The Basics of Financial Statements - Definitions & Examples

Accounting may not have the best reputation; however, it is essential to running a business. But what exactly is the bread and butter of this practice?

Well, there is the primary rule: debits on the left and credits on the right. When each column is totaled, they should be equal, or in other words, the books should be balanced. This is great but what we really need to discuss financial statements.

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What are financial statements?

Financial statements summarize an entity’s business activities, financial performance, financial position, and cash flows through a series of written reports.  Each report should be structured to convey relevant data in an easily digestible manner. Essentially the cliff notes of a business’s financial workings. These  reports typically give a snapshot of a specific time frame, usually a given month or year, or indicate the activities over a stated period. These financial reports are crucial to understand the business & how it is performing.

These summary-level records are compiled by a company’s accounting department to be assessed by management, stakeholders (present or future), and/or any outside auditor. For the management team, these statements are often utilized to plan and budget future operations, evaluate the company's performance as whole or individual sectors, or communicate with investors and stakeholders as well as creditors or government regulators. Depending on the size of your business, the type of industry, or the services you offer, regulators may use the information to discern various aspects of the company encompassing everything from its financial stability to its ability to generate cash and pay debts. 

Regardless of the audience, financial statements should be consistent, reliable, and comparable, at the very least within the company, if not against national or international standards. It’s difficult to speak about the consistency of financial statements without talking about the GAAP, or the Generally Accepted Accounting Principles. If the different financial statements made up the peanut butter and jelly of an accounting sandwich, the GAAP would be the bread. GAAP standards provide the framework and foundational structure of financial reporting. Mmm…delicious accounting sandwich.

Originally conceived out of necessity after the stock market crash in the late 1920s, a committee of accountants formed a set of broad principles to improve the accounting process. By the 1940s, the first official standards were issued by the Securities and Exchange Commission (SEC). Government regulators and agencies now often require conformance to some sort of GAAP. The most influential GAAP standards in the U.S. are now set forth by the Financial Accounting Standards Board (FASB). 

But enough about the captivating history of GAAP standards (but if you are really interested in the history of the GAAP standards or  FASB…). Let’s discuss the four main types of financial statements, what’s included in them, and what they are used for.

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What Are The Four Main Financial Statements?

The most common financial statements are the balance sheet, the income statement, the cash flow, and the statement of changes in shareholder equity.

Income Statement

This financial statement shows a company’s profit or loss by displaying a summary of a company's revenues, expenses, and profits or losses over a given period of time, usually one month, three months (i.e., quarterly), or one year. The profit or loss is determined by taking all revenues and subtracting all expenses from both operating and non-operating activities. The components of an Income Statement typically include Revenue, Expenses, Cost of Goods Sold (COGS),  Operating Income, Interest Expense, Pre-Tax Income, Income Taxes, and Net Income, in a coherent and logical manner. These periodic statements aggregate into the total values for quarterly, year-to-date, and annual results. The income statement is sometimes given prominence over the other three core statements – particularly among small- to medium-sized businesses; an income statement is important because it offers a recent picture of the company's revenues and expenses and overall profitability. It shows a company's ability to generate sales, manage expenses, and create profits over a period of time.

Balance Sheet

The Balance Sheet is a statement of the Assets, Liabilities, and Stockholder’s Equity of a business or other organization at a particular point in time. It reflects the income and expenses of the period on an entity's assets, liabilities, and stockholder's equity. The basic accounting equation to remember here is Assets = Liabilities + Stockholder’s Equity. This equation explains that a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing equity). Assets generally can be described as cash, receivables, investments, inventory, and property. Liabilities are payables (including those imminently due, such as rent, wages, taxes, and utilities) and loans. And Stockholder’s Equity is retained earnings, paid-in capital, and common stock. By itself, a Balance Sheet for a single period cannot give a sense of the trends that are playing out over a longer period -  rather, it is a ‘snapshot’ of the business’s financial health at a specific point in time. For this reason, the balance sheet should be compared with those of previous periods. It also should be compared with those of other businesses in the same industry since different industries have unique approaches to financing and the use of assets. The balance sheet is used alongside other important financial statements in order to conduct fundamental analysis. It provides a basis for computing rates of return and evaluating the organization’s capital structure. A number of ratios can be derived from the balance sheet, helping investors get a sense of the financial health of a company. These ratios might include, for example, the debt-to-equity ratio and the acid-test ratio, along with many others. Taken together, the income statement and statement of cash flows also provide valuable context for assessing a company's finances.

Statement of Cash Flows

This financial statement summarizes the amount of cash and cash equivalents entering and leaving a company. The main components of the cash flow statement, or SoCF, are cash from operating activities, cash from investing activities, and cash from financing activities; and the disclosure of noncash activities is sometimes included. The operating activities of the SoCF include any sources and uses of cash from business activities such as sales of goods and services and interest payments. The investing activities include sources and use of cash from a company's investments such as the purchase of a plant and equipment or providing a long-term loan to another party. Financing activities include the sources of cash from investors or banks, as well as the cash paid to stockholders. Examples of financing activities include repurchasing stock from shareholders or issuing debt and equity. Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in revenue, expenses, and credit transactions – which are shown via the balance sheet and income statement – resulting from transactions that occur from one period to the next. The SoCF measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses. A cash flow statement is a valuable measure of strength, profitability, and of the long-term future financial outlook for a company. The SoCF can help determine whether a company has enough liquidity or cash to pay its expenses. A company also may use a cash flow statement to help predict future cash flow, which helps with matters of budgeting.

Statement of Changes in Stockholder’s Equity

This financial statement conveys any changes in the value of stockholder’s equity in a company during a year - or between years. Business activities that have the potential to impact stockholders’ equity are recorded in the statement of stockholders’ equity. In other words, it shows all equity items that may affect the equity balance, such as dividends, net profit or income, and common stock. Stockholder’s equity is basically the difference between total assets and total liabilities. In equation form, it looks like this: Stockholder’s equity = Assets – Liabilities. Another way to calculate Stockholder’s Equity = Contributed Capital + Retained Earnings. This statement is valuable for investors because it shows profits earned and held, potentially for internal use. These profits may show if a company can cover future expenses or if a company should reinvest. This statement also shows if dividends are paid to stockholders and allows them to see how their investment is doing. It also may facilitate management’s decision-making regarding the future issuances of stock shares or stock buy-backs.

What is the most important financial statement?

This question is definitely an “eye of the beholder” matter and varies depending on the specific needs or goals of the party inquiring. For instance, from the view of an investor, the review of their share value will mostly be based on the cash flow. However, an auditor may choose balance sheets. Generally unphased by profitability and more with accuracy, they can gather more about the financial health and its compliance with accounting standards through balance sheets. A manager, on the other hand, can use the information from an income statement to increase productivity or profitability by tweaking and fine tuning the inner workings of their company. Between cost and revenue analysis, budgeting, and performance evaluation, a manager can implement policies or allocate resources more effectively using the information provided by an income statement. 

The financial statements are not isolated items, they are closely related and flow between each other to give a larger picture of the business's financial circumstances. Each statement can stand alone to offer a snapshot of the given information; however, separately, they do not allow an in-depth view of the whole financial state of the company.

Each statement compares different metrics and all hold arguably equally significant information. When really auditing a company, one should look at everything together, much like reading a GPS map while on a road trip. The balance sheet would be the whole map, a snapshot of the topographical elevations and valleys that are your assets and liabilities. The income statement would be like the route and stops, showing snapshots of the various sources of revenue and expenses that have come to impact a company’s financial performance. The GPS location would be represented by the cash flow statement. It shows where the company currently stands in terms of its liquidity as well as its ability to meet its obligations financially. Last would be the statement of changes in shareholder’s Equity. The completely separate, but still accurate paper map your passenger is holding while yelling at you to, “TURN HERE!!”, whether your GPS device agrees or not.

Financial statement templates and examples

We’ve included a few statement examples and templates below for you to check out! If you need more guidance, don’t hesitate to contact us here at Decimal!

Common financial statement FAQs

Why are financial statements so valuable?

Financial statements give information about a business’s financial health and position. They are tools that allow stakeholders to make informed decisions about the company. 

What is the difference between accrual-based accounting and cash-based accounting, and how do they affect my cash flow statement?

These are two methods of recognizing financial transactions. The biggest difference between the two is when each transaction is recorded in your financial statements. The timing is what affects your cash flow statement. Accrual-based accounting records transactions as soon as they’re incurred, regardless of payment status. This could mean that your statement may show future cash inflows or outflows that have yet to occur. Cash-based accounting records transactions only when the cash is received or paid out.

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What do financial statements actually look like?

Generally, financial statements are a multi-column table with a line item and a number in dollar amounts. They are organized in sections of relevant data based on the goal of the statement. We’ve included some examples in our next section as well as some templates for basic sheets!

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Who is responsible for assembling financial statements?

In most companies, that would be the responsibility of the accounting department. A CFO may be the one to oversee the integrity of the information or, in smaller companies, create it themselves. And for sole proprietors, you may be the one to do it!

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How would an outsourced accounting department help me manage my business?

An outsourced accounting service can free up much-needed time and resources so that you may focus on developing your business. Whether you need help with bookkeeping, financial statements, accounts payable, or paying bills, an outsourced accounting service (especially a reliable, well-priced service) can give you peace of mind knowing that your financial information is being handled by a team of experts.

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Financial statement tools and services

We pretty much just covered the first semester of a college-level course on accounting! This can be pretty overwhelming for someone who is new to financial statements and accounting in general. It may seem confusing and complicated at first, but understanding how to review and analyze these statements will be key to the future of your business.

There are many DIY services and programs that can assist you in creating and maintaining your financial statements. A few of the most common software programs include QuickBooks, Xero, and Wave. There are even online financial statement generators of varying quality, cost, and legitimacy. But if you don’t have the time or find yourself out of your depth and need help, check out Decimal! 

We are here to assist with your bookkeeping needs. We focus on accounting operations to build processes and lean on technology to help your business needs.. Talk to us today to get a free consultation and see where we can help!