What is a financial statement? Types and how to use them

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. 

To make informed, data-driven decisions in today's fast-changing economy, small business owners should first grasp what a financial statement is and how it fits into the accounting cycle.

Next, they should familiarize themselves with the three key types: the balance sheet, income statement, and cash flow statement. Learning how to read financial statements will help you make informed decisions and guide your company’s financial health.

Jump to:

• How financial statements work
• 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 for your business

How financial statements work

Financial statements are reports that explain a company’s financial performance and profitability for a certain period. 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 (profit and loss statement)
• A cash flow statement

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

With accounting software like QuickBooks Online, you can generate financial records with a click. If you don't yet have access, sign up for your free QuickBooks Online trial today.

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—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 to determine your eligibility for a business loan. Public companies must also publish their financial statements in an annual report. 

Financial statements typically 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’s financial position at a particular period and provides information for three categories:

• 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 some 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. A multi-step income statement calculates gross profit first, followed by operating income, for a specific period.

Key components of the income statement include:

• Revenue represents the income generated from the company's primary business activities
• Cost of goods sold (COGS) is the direct costs of producing the goods or services sold
• Gross profit is calculated by subtracting COGS from revenue.
• Operating expenses are the costs incurred during normal business operations, excluding COGS
• Operating income is profit generated from core business activities, calculated by subtracting operating expenses from gross profit

Operating income indicates a business's sustainability, stemming from consistent operations. Unlike unreliable non-operating income, a company needs to generate the most net income from operating activities.

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. This statement has three categories:

• Operating activities indicate the sources and uses of cash related to a business’s daily activities. 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 that ended Dec. 31. Note that the ending cash balance ($40,000) equals the cash balance in the balance sheet.

How to prepare a financial statement

Each type of financial statement requires different information to prepare, but they're created using the same three accounting principles. 

Using accounting software can be the simplest way to generate financial statements. QuickBooks Online also gives you access to QuickBooks Live Expert Assisted, with professionals who can answer your questions about financial statements and your underlying bookkeeping.*

1. Gather financial data

To prepare your financial statements, start by collecting all relevant financial data. This includes:

• Income statements
• Balance sheets
• Statements of cash flows

Ensure that all transactions are accurately recorded and classified in the right accounts. With accounting software, like QuickBooks, you can automatically pull data from your transactions, reducing manual entry errors.

Additionally, using the original or historical cost principle ensures that assets are recorded at their purchase price, preventing inflated values and discrepancies in your financials.

2. Choose an accounting method

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. 

3. Organize income and statements

Use your best organizational skills when preparing your financial statements. Start by: 

1. Categorizing your revenue sources, including product sales, service income, or any other form of revenue your business generates.
2. List all your business expenses, separating between fixed and variable costs. Fixed costs might include rent or salaries, while variable costs could be raw materials or sales commissions. 

Accurate classification will help you assess your company’s cost structure and identify potential areas to reduce expenses.

4. Prepare the income statement

The income statement reveals a company's profitability over a specific period. It calculates net income to provide a clear picture of financial performance by outlining revenues, expenses, gains, and losses.

To determine your net profit or loss, subtract total expenses (both fixed and variable) from total revenue. If revenue exceeds expenses, you have a profit; if expenses surpass revenue, you incur a loss. 

The income statement is essential for evaluating your business's financial health and identifying trends over time.

5. Create the balance sheet

The balance sheet outlines your company's financial position at a specific point in time. To prepare it, you need to list your assets and liabilities and determine your owner’s equity.

• Assets refer to cash, accounts receivable, and inventory, as well as long-term assets like equipment and real estate.
• Liabilities include any debts, including short-term liabilities (accounts payable) and long-term liabilities (loans, mortgages).
• Owner’s equity represents the net value of the business, calculated by subtracting liabilities from assets.

A well-prepared balance sheet helps you assess financial stability, track changes over time, and make informed business decisions.

6. Compile the cash flow statement

The cash flow statement is essential for tracking inflows and outflows across three main activities. To properly pull this information into your cash flow statement:

1. Begin by categorizing each transaction under the appropriate activity
2. Record daily operational transactions under operating Activities
3. Document purchases or sales of assets under Investing Activities
4. Track financing transactions like loan repayments or stock issuance under Financing Activities

This approach provides a comprehensive view of how cash flows through your business, helping you meet financial obligations and plan for growth.

7. Review and finalize

Before finalizing your financial statements, review them for accuracy and completeness. Double-check all calculations and ensure the data reflects your records accurately.

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. 

Carefully reviewing your financial statements ensures they accurately represent your business. Compare your finalized statements with previous periods to identify trends, which can offer valuable insights into your business's performance.

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4 common mistakes on financial statements

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

1. Not including comparative data 

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

2. Not reflecting reality accurately

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. Not revising the procedures to reduce discrepancies 

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

4. Not auditing 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.

Create financial statements for your business

Integrating financial statements into daily operations enhances business management and reveals areas for improvement and growth. Regularly reviewing them can transform your business.

With QuickBooks Live Expert Assisted, you get on-demand access to certified professionals who can answer your questions about financial statements and reporting*. 

Advanced accounting software simplifies financial reporting, providing automatic insights that allow you to focus on growing your business in 2025's competitive landscape.

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