Understanding Financial Statements: The Balance Sheet, Income Statement and Cash Flow Statement (2024)

Not every small business owner comes to the role armed with financial expertise. If spreadsheets are not your strong suit, you may use a tool like QuickBooks to help, or delegate balancing the books to an accountant or bookkeeper. But whether you take the DIY approach or hand off accounting duties, a firm grasp on the fundamentals of financial statements is essential to success. Here is a closer look at what financial statements are, why they matter, and what they can help you do.

What Is a Financial Statement?

Financial statements are financial reports you can use to monitor your business’s finances and assess its financial health. Lenders and investors will want to see your business’s financial statements before making a decision about giving you a loan or investing in your company. But even if you aren’t seeking outside financing, financial statements are essential tools to help you stay on top of your business’s finances, plan for the future, and spot potential problems.

There are three financial statements that work together to create a complete picture of your business’s finances: the income statement, balance sheet, and cash flow statement. Here is a closer look at each.

1. Balance Sheet

Your balance sheet is a snapshot of your business’s assets and liabilities at a specific point in time, such as the end of the month, quarter, or year.

A balance sheet lists the following:

  • Current assets (such as cash, accounts receivable, and inventory)
  • Long-term assets (such as savings or investments you don’t plan to use or convert to cash for at least one year)
  • Fixed assets (such as equipment, buildings, or vehicles you don’t plan to sell)

The balance sheet also lists:

  • Current liabilities (debts due within 12 months, such as accounts payable, loan payments, and taxes)
  • Long-term liabilities (debts due more than 12 months from now)
  • Subtracting your assets from your liabilities will show your owner’s equity or net worth. This reflects the percentage of ownership you have in the company or the profit you’d earn if you sold the business’s assets and paid off its liabilities.

A balance sheet provides a snapshot of your business’s overall financial health. Investors and lenders typically require a balance sheet to help them assess your business’s net worth.

View a balance sheet template.

2. Income Statement

Also known as a profit and loss statement (P&L), the income statement records a business’s income and expenses over a specific reporting period, typically a month, quarter, or year.

There are two main parts to an income statement: revenues and expenses.

  • Revenues indicate how much your business earned over the period shown.
  • Expenses indicate how much you spent to run your business over the period shown.

Subtract your expenses from your revenues to get your net operating income.

For a simple, one-person business, this could be all you need to include. However, you can also get a more detailed picture of how your business is doing by incorporating more information into your income statement. For example, you can:

  • Divide revenues into two parts: operating income (earned from sales of your product or service) and other income (earned from other activities, such as selling a piece of equipment)
  • Include your cost of goods sold (COGS), or the costs associated with producing and selling your product or services. Subtracting COGS from your revenues shows your gross margin (or gross profit)
  • Include depreciation of fixed assets. Subtracting depreciation from your net operating income will show your taxable income.

Your income statement can help you spot changes in costs, revenues, and profitability so you can make informed business decisions. For instance, you may think your business is doing well because your revenues are rising. However, if your income statement reveals that expenses are growing faster than revenues, you can steer your business back to its previous profit margins by reducing expenses, raising prices, or both.

View an income statement template.

3. Cash Flow Statement

A cash flow statement shows how much cash goes into and comes out of your business over a specific period. Most small business accounting software can automatically generate a cash flow statement at the end of each month using the data you’ve input.

The cash flow statement lists:

  • Cash received (often categorized into cash from operations, investments, and financing)
  • Cash paid out (for expenses such as payroll, loan payments, rent, inventory, and taxes)

Subtracting your cash paid out from your cash received will show you the amount of cash you have at the end of the statement period.

Running out of cash is the biggest reason small businesses fail. Consistently monitoring your cash flow can help ensure you always have enough cash on hand to pay your rent, employees, taxes, and other financial obligations.

In addition to a cash flow statement, you should also create a 12-month cash flow projection, which forecasts your cash income and outgo and helps you plan for the future. Comparing your cash flow projections to your actual statement of cash flows at the end of each month will help you spot trends so you can better manage your cash flow. For instance, you can accelerate cash inflows by invoicing promptly, and delay cash outflows by asking your suppliers for 60- or 90-day payment terms.

View a cash flow statement template.

3 Financial Statements, One Goal

Your business’s balance sheet, income statement, and cash flow statement work together to provide a 360-degree view of your business’s financial position. From the nitty-gritty of your monthly cash flows to the big picture of your net worth, financial statements can reveal all you need to know to manage your business’s finances wisely and steer your company toward success.

I am a financial expert with extensive knowledge and practical experience in the field. Over the years, I have not only gained a deep understanding of financial principles but have also applied them in real-world scenarios, helping businesses navigate complex financial landscapes. My expertise extends to various aspects of financial management, including the creation and interpretation of financial statements.

In the provided article, the importance of financial statements for small business owners is highlighted, and I can certainly attest to the crucial role these statements play in assessing a company's financial health. Let me break down the key concepts mentioned in the article:

Financial Statements Overview:

1. Financial Statements:

  • Definition: Financial statements are reports that provide insight into a business's financial status and performance.
  • Significance: Lenders and investors use these statements to make informed decisions about providing loans or investing in a company.

2. Importance of Financial Statements:

  • Monitoring Finances: Financial statements help business owners monitor their finances.
  • Planning for the Future: They aid in planning for the future and identifying potential problems.

3. Types of Financial Statements:

  • a. Balance Sheet:

    • Definition: A snapshot of a business's assets and liabilities at a specific point in time.
    • Components: Current assets, long-term assets, fixed assets, current liabilities, and long-term liabilities.
    • Calculation: Owner's equity or net worth is calculated by subtracting liabilities from assets.
    • Purpose: Provides an overview of the business's overall financial health.
  • b. Income Statement (Profit and Loss Statement):

    • Definition: Records a business's income and expenses over a specific period.
    • Components: Revenues (income) and expenses.
    • Calculation: Net operating income is obtained by subtracting expenses from revenues.
    • Detailed Analysis: Can include operating income, other income, cost of goods sold (COGS), and depreciation.
    • Purpose: Helps in assessing changes in costs, revenues, and profitability.
  • c. Cash Flow Statement:

    • Definition: Shows cash inflows and outflows over a specific period.
    • Components: Cash received and cash paid out, categorized into operations, investments, and financing.
    • Calculation: Ending cash balance is determined by subtracting cash paid out from cash received.
    • Importance: Critical for avoiding cash shortages, a common reason for business failures.

4. Monitoring and Planning:

  • Cash Flow Projection: In addition to the cash flow statement, a 12-month cash flow projection helps in planning for the future.
  • Trend Analysis: Regularly comparing projections with actual statements aids in identifying trends and managing cash flow effectively.

5. Integrated Insight:

  • Holistic View: The balance sheet, income statement, and cash flow statement collectively offer a comprehensive understanding of a business's financial position.
  • Management Tool: Used wisely, financial statements guide informed decision-making, contributing to the success of a business.

In conclusion, a solid understanding of financial statements is imperative for small business owners, whether they choose a do-it-yourself approach or delegate accounting tasks. These statements serve as indispensable tools for managing finances, planning strategically, and ensuring the long-term success of a business.

Understanding Financial Statements: The Balance Sheet, Income Statement and Cash Flow Statement (2024)
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