Financial statements are a key tool for running your business. They’re a snapshot of your company’s finances and give crucial information about your business performance. They’re also the foundation for planning your future course.
Financial statements are also used by bankers, investors and others to assess the health and liquidity of your business and make decisions that affect it.
“Financial statements show the sustainability of your business and allow you to make educated financial decisions to ensure it is as successful as it can be,” says Grant Godfrey, a Senior Account Manager at BDC.
Financial statements can provoke discussion and show if you’re on track so you can know early and often where to pivot and how to pivot.
What are financial statements?
Financial statements are a set of documents that show your company’s financial status at a specific point in time. They include key data on what your company owns and owes and how much money it has made and spent.
There are four main financial statements:
- balance sheet
- income statement
- cash flow statement
- statement of retained earnings
Financial statements may be prepared for different timeframes. Annual financial statements cover the company’s latest fiscal year. Companies may also prepare interim financial statements on a monthly, quarterly or semi-annual basis.
Interim statements sometimes include fewer components than year-end statements. For example, they may lack a cash flow statement and a statement of retained earnings.
Financial statements generally give information for both the latest period and the prior period to make comparisons easier. For example, a financial statement covering January 1 to December 31, 2021, would include the statements for both that year and the previous year—January 1 to December 31, 2020.
What are the elements of financial statements?
1. Balance sheet
The balance sheet shows what the company owns and how much it owes at the end of the period. It is based on the equation:
Assets = Liabilities + Shareholders’ Equity
Below is a sample balance sheet.Enlarge the image
2. Income statement
An income statement shows the profitability of your business. It details how much money your business earned and spent. The income statement is also sometimes referred to as a profit-loss statement or an earnings statement.
It shows your:
- revenue from selling products or services
- expenses to generate the revenue and manage your business
- net income (or profit) that remains after your expenses
Below is an example of an income statement.Enlarge the image
To supplement an income statement, a business may also prepare a statement of comprehensive income. This reports revenues and expenses that haven’t yet been realized, such as unrealized gains or losses from:
- financial investments
- foreign currency adjustments
- pension liabilities
3. Cash flow statement
The cash flow statement, sometimes called a statement of changes in financial position, shows how money has moved through your business during the period.
Here is an example of a cash flow statement.Enlarge the image
4. Statement of retained earnings
The statement of retained earnings shows the cumulative earnings of the business after any dividends or distributions to shareholders. As well, this statement, sometimes called a statement of changes in equity, also shows the change in the retained earnings account between the opening and closing periods on each balance sheet.
Sample retained earnings statement:Enlarge the image
5. Notes to the financial statements
Notes to the financial statements disclose the assumptions made in preparing the statements and help interpret and analyze the information. They typically explain:
- Accounting policies, judgments and estimates involved in preparing the statements
- Supplemental information about certain line items, such as:
- a breakdown of accounts payable and receivable
- a revenue breakdown by segment or region
- remaining economic life of assets
- Other important information, including:
- risks to the business, such as exchange-rate risk or concentration risk
- debt covenants
- contingent liabilities
- revenue and profit or loss of an acquired business or strategic investment
- Whether the statements were prepared on a cash or accrual basis
- Which accounting standards the company follows (e.g. International Financial Reporting Standards or Accounting Standards for Private Enterprises)
- The type of financial statement (see below)
We take our time going through the financials. We look at them from front to back. We look at every page and every line item.
What are the types of financial statements?
There are four types of financial statements. Each has a different level of complexity, validity and cost.
1. Internally prepared
Internally prepared statements are prepared by a company without involvement of an external accounting professional. Interim financial statements are often internally prepared.
2. Notice to reader
Notice to reader (NTR) is the most basic type of financial statement prepared by an accountant. NTR usually relies entirely on the information provided by the company, with little or no validation or auditing of figures by the accountant.
However, depending on the accountant, they may perform some limited tasks, such as:
- some vetting of figures
- breaking down expenses
- ensuring that the capital cost allowance is calculated correctly
- making sure the correct amount of income tax is paid
- preparing rudimentary notes to the financial statements
It’s important to check what services are included. NTR may be suitable for smaller or less complex companies preparing year-end financial statements.
“The validity of notice-to-reader can vary a lot depending on the accounting firm,” Godfrey says. “Some just regurgitate the client-prepared information. Others have the same reliability and depth as review engagement.”
3. Review engagement
Review engagement is the next step up in sophistication. This type of statement usually involves some validation by the accountant. This could include reviewing the company’s:
- accounting practices
- procedures for recording financial information
- management controls
- fraud management
A review engagement may be suitable for mid-sized and more complex businesses. This type of statement may also be required by lenders, investors, other partners or someone interested in buying the company.
4. Audited statements
Audited financial statements provide the highest level of assurance of the validity of the information. The accountant may:
- request supporting documents
- review internal controls
- verify accuracy of numbers
- conduct on-site spot checks
- perform an audit count of inventory
- evaluate accounts receivable
“Audited statements provide validity and involve a deep dive into a company,” Godfrey says. “The accountant makes sure the financials are accurate and correct.”
Audited statements may be suitable for larger businesses and those contemplating a substantial loan or investment.
How are the different financial statements connected?
All four financial statements are linked. For example, net income is recorded at the bottom of the income statement (see below). It is also found on the cash flow statement and statement of retained earnings. After dividends are subtracted, we get retained earnings, which are stated on the balance sheet.Enlarge the image
Why are financial statements important and how do I use financial statements to build my business?
Financial statements are important for many reasons and are a key tool for building your business.
- They’re essential for managing your business and planning its future. Financial statements are used in strategic planning, budgeting and forecasts. You can monitor interim and annual financial statements to see how your business is performing, spot important trends and compare your actual finances with targets, budgets and forecasts.
“Financial statements can provoke discussion and show if you’re on track so you can know early and often where to pivot and how to pivot,” Godfrey says. “If revenues are up but profit margin is down, you may need to increase the gross profit margin. If expenses are higher than what you budgeted, you may need to trim down on some expenses.”
- Financial statements are used by lenders, investors and other partners to understand a business and its health.
“We take our time going through the financials,” Godfrey says. “When we get a set in, we don’t just forget it or look at a small piece. We look at it from front to back. We look at every page and every line item.”
- Financial statements are used to assess annual tax filings.
What is the difference between financial statements and financial reporting?
Financial reporting is the obligation to provide financial documents in specific situations. Financial reporting may be required by:
- financing partners
- angel and private investors
- bonding and insurance companies
- regulatory agencies and tax authorities
- rating agencies
- investment analysts
Reporting requirements may obligate a business to disclose both year-end financial statements and interim (monthly, quarterly or semi-annual) documents, such as an interim balance sheet and income statement, aged receivables and payables, and a margin report.
What is the most important financial statement?
All financial statements are equally important.
Who prepares an annual financial statement?
Year-end financial statements are usually prepared by an accountant, but smaller businesses often prepare them internally—for example, with the help of a bookkeeper. Interim financial statements are typically prepared internally.
Get a full picture of your business’s financial health by downloading our free guide: Understand Your Financial Statements.
Financial ratios are a way to evaluate the performance of your business and identify potential problems. Each ratio informs you about factors such as the earning power, solvency, efficiency and debt load of your business.