The Main Types of Financial Statements and How They Work

When it comes to running your business and ensuring it reaches its full potential, there are no documents more important than your financial statements. Yet, despite this many business owners approach preparing their financial statements with trepidation – if they prepare them at all. Just as alarmingly, many that actually prepare financial statements have a hard time fully interpreting what the numbers within them mean for their business and how they can use them to propel it to new heights.

However, help is at hand – in this post, we explore the main types of financial statements and the benefits each brings to your business.  

Understanding Financial Statements

Let’s begin with a general overview of the main financial statements, including what they are and why they’re important.

What Is A Financial Statement?

  • A financial statement is a written record that details a company’s operations and financial performance. There are four main financial statements: the income statement, cash flow statement, balance sheet, and statement of changes in equity.

    What Information Is There In A Financial Statement?

    Each of the four main financial statements contains different information collected over a particular reporting period.

    • The income statement  records a company’s revenues and expenses and whether it recorded a profit or a loss
    • The cash flow statement details how a company generates and spends its cash
    • The balance sheet provides an overview of a company’s assets, liabilities, and shareholders’ equity
    • The statement of changes in equity explains the changes in the business owners’ equity based on what they did with the revenue they generated

    Why Are Financial Statements Important?

    Financial statements are important for several reasons. Firstly, for the company’s owners and management, they are crucial for illustrating the performance and financial health of their business. They detail what they’re doing well, and should expand on, and the areas in which they’re lacking or struggling, providing insight into how they should correct course. Put another way, they allow a business’ stakeholders to make better strategic decisions regarding their operations and financing that will ensure the company first survives and then thrives.  

    Secondly, financial statements allow potential investors to analyse a company and decide whether they should invest their capital in it. Similarly, if a company is asking a bank or other financial institution for a loan, its financial statements will be used to determine its ability to repay it, i.e., how creditworthy they are.

    Lastly, keeping accurate financial statements is important for tax planning. They give the business a better idea of their tax liability so they’re not caught off-guard, fail to put enough money aside, and are hit with late fees and penalties. They also enable an accountant to properly prepare the business’ tax returns and ensure its tax bill isn’t higher than it should be. Plus, in the event of an audit, the business can present a complete set of financial records, including financial statements, receipts, and invoices, to make the process go smoothly.

    What Is An Income Statement?

    Let’s look at each financial statement in detail – starting with the income statement.

    What Is An Income Statement?

    Also known as a profit and loss statement, an income statement shows a company’s revenues and expenses ever a period: typically for a month (for internal use), a quarter, or a year. Subsequently, by tallying up all of its income and outgoings, a company can determine whether they’ve made a profit or a loss and gain insight into measures required to increase profitability.

    What Is The Use Of An Income Statement?

    The main use of an income statement is to show a company’s stakeholders, potential investors, accountants, auditors, etc., how much revenue they’ve generated, the expenses they’ve incurred, and, subsequently, their level of profitability. It also helps a company’s owners and management analyse their income and outgoings and devise strategies for maximising profitability.

     On one hand, they can increase their income by changing their pricing structure or by offering additional products and services. On the other, they can work out ways to cut costs and increase efficiency. In most cases, businesses will seek to do both. 

    Because creating an income statement is usually more straightforward than the other financial statements, companies can publish them more frequently, i.e., quarterly or monthly. This gives them a better awareness of how effective their various strategies towards profitability have been and how they should best proceed.  

    The income statement also gives investors an overview of the company before they commit capital, and allows banks and other financial institutions to decide if the business is suitable for a loan.

    What Are The Components Of An Income Statement?

     

    Put simply, the components of an income statement are revenue and expenses. And deducting expenses from revenue will reveal a company’s net income – and whether that reflects a profit or loss for the reporting period. However, income statements include several components that paint a more accurate picture of a company’s performance and financial health.

    Items commonly found in an income statement include:

    Revenue

    This is generally divided into:

    • Operating Revenue: income generated from sales of the company’s products or services, i.e., the business’ core activities
    • Non-Operating Revenue: income generated from outside the business’ core activities, such as:
      • Interest earned from bank accounts
      • Gains from the sale of assets
      • Rental income
      • Royalty payments

    Cost of Goods Sold (COGS): Cost of Goods Sold (COGS) refers to the costs directly involved in selling products to generate revenue.  Alternatively, this may appear as Cost of Sales (COS) if the company provides services as opposed to products. COGS can include labour, raw materials, parts, inventory for resale, and shipping costs.


    Gross Profit: this is calculated by subtracting COGS from revenue

    Expenses

    Expenses, and how they are categorised, depend on the business but can include:

    · Marketing, Advertising, and Promotion Expenses: expenses accrued in increasing awareness of the business within its target market.

    · Sales, General and Administrative (SG&A) Expenses: salaries, rent and office expenses, and, other operational expenses.

    · Other Expenses: this includes fulfilment, technology, research and development (R&D), stock-based compensation, impairment charges, forex costs, and other industry-specific expenses.

     

    Depreciation and Amortisation: When a business acquires an asset, such as machinery, equipment, a vehicle, etc., it should benefit them over time – and not just in the period in which it was acquired. To accurately reflect this, the assets can be expensed each year over their lifespan. This is known as depreciation and amortisation and is used as a tax deduction, reducing the company’s annual tax liability.

    The difference between the two is that depreciation applies to tangible assets while amortisation is used for intangible assets.

    Operating Income (EBIT): Deducting depreciation and amortisation gives you a company’s operating income, or earnings before interest and taxes (EBIT).

    Interest: expenses incurred from interest on loans and other financing

    Income Taxes: the company’s income tax liability

    Net Income: Finally, deducting interest and income taxes from EBIT gives you a business’ net income. If this figure is positive, the business has turned a profit while it being negative indicates it, ultimately, lost money over the reporting period.

    How Does The Income Statement Work?

    The income statement works by keeping a ledger of a business’s income and expenditure and arriving at a final figure that reveals if the company is profitable. In short, all the company’s income (operating and non-operating activities) is added together and then its various expenses (COGS, marketing, SG&A, etc.) are tallied up and subtracted from total revenue. The result of this calculation will be a positive number, indicating a profit, or a negative number, indicating a loss.

    What Is A Cash Flow Statement?

    The second main financial statement is the cash flow statement; let’s look at how it works.

    What Is A Cash Flow Statement?

    The cash flow statement paints a picture of how cash flows through a business: namely, where it comes from and how it’s spent. It details how much cash the business has available (i.e., its liquidity) to fund its operations, pay its debts and expand.

    Why Is a Cash Flow Statement Important?

    The cash flow statement is important for several reasons:

    Improved Knowledge of Cash Balance: whether the company has an excess or deficit of cash. An excess allows for growth opportunities while a deficit requires a cash injection from external sources for the company to stay solvent.

    Crisis Management: projecting a potential cash shortage in the near future allows management to devise ways to help the company overcome the resulting challenges ahead of time – before they evolve into a full-blown crisis.

    Better Insight into Spending Activities: it offers a more detailed view of a company’s expenses than the income statement. For example, if a company is repaying a loan in instalments, that wouldn’t be reflected in the income statement but would be included in the cash flow statement.

    Short-term Planning: helping management project cash flow in the immediate future and keep track of spending to meet short-term objectives.

    Long-term Planning: helping management identify strategic changes for how it uses its cash to facilitate the company’s growth. Also, the activity the company should prioritise to ensure adequate liquidity and revenue generation in the long-term.

     

    How Does The Cash Flow Statement Work?

    There are three main sections within a cash flow statement.

     

    Cash from Operating Activities

    This details how much cash a company generates from its products or services and, in turn, how much it spends on generating that cash.  

    This section starts with the company’s net earnings from the last reporting period (as carried over from the income statement) before adding and subtracting items, including:

    • Receipts from sales of goods and services
    • Salaries
    • Rent payments
    • Interest payments
    • Income tax payments
    • Payments made to suppliers
    • Depreciation and amortisation
    • Other operating expenses

    Cash from Investing Activities

    Cash from investing details all changes in equipment, assets, or investments.

    These include:

    • Purchase or sale of assets
    • Payments related to mergers and acquisitions

    Cash from Financing Activities

    Cash from financing activities includes the sources of cash from investors and banks, as well as the way cash is paid to shareholders.

    These include:

    • Loans taken out
    • Repayment of debt principal (loans)
    • Capital raised from issuing equity (shares) or debt (loans)
    • Dividends
    • Payments for stock repurchases

    Also, it’s crucial to note that there are two methods of calculating cash flow: the direct method and the indirect method.

    The direct method simply adds up all the cash transactions that occur within a business. This includes all cash received from customers and cash paid out to employees, suppliers, etc.

    The indirect method, in contrast, calculates cash flow through adjustments to net income by adding or subtracting differences resulting from non-cash transactions. These non-cash transactions appear in the company’s balance sheet, as changes to assets and liabilities. Consequently, you can identify the increases and decreases to asset and liability accounts that will adjust the net income figure, to identify accurate cash inflows or outflows.

    What Is A Balance Sheet?

    The third, and for many businesses, final, financial statement is the balance sheet. Let’s look at it in detail.  

    What Is A Balance Sheet?

    The balance sheet records a business’ assets, liabilities, and shareholder equity for a specific reporting period. It provides a snapshot of what a company owns, owes, and the amount invested by shareholders. Subsequently, a balance sheet can be used to determine a company’s worth – or “book value”.

    Components of a Balance Sheet

    A balance sheet is composed of two sides, with the left side listing the company’s assets and the right side listing its liabilities and shareholder equity. Let’s look at each component in detail.


    Assets

    This is everything a company owns, listed in order of their liquidity, i.e., how easily they can be converted into cash. They are divided into current assets, which can be converted in a year or less, and non-current, or long-term, assets.

    Current assets include:

    • Cash And Cash Equivalents: the most liquid assets, including cash itself, Australian Government Bonds (AGBs), and short-term certificates of deposit
    • Accounts Receivable(AR): money owed to the business by customers or clients
    • Marketable Securities: equity (shares) and debt securities (bonds) that can be easily sold
    • Prepaid Expenses:costs already accrued in operations, such as rent or insurance
    • Inventory

    Non-current assets include:

    • Long-term Investments: securities that can’t, or won’t, be liquidated within the next year
    • Fixed Assets: also known as Property, Plant, Equipment (PP&E), this includes land, buildings, machinery, and equipment
    • Intangible Assets: non-physical assets such as intellectual property (patents, trademarks, copyrights, etc.) and goodwill (company reputation, brand recognition, customer loyalty, etc.)

    Liabilities

    A liability is an amount that a business owes to external parties. This includes everything from rent and utility bills to invoices from suppliers and wages owed to employees.

    Much like assets, they are divided into current liabilities and non-current, or long-term, liabilities. Current liabilities are due within a year while long-term liabilities are due after a year.

    Current liabilities include:

    • Accounts Payable: debt obligations on invoices related to the company’s operations: usually due within 30 days of receipt
    • Wages Payable: salaries and benefits owed to employees, typically for the most recent pay period
    • Short Term Debt: e.g., loans, used to finance operations
    • Current Portion Of Long-Term Debt: the portion of long-term debt due within the next 12 months
    • Interest Payable: accumulated interest owed on outstanding debts
    • Customer Prepayments: money received by a customer before the product or service has been delivered
    • Dividends Payable: approved dividends that haven’t been paid out yet

    Long-term liabilities include:

    • Long-term Debt: any debts due after a year, such as interest and principal on issued bonds, lease obligations, and other contracts
    • Pension Fund Liability: money that a company is required to pay toward its employees’ pensions
    • Deferred Tax Liability: taxes that won’t be paid for another year

    Shareholder Equity

     

    Shareholder equity is a company’s net worth (or net assets) and represents the amount that would be returned to shareholders if the company was liquidated and paid off its debts.

    Put another way: Shareholder Equity = Total Assets – Total Liabilities.

    Components of shareholder equity include:

    Retained Earnings: the amount a company either reinvests or uses to pay off debt – after it issues dividends.

    Share Capital

    This can be composed of:

    • Common Stocks: shares that have voting rights and variable dividends
    • Preferred Stocks: shares that have no voting rights and fixed dividends. However, holders of preferred stocks will receive their money before investors with common stock if the company goes into liquidation
    • Treasury Stock: stock repurchased by the company, which can be sold later to raise capital or to prevent a hostile takeover
    • Additional Paid-In Capital (Or Capital Surplus): the amount shareholders have invested in the business, in excess of preferred or common stock

    Why Is The Balance Sheet Important?

    Your balance sheet allows management, potential investors, accountants, and auditors, to quickly determine the financial health of a company. As well as offering a lot of insight into its financial condition, a balance sheet also reveals a business’ creditworthiness and the best way to finance its operations

    Furthermore, an accurate and up-to-date balance sheet is required if the owners of a company are looking to raise additional capital or want to sell it and want to determine its value.

    How Does a Balance Sheet Work?

    The balance sheet revolves around the equation below, with assets on one side and liabilities and shareholder equity on the other:

    Assets = Liabilities + Shareholders’ Equity

    This makes sense, as a company has to pay for all the things it owns (assets) by either borrowing money (liabilities) or raising money from investors (shareholder equity). For example, if a company takes out a loan from a bank, its assets will increase. Conversely, as it has to pay the loan back, its liabilities will increase. Similarly, if the company raises capital from investors, its assets will increase – and so will its shareholder equity.

    However, while a balance sheet gives an overview of a company’s financial standing at a given point, it doesn’t reveal trends that play out over time. To get some insight into such trends, you’d need to compare balance sheets from different periods – as well as look at the other financial statements.

    What Is A Statement Of Changes In Equity?

    The final type of financial statement is called the statement of changes in equity; here’s how it works.

    What Is A Statement Of Changes In Equity?

    A statement of changes in equity details how equity has changed within a business for a particular reporting period, which is typically a year. It provides a link between a company’s income statement and balance sheet.

    What Is The Content Of The Statement Of Changes In Equity?

    A statement of changes in equity will typically include:

    • Net profit/loss
    • Proceeds from issuing stock
    • Cost of purchasing stock
    • Dividend payments
    • Recognised (i.e., when an asset or investment is actually sold) gains or losses in equity

    Why Is a Statement Of Changes In Equity Important?

    The purpose of a statement of changes in equity is to furnish shareholders with information that can further inform their investment strategy and strengthen investor confidence.

    Although some businesses don’t include a statement of changes in equity, it’s useful for adding context to the other financial statements and helping shareholders understand what’s influenced an increase or decrease in the company’s equity.

    How Does It Work?

    A statement of changes in equity begins with the opening equity balance for the period. You then need to add net income, subtract dividend payments, and account for other changes to calculate the closing balance.

    As a result, the general calculation used is:

    Beginning equity + Net income – Dividends +/- Other changes = Ending equity

    What Are Notes To Financial Statements?

    Often, depending on their circumstances, a company will include an addendum to their financial statements. This addition is known as notes to financial statements and we’ll take a brief look at them here.

    What Are Notes To Financial Statements?

    Notes to financial statements are supplemental information that many companies include when they publish their financial statements. They’re used to explain the processes and accounting policies the company used to reach the figures in their financial statements, as well as any extenuating circumstances that affect their financial position.

    Why Are Notes To Financial Statements Important?

    Notes to financial statements help stakeholders within a business, as well as accountants, auditors and potential investors to better interpret the figures within the statements. They may provide information on any irregularities and inconsistencies regarding the company’s performance and financial position that aren’t made fully apparent by the number and could lead the reader to draw inaccurate conclusions.

    What Do Notes To Financial Statements Look Like?

    In contrast to the financial statements themselves, which consist of line items and figures, the notes mainly feature text. Each note is a few sentences or paragraphs long and usually has a subheading relating to the aspect of the financial statement that they address. Additionally, some of the notes will feature line items and figures to explain how particular numbers in the financial statements were calculated.

    How Do Notes To Financial Statements Work?

    The content of notes to financial statements vary, according to the company and their activities and changing circumstances over the reporting period. However, common items found in the notes include:

    · Basis of Presentation: this explains the basis of preparing and the business’ financial statements.

    · Accounting Policies: this details which accounting policies were used when preparing the financial statements.

    · Depreciation Of Assets: details on information on the method used when for asset depreciation.

    · Valuation of Inventory: this details how the company valued its inventory, making it easy for them to compare inventory figures from different periods.

    · Subsequent Events: this refers to events that occur after the balance sheet date but before the release of the financial statements. These are most applicable if the events notably change the company’s financial standing as of the balance sheet date.

     

    • The two types of subsequent events are:
      • Additional Information:additional information that affects estimates used to prepare the financial statements, e.g., a merger or acquisition, after the balance sheet date
      • New Events: An event that provides new information about conditions that didn’t exist as of the balance sheet date, e.g., damage to or theft of capital

    · Intangible Assets: how the company determined the balance sheet value of its intangible assets

     

    · Employee Benefits: the benefits that the company provides to its employees, including health insurance, pension plans, fringe benefits, etc.

    Contingent Liability: refers to liability that could occur – depending (or contingent) on the outcome of a future event, e.g., an outstanding lawsuit or a tax dispute.

    What Is The Relationship Between The Different Financial Statements?

    All three financial statements are important for analysing a company’s performance from different angles. That said, there are various points where the three intersect and influence each other. Here are some of the main ways that the three financial statements are interconnected:

    • Net incomein the income statement is added to retained earnings in the shareholder equity section on the balance sheet. It also appears as the starting figure in cash flows from operating activities in the cash flow statement.
    • The purchase of assets is reflected in a change of assetson the balance sheet and as an expense on the income statement. In contrast, the sale of assets is also shown as a change of assets on the balance but can result in a gain or loss on the income statement.
    • Depreciation and amortisationflow out of the balance sheet from Property, Plant, and Equipment (PP&E) as accumulated depreciation onto the income statement as an expense, as well as being added to operating activities in the cash flow statement.
    • The cash flow statement is interconnected with the balance sheet, as cash going in and out of the business corresponds with its assets, liabilities, and equity. For example:
      • When a company takes out a loan, it appears in both liabilitiesin the balance sheet and a cash in-flow in the financing activities section of the cash flow statement.
      • Conversely, when a company purchases equipment, land, etc., this adds to the assetsin its balance sheet and represents a cash outflow in the investing activities section of the cash flow statement.

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    In summary:

    • A financial statement is a written record that details a company’s operations and financial performance.
    • Each of the four main financial statements contains different information collected over a particular reporting period:

    If you’d like some assistance preparing your financial statements or have any queries about tax planning or any other aspect of your company’s finances, please don’t hesitate to get in touch.