Financial statements: What business owners should know

Understanding your company’s financial position is integral to its success. A financial statement can indicate whether your company is bringing in a profit or heading toward trouble. 

There are three common types of financial statements: the balance sheet, income statement, and cash flow statement. Small business owners should know what these financial reports mean and how to use them to support data-based decision-making.

• What's a financial statement?
• Why financial statements are important
• Balance sheet
• Income statement
• Cash flow statement
• How to prepare a financial statement
• 4 common mistakes on financial statements
• Create financial statements in your business
• Financial statement FAQ

What's a financial statement?

Financial statements are reports that explain a company’s financial performance and profitability for a certain period of time. They're created during the process of financial reporting, which is an objective way to assess your company’s financial health. There are three basic financial statements:

• A balance sheet. 
• An income statement, also called a profit and loss statement.
• A cash flow statement.

Business owners use another financial report—statement of retained earnings—less frequently. Larger companies might produce a variety of other financial statements.

If you use accounting software like QuickBooks Online, you can generate financial reports in a click. If you don't yet have access, sign up for your free QuickBooks Online trial today. If something doesn't look right in the reports, QuickBooks Live Expert Assisted can help guide you and answer questions.*

Why financial statements are important

Most importantly, financial statements help business owners better understand their bottom lines and make smarter business decisions. 

Financial statements let stakeholders—such as shareholders, creditors, and regulators—understand a company’s overall financial performance and health. If you’re ready to seek funding for your business, lenders look at your financial statements as they determine your eligibility for a business loan. Public companies are also required to publish their financial statements in an annual report. 

Typically, financial statements provide information for a business about its:

• Economic resources and obligations.
• Earning capacity.
• Potential cash flows.
• Management status.
• Accounting policies.

Balance sheet

A balance sheet, or statement of financial position, is a financial statement that lists a company’s assets, liabilities, and equity balances. It showcases a business’ financial position at a particular point in time. A balance sheet provides information for three categories: assets, liabilities, and equity.

• Assets are resources that generate revenue, or sales, and profits in a business. An asset may be tangible, like a vehicle, or intangible, like a patent or other intellectual property.
• Liabilities are amounts the business owes to other parties, including accounts payable (current liabilities) and long-term debt.
• Equity is the difference between assets and liabilities, and refers to the true value of a business. Equity includes common stock, additional paid-in capital, and retained earnings. Equity is also known as shareholder’s equity, owner’s equity, or net worth.

The balance sheet formula drives the three components of the balance sheet. The formula subtracts liabilities from assets to determine equity. The formula follows:

Assets – liabilities = equity

The double-entry accounting system requires the accounting equation to stay in balance as transactions post. Balance sheet accounts calculate working capital and other important ratios.

Balance sheet example

Review the balance sheet for Centerfield Sporting Goods as of December 31. Total assets ($185,000) equals the sum of total liabilities ($150,000) plus equity ($35,000).

Income statement

An income statement shows a company’s revenue and expenses for a period of time. It provides information relating to returns on investments, risks, financial flexibility, and operation capabilities. 

Most companies produce a multi-step income statement, which documents how a firm produces net income. In a multi-step income statement, you first find your gross profit then your operating income for a period of time.

Sales, cost of goods sold (COGS), gross profit, and operating expenses are all inputs for the income statement. So is operating income, which you generate from day-to-day business activities. Non-operating income is inconsistent and unpredictable, so you can't rely on it to produce annual profits. Your business must produce a majority of its net income from operating income activities because operating income is sustainable. 

Income statement example

Review the Centerfield company’s income statement for the period ending December 31. Sales totaled $520,000, and the cost of sales totaled $420,000. So its gross profit was $100,000. And Centerfield had operating expenses of $90,000. That gave it $10,000 in operating income for the period. Since the company did not generate any non-operating income, its operating income was its net income balance.

Cash flow statement

The cash flow statement, also called the statement of changes in financial position, documents a company’s cash inflows and outflows. Cash flow can be separated into three categories.

• Operating activities indicate the sources and uses of cash related to a business’s daily activities. Operating activities include cash from customer sales and inventory. A company should produce most of its cash inflow from day-to-day operations that it can sustain over months and years.
• Investing activities refer to cash activity related to buying and selling assets like machinery, equipment, and vehicles.
• Financing activities occur when a company earns money from a stock or bond issue. The financing category also accounts for cash repayments to investors.

Most of the cash activity in a business takes place in the operating category. When generating the cash flow statement, identify the investing and financing transactions first. All remaining cash activity is in the operating category.

Cash flow statement example

Review Centerfield’s statement of cash flows for the accounting period ended December 31. Note that the ending cash balance ($40,000) equals the cash balance in the balance sheet.

How to prepare a financial statement

Using accounting software can be the simplest way to generate financial statements. QuickBooks Online also gives you access to QuickBooks Live Expert Assisted who can answer your questions about financial statements and your underlying bookkeeping.* If you're preparing financial statements manually, visit our articles about the balance sheet, income statement, and cash flow statement for preparation details.

Each type of financial statement requires different information to prepare, but they're created using the same three accounting principles. Because financial statements serve as fundamental sources of financial information, you need to apply basic accounting principles to ensure accuracy and consistency. 

1. Recorded facts

An original or historical cost of accounts can help you prepare financial statements. Typically, you record prices and assets you purchase at different times at the original cost.

2. Accounting conventions

Using accounting conventions makes your financial statements comparable and realistic. For example, the principle of consistency requires accountants to apply standards consistently year after year.

3. Personal judgments

Your financial statements are based on personal judgments and estimates to avoid overstating assets and liabilities.

You can maintain accurate financial statements by choosing your accounting conventions and sticking to them over time. Ultimately, the best way to create an accurate, dependable financial statement is to automate the process wherever possible. Using accounting software, for example, leverages technology to handle all the number crunching and avoid manual accounting errors.

4 common mistakes on financial statements

Making one of these common mistakes can affect the accuracy of your financial statements and business decisions.

1. You don't include comparative data.

Including prior-year, prior-month, or budgeted amounts makes it easier to see if actual amounts meet expectations.

2. You don't reflect reality.

Financial statements should always reflect the true financial condition of a business. Consider having your financial statements reviewed by a third party to identify inaccuracies.

3. You don't revise procedures to reduce discrepancies.

If you identify an error or discrepancy in your financial statements, take the time to revise your accounting procedures.

4. You don't audit your financial statements.

Financial statements are only beneficial if they’re accurate. Don’t generate a financial statement just for the sake of having one. Read the statement, address any discrepancies, and use it to understand your business’s financial health better.

See how this flower farm slash florist uses QuickBooks Live Expert Assisted.

Create financial statements in your business

Incorporating financial statements into your workflow and processes can not only help you better manage your business, but they can highlight areas in need of improvement and opportunities for growth.

Getting into the habit of reviewing financial statements and reports is essential. QuickBooks Live Expert Assisted can give you access to help when you need it, including live experts to answer your questions about topics like financial statements*. Accounting software simplifies review and automates the financial reporting process to give you more time to focus on running your business.

*QuickBooks Live Expert Assisted requires QuickBooks Online subscription. Additional terms, conditions, limitations, and fees apply.