Financial statements are a standardized set of reports that communicate financial informationto stakeholders both inside and outside of a company. These statements are important tobusinesses of all sizes — investors and lenders use them to make decisions, andcompany managers depend on them as a starting point for business analysis and future budgets— so getting them right is a priority.
The challenge for most businesses is how to routinely produce, and for public companies,publish, their financial statements in a timely and efficient manner using the fewestresources. Fortunately, flexible financial software has replaced generating financialstatements from leather-bound ledgers, seven-column accounting worksheets and spreadsheetapplications.
What Is a Financial Statement?
Financial statements are reports that summarize a company’s accounting data in astandardized way. They’re meant to enable comparisons over time and with othercompanies. Each financial statement is a standalone report with a unique purpose, but theyare most useful when read together, since they are interrelated.
The standard formats and conventions for each statement are included in Generally Accepted Accounting Principles(GAAP) or International Financial Reporting Standards (IFRS). A publiccompany’s statements must comply with one of those standards, depending on where it islisted. U.S. companies must comply with U.S. GAAP, while in most other countries, IFRS rulesapply. Some large public companies choose to produce different editions of their financialstatements for each standard.
Private companies are freer to adjust financial statements to their business needs, but theyusually shouldn’t stray too far from the conventions expected by finance professionalswho may someday be reviewing their statements to, for example, determine creditworthiness.
- The three core financial statements — income statement, balance sheet and cashflows — are standalone but interrelated, standardized reports.
- Lenders, investors and compliance agencies use them because they show a company’sprofitability, net worth and liquidity and solvency.
- Internal processes like financial modeling, budgeting and forecasting use financialstatements as a starting point.
- The standard accounting and reporting rules that govern financial statements for allcompanies make them a valuable tool for comparisons, but they can require significantcompany resources to compile.
- Preparing accurate, auditable financial statements is considered table stakes for justabout all companies. Flexible, integrated financial management software can provide theright level of detail and customization for various companies.
Financial Statements Explained
There are at least five financial statements, three of which are considered“core:” balance sheet, income statement and statement of cash flows.
- The balance sheet shows a company’s financial position at acertain point in time by listing assets, liabilities and shareholder equity.
- The income statement captures a company's revenue, expenses, gains andlosses during a specific reporting period, and indicates whether the business generateda profit.
- The statement of cash flows highlights inflows and outflows of cashduring a given reporting period.
For publicly-traded companies, a complete set of financial statements also includes astatement of retained earnings and “notes” pertaining to the financialstatements. Retained earnings are a company’s accumulated historical profits that havenot been paid out to owners, either as distributions or dividends, and are therefore“retained” by the business. The statement of retained earnings, therefore,serves to reconcile any changes in a company’s equity accounts during a reportingperiod.
The notes to the financial statements, sometimes referred to as “footnotes,” is aunique report that provides context to the financial statements, such as accounting methodsused and supporting detail for certain balances. Footnotes are most often associated withpublic filings and audited financial statements.
Private companies may choose to produce a subset of these five statements — perhapsjust an income statement for use in future planning. If the statements are produced forinternal purposes only, there is often no need for footnotes or managers’explanations. Public companies, however, may be required to publish any number of additionaldocuments beyond these five, such as consolidated schedules and subsidiary schedules. Publiccompanies often include a section called “Management’s Discussion andAnalysis,” or MD&A, in which the company’s managers explain complex ornonobvious aspects of the business or business conditions that influenced the results beingreported.
Why Are Financial Statements Important for Businesses?
Financial statements provide a snapshot of a company’s financial situation for useinternally and externally. They help internal managers make better-informed decisions andare often a starting place for financial analysis and modeling, especially when viewedcomparatively to other fiscal periods or to competitors.
Equally important, financial statements serve as a primary information package for externalconversations. Lenders, like financial institutions and corporate credit card issuers,require them during the application process and to fulfill ongoing debt covenantrequirements. Investors and potential partners use them as a first step in their analyses.Further, the Securities and Exchange Commission (SEC) mandates them for public companies.
It’s important to get financial statements right. Most companies have an accountingprocess that handles preparation of financial statements as part of their financial close process.
Advantages of Financial Statements
Financial statements are a useful way to summarize many key aspects of a company’sfinancial profile. The three core financial statements neatly present a company’sassets, liabilities, equity, revenue, expenses, profit, sources of cash and uses of cash.Financial statements provide advantages for internal management and external negotiation,and can help companies stay in compliance with other regulations.
Internally, financial statements can be a useful decision-making tool for company management.They often serve as a jumping-off point for financial analysis, modeling and forecasting.
Externally, the consistency and standardization of financial statements assistslenders’ and investors’ decision-making. When a company needs a loan to fuelexpansion, launch a new product or buy more equipment, a lending bank will typically requirefinancial statements. Similarly, suppliers may want to review financial statements beforeextending credit. And potential investors, whether friends and family, private equity orpublic markets, will review financial statements as part of their own decision-making.
For these reasons, many compliance agencies, like local, state and federal taxingauthorities, require financial statements from companies of all sizes, just as the SECrequires them for public companies.
Disadvantages of Financial Statements
Even when prepared properly, devoid of fraud and errors, financial statements havedisadvantages. Some stem from the technical accounting rules that govern them, such asrequirements to use historical costs and ignore inflation, which may cause values on thefinancial statements to become obsolete over time. For example, the value of a buildingpurchased decades ago would reflect the original acquisition cost minus depreciation, ratherthan its actual value in the current real estate market.
Other technical disadvantages arise when comparing financial statements that cover differenttime periods, especially for seasonal businesses like retail, or when comparing differentcompanies that choose different accounting methods. Imagine the inconsistencies in acomparison of a retail business’s income statement for the quarter ended December 31to one ended March 31, or when comparing the statements of a manufacturer that uses last in,first out accounting rules versus another that uses the first in, first out inventoryaccounting method.
Financial statements also have conceptual limitations. By their nature, financial statementsreflect only a company’s measurable financial transactions, ignoring certainunquantifiable aspects of its holistic value, like brand recognition, market share orcustomer satisfaction. Further, financial statements show past results and are notfuture-looking, which limits their predictive value.
3 Major Types of Financial Statements for Businesses
The income statement, balance sheet and statement of cash flows — the big threefinancial statements — each group and categorize information in a way meant tohighlight relationships and help readers find relevant details quickly. The income statementand statement of cash flows present activity over a fiscal period, such as a month, quarteror year. The balance sheet can reflect values at any single point in time, but, like theothers, the last day of a fiscal period is typically chosen. Most investors, lenders andinternal managers view the income statement as most important for measuring success,although all three statements tell an important part of the financial story.
Income Statement: Sometimes referred to as the “statement ofoperations” or , the income statement shows a company’s revenue, expenses, gainsand losses, ultimately ending with net income or loss for the period covered.
Parts of the income statement: The income statement can bepresented in condensed form or in multiple steps showing different levels ofdetail, but it always includes revenue, gains, expenses, losses and netincome/(loss). Net income/(loss) is often called “the bottomline” because it’s the last item on most income statements,although public companies add a line for earnings per share. Incomestatements typically show the current period results and a comparativeperiod, such as the same quarter in the prior year or year-to-date results.
Income statement example: General Motors’ ConsolidatedIncome Statement for the fiscal year ended Dec. 31, 2020, illustrates thetop-level revenue and expense categories.
Balance Sheet: This shows a company’s assets, liabilities andowner equity accounts as of a certain date. A typical balance sheet shows thecurrent-period balances and a comparative column with the prior fiscal year endbalances.
Parts of the balance sheet: The balance sheet groups assetsseparately from liabilities and owner’s equity. The assets section hassubcategories to distinguish current assets — those expected toconvert to cash within a year, such as customer accounts receivable —from non-current assets, like buildings. Similarly, the liabilities sectiongroups current liabilities — those that are payable within the year,such as rent — from non-current liabilities, like a mortgage. Theequity section reflects the company’s net worth and retained earnings,which belongs to the owners. It also reflects ownership interests in othercompanies that are not subject to GAAP consolidation rules. A complete setof financial statements would include a separate statement of retainedearnings, which provides a detailed reconciliation of activity in theretained earnings account that appears on the balance sheet.
Balance sheet formula: In double-entry accounting,debits and credits must always balance — in other words, they net tozero. This supports the accounting equation, also called the balance sheetequation:
Assets = liabilities +owner equity
Balance sheet example: An example of a condensedconsolidated balance sheet from General Motors highlights the accountingequation by featuring an asset section and a section for liabilities andequity.
Cash Flow Statement: The statement of cash flows summarizes thesources and uses of cash in a business. It provides an important perspective on thehealth of a company, especially small and midsize enterprises (SMEs) and early-stagebusinesses. Ultimately, it shows whether the company has increased or decreased itscash balances over the reporting period, helping readers evaluate liquidity,solvency and financial cushion against unexpected events. The statement of cashflows presents balances comparative to the same fiscal period in the prior year.
Parts of the cash flow statement: A cash flow statementbegins with net income/(loss) from the income statements and adjusts for anynon-cash activity for the period. A simple example is depreciation, which isa business expense involving no real cash, and so it is added back for thepurpose of the cash flow statement. Non-cash activity falls into threecategories based on the nature of how the cash came in or out: operating,investing or financing. Operating activities are all the transactionsgenerated in the course of business as reflected on the income statement.Investing activities reflect changes in long-term assets and liabilities,such as purchases or sales of equipment or stocks and bonds. Financingactivities show changes in the equity and debt accounts for items such asowner capital contributions, new borrowings and repayment of debt. The“bottom line” of the cash flow statement is the company’scash balance at the end of the reported period.
Cash flow statement example: An example of a condensedconsolidated statement of cash flows from General Motors shows the threecategories – operating, investing and financing.
The following chart compares the three core financial statements.
The Core 3 Financial Statements Compared
|Statement of Cash Flow
|Liquidity & Solvency
|As of Point in Time
|For the Period Ended
|For the Period Ended
|Beginning Cash Balance
Sources of Cash
Uses of Cash
Ending Cash Balance
|Cash Flow from Operating Activities
Cash Flow from Investing Activities
Cash Flow from Financing Activities
Net Increase/(decrease) in Cash
Elements of Financial Statements
All the accounts in a company’s general ledger ultimately flow into one or morefinancial statements. Among the most common elements are:
Assets: Found on the balance sheet, assets are resources owned andcontrolled by a company that can provide future economic benefit. Examples includecash, accounts receivable, equipment and investments in marketable securities.
Income: The profit generated by the sale of goods or services, asreflected on an income statement by revenue – expenses = income.
Distributions: Payments of profit made to company owners, such ascash payments and cash or stock dividends.
Equity: The value of the company shared by its owners — inother words, its net worth after subtracting liabilities from assets.
Expenses: Company spending related to its operations. Examplesinclude shipping, salaries and rent.
Gains: Positive impact of an incidental event, outside ofoperations, such as sale of old equipment for more than its value on acompany’s books.
Investments: May be either a company’s investment inmarketable securities (which is also classified as an asset) or a companyowner’s transfer of value, such as cash, property or services, to make anequity investment in the company.
Liabilities: Obligations of the company owed to outsiders at afuture date, such as accounts payables or prepayments from customers for goods orservices not yet delivered.
Losses: Negative impact of an incidental event, outside ofoperations, such as the sale of old equipment for less than its value on acompany’s books.
Revenue: Sales of goods and services from a company’soperations, sometimes referred to as its “top line.”
Using Financial Statements in Modeling
Financial modeling hasmany different purposes but almost always begins with financial statements or data fromthem. For example, “pro-forma” financial statements are models created formergers and acquisitions to model what the combined entity might look like using variousassumptions about efficiencies and changes.
Budget preparation is another example of using financial statements as a template to create acomprehensive model for future fiscal periods. Additionally, many finance teams usefinancial statements combined with operating data in their forecasting process to identifytrends and support projections.
Financial Statement Auditing
External readers of financial statements, like lenders and investors, often require them tobe audited because of the statements’ importance in their decision-making. During afinancial statementaudit, a certified public accountant investigates and tests thestatements’ accounting data to provide a “reasonable assurance” that thefinancial statements are “materially” correct. In the U.S., the AccountingStandards Board (ASB) issues the Generally Accepted Auditing Standards (GAAS) — therules that guide financial audits. The output of a financial statement audit is theIndependent Auditor’s Report, which is meant to provide a level of assurance that thefinancial statements are free of significant misstatement. But ultimate responsibility forthe accuracy of financial statements rests with company management.
Free Financial Statement Template
Financial statement templates for the income, balance sheet and cash flow statements areprovided here. These may be useful for very small companies, but for mostbusinesses, spreadsheet-based financial statements such as these lack sufficientflexibility, automation and information integration. They are supplied with sample numbersfor a hypothetical company, which can be replaced with a small business’s owninformation.
Manage Your Financial Statements With Software
Large public companies such as the Fortune 500 tend to have well-resourced accountingdepartments handling the management of their financial statements and the complex accountingand consolidation issues such organizations face. For smaller businesses, producing andpublishing accurate, reliable financial statements often means significant challenges.Studies show that shortages in staff, inadequate accounting expertise, changing regulationsand insufficient technology are among the largest obstacles small and midsize organizationsface in managing their financial reporting.
While financial accounting software can usually generate financial statements, most do notaddress all these challenges. A solution like NetSuite Financial Management, however,includes features that automate financial statement production with accounting rulesbuilt-in, can be customized for an individual business’s needs, and can even integrateinformation from other systems — all of which address the core of smallerenterprises’ financial statement challenges.
Financial statements are important and useful tools for internal management as well asinterested external people, such as investors and lenders. The income statement, balancesheet and statement of cash flows are the most important three statements, each with theirown purpose and elements. Standardized accounting guidance helps make financial statementsuseful and consistent across different businesses. But the rules require specializedaccounting expertise. Still, producing financial statements that are accurate and auditableare table stakes for most companies. Producing them efficiently with the right level ofdetail and customization for various stakeholders is a challenge best served by flexible,integrated financial management software.
Financial Statements FAQs
What are the four basic financial statements?
The four basic financial statements are the income statement, balance sheet, statement ofcash flows and statement of retained earnings. Companies that produce all four generallyalso produce the fifth: the “notes” to the financial statements. Publiccompanies are required to publish all five.
What are the five financial statements?
The five basic financial statements are the income statement, balance sheet, statement ofcash flows, statement of retained earnings and “notes” to the financialstatements. Often referred to as “footnotes,” the notes to the financialstatements is a written document that provides context to the financial statements, such asaccounting methods used and supporting detail for certain balances.
What is the purpose of the three major financial statements?
The three main financial statements — the income statement, balance sheet and statementof cash flows — present a standardized summary view of the financial position of acompany.
How do you do financial statements in accounting?
Financial statements follow standard formats to summarize accounting data in a meaningful andintuitive way. They are prepared using standardized formats defined in the GenerallyAccepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).A certified public accountant may audit financial statements to provide assurance that theyare free of material errors and misstatements.
I am an expert in financial statements with a deep understanding of accounting principles and financial reporting. My expertise is grounded in practical experience and a comprehensive knowledge of Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). I have hands-on experience in preparing, analyzing, and auditing financial statements for various types of businesses, including public companies.
Now, let's delve into the concepts mentioned in the article:
1. Financial Statements Overview:
- Financial statements are standardized reports conveying financial information to stakeholders.
- Importance for investors, lenders, and company managers.
- Challenge in routine production and publication, addressed by flexible financial software.
2. What Is a Financial Statement?
- Reports summarizing a company's accounting data.
- Meant for comparisons over time and with other companies.
- Compliance with GAAP or IFRS standards for public companies.
3. Core Financial Statements:
- Three core statements: income statement, balance sheet, and statement of cash flows.
- Standalone but interrelated, providing a comprehensive view.
- Standard formats and conventions under GAAP or IFRS.
4. Additional Financial Statements:
- For publicly-traded companies: statement of retained earnings and notes.
- Private companies have more freedom but should align with financial conventions.
5. Importance of Financial Statements:
- Snapshot of a company's financial situation for internal and external use.
- Aid in decision-making, financial analysis, and modeling.
- Required by compliance agencies and the SEC for public companies.
6. Advantages and Disadvantages of Financial Statements:
- Advantages: Summarize key aspects, aid in decision-making, assist in compliance.
- Disadvantages: Technical accounting rules, conceptual limitations, and limitations in predicting the future.
7. Types of Financial Statements:
- Income Statement: Shows revenue, expenses, gains, and losses.
- Balance Sheet: Reflects assets, liabilities, and owner equity.
- Cash Flow Statement: Summarizes sources and uses of cash.
8. Elements of Financial Statements:
- Assets, income, distributions, equity, expenses, gains, investments, liabilities, losses, revenue.
9. Using Financial Statements in Modeling:
- Financial modeling purposes: Mergers and acquisitions, budget preparation, forecasting.
- Financial statements serve as a foundation for modeling.
10. Financial Statement Auditing:
- External readers often require audited financial statements.
- Certified public accountants ensure reasonable assurance of accuracy.
- Independent Auditor's Report provides the outcome of the audit.
11. Managing Financial Statements with Software:
- Challenges faced by smaller businesses in producing accurate statements.
- Financial accounting software like NetSuite Financial Management addresses these challenges.
In conclusion, financial statements are crucial tools for both internal and external stakeholders, providing a standardized summary of a company's financial position and performance. The core statements, when read together, offer a comprehensive view that aids in decision-making and analysis. Compliance with accounting standards and the use of flexible financial software are key in ensuring accurate and efficient financial statement production.