Financial Statements – A Step-By-Step Guide

Financial statements are formal documents that offer a snapshot of your company’s finances at a point in time. They detail what your business owns (assets), owes (liabilities), and shares owned by shareholders.

This book helps non-financial managers, investors, students, lawyers, lenders, and entrepreneurs understand how to prepare precise financial statements using straightforward transaction examples.

1. Income Statement

Financial statements are the backbone of a business, providing valuable information about past performance and guiding future projections and decisions. They also play a key role in securing funding, as investors and banks carefully review these documents before committing any resources. There are three main types of financial statements: the balance sheet, the income statement, and the cash flow statement. Each serves a different purpose and delivers unique insights into your company’s financial health.

The income statement (also known as a P&L sheet) gives you a clear picture of your company’s profitability over a specific period. It combines all sources of revenue with corresponding operating expenses to reveal your net income or loss.

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To prepare an income statement, start by adding up all the total sales revenue for the reporting period. Then subtract returns, discounts, and other allowances to find your net sales figure. Next, add up all the costs of goods sold (COGS) for the period, which reflects the raw materials and labor necessary to produce your products. Finally, add up all the other operating expenses, such as wages, rent payments, utilities, and depreciation, to arrive at a total expense figure. Then subtract your total expenses from your total sales to find your gross profit.

This figure is an important one to consider, as it represents the portion of your sales revenue that is profit. It is often the largest line item on an income statement, so it’s critical to ensure that it’s accurate and detailed.

Once you’ve calculated your gross profit, you can deduct the applicable taxes from this amount to arrive at your final net income figure. This is the amount that you will be able to reinvest in your business or use to pay off debt. Similarly, you can calculate your company’s losses by subtracting nonoperating revenues and expenses from your net income. These might include investment income, interest income, and gains on asset sales, for example. These figures are essential to keep in mind when comparing your results to the competition’s. They can provide insight into whether your company’s costs are competitive and help identify areas for improvement.

2. Balance Sheet

A balance sheet offers a snapshot of a company’s assets, liabilities, and owner’s equity at a given point in time. It’s based on the accounting equation: Assets = Liabilities + Equity.

A company’s balance sheet is an essential document for several reasons. It helps a company assess its financial health, and it serves as a tool for evaluating the risk of investing in a business. It’s also necessary when applying for loans and credit, and lenders and investors often request it.

The balance sheet lists all of a company’s assets – including cash and other liquid investments, inventories, accounts receivable, and long-term investments such as property and equipment – as well as its debts and financial obligations. Generally, the assets are listed with the most liquid elements at the top, and the least liquid elements appear toward the bottom of the list. A comparative two-year balance sheet will also typically show the amounts of these assets as they were at the end of the previous reporting period, so that a company can see the changes from one period to the next.

In the liabilities section, a company lists all of its short-term debts and other financial obligations that need to be paid within a year or less with cash, such as accounts payable and credit card balances. It also lists any long-term debts and financial obligations that need to be paid with non-cash resources, such as a mortgage. Finally, the owners’ equity section shows a company’s net worth and retained earnings, which is the amount of money left over after all expenses are paid and all assets have been liquidated.

Because of the many ways in which a company can game its figures, it’s essential to carefully review and validate each item listed on a company’s balance sheet. This includes checking for things like double-counting of assets, incorrectly recorded transactions, inaccurate inventory numbers, and the use of different accounting systems for depreciation and amortization. It’s also essential to ensure that the total of all assets and liabilities in the assets section equals the sum of all items in the liabilities and owners’ equity sections.

3. Cash Flow Statement

The cash flow statement provides a detailed picture of the company’s cash inflows and outflows during an accounting period. It shows whether the company has enough cash to pay its expenses and debts. It is one of the primary statements used by lending organizations to review an application for a loan or credit card. It is also a crucial report for business owners, entrepreneurs, and investors.

The statement begins with the net income from the income statement and then adjusts for non-cash activities. For example, depreciation is a cost that does not involve cash but must be recorded to make the income statement accurate. Once all of the non-cash activities are removed, the actual cash inflows and outflows are recorded in three categories based on the way that they came about: operating, investing, and financing.

Operating activities show the cash that comes in from running the business, such as product sales and customer payments. Investing activities record the money that is invested in long-term assets, such as property, plant, and equipment. Finally, the financing activity section records all cash transactions that involve raising capital or paying back capital, such as issuing and selling stock, cash dividends, and taking out or repaying loans.

Financial statements can be a bit intimidating for newbies, but with practice, they become easier to interpret. Learning the language of these primary documents is essential for all working professionals and aspiring entrepreneurs, managers, and investors. By understanding the information these reports contain, investors can identify and mitigate risks, while businesses can make more strategic decisions that help them grow.

Financial statements offer a window into the health of a business that is often obscured by technical terms and complex formulas. By developing an ability to read and interpret these key documents, everyone from the average investor to the accountant can gain a clearer view of the financial landscape. Just as a CPR course teaches you the basics of performing cardiopulmonary resuscitation, this guide will give you the confidence to tackle the language of financial statements.

4. Statement of Retained Earnings

Financial statements provide insight into the company’s health but require a high level of expertise to interpret. Finance professionals need to be able to understand these documents so they can turn data into strategic insights for their stakeholders. For example, understanding a retained earnings statement can help you decide how much to invest in growth and how to balance those investments with shareholder returns.

A retained earnings statement offers a reconciliation of activity in the company’s accumulated reserve and retained earnings account, which is part of the equity section of the balance sheet. The statement also shows how the company has either increased or decreased its retained earnings between accounting periods. It includes information such as profit or loss, share issue or redemption, dividends paid, and other items charged to – or credited from – accumulated other comprehensive income.

The retained earnings statement is usually a standalone document, but can be appended to the bottom of other financial statements, such as the income statement and cash flow statement. Start with the beginning retained earnings figure from the previous period, which is found in the equity section of your balance sheet. Next, pull the current period’s net income from your income statement (revenue minus expenses). Finally, subtract any cash and stock dividends distributed to shareholders and any owner draws that reduce profits and company assets.

This is the sum of all of your company’s accumulated profits and reserves up to the current period. Your business can use this money for a variety of purposes, including investing in new equipment and technology, paying down debt, or distributing to shareholders. The more your business has in reserve, the more secure it is, which gives investors confidence that it’s worth investing in.

The ability to read and interpret financial statements is a crucial skill for any aspiring investor, entrepreneur, or business professional. Whether you’re an accountant or not, learning how to read financial statements will help you make more informed decisions and better understand your business’s health and potential. For more on turning financial statements into strategic insights, request a demo of Abacum’s FP&A platform to see how our unified workspace connects your financial statement data with operational metrics for a more holistic view of business performance. https://www.youtube.com/embed/eorpdJUWfTA