous periods and competitors.

Investors should start by learning how to interpret key figures on a company’s balance sheet, income statement, and statement of cash flows. Those wanting to dig a little deeper may want to consider learning how to analyze reports, such as shareholder’s equity and retained earnings. Investors can find a publicly traded company’s financial statements in its annual report or a 10-K filed with the SEC.

Financial statements only provide a snapshot of a company’s financial situation at a specific point in time. They also don’t consider non-financial information, such as the health of the broader economy, and other factors, such as income inequality or environmental sustainability. Forward-looking financial statements rely on estimates and assumptions, which may not always be accurate and are subject to change.

Conclusion

Understanding the basics of financial statements provides investors with valuable information about a company’s financial health. Investors can use key reports, such as a balance sheet, cash flow statement, and income statement, to evaluate a company’s performance, helping to make more informed investment decisions.

However, it’s also important to understand the limitations of overly relying on financial statements and consider other metrics, such as the impact of non-financial information, when analyzing a company’s overall financial position. Financial statements play a vital role in maintaining the integrity of the financial system and promoting trust between companies and investors.