Financial Statements 101
Contents >> Financial Statements 101 | Importance of Financial Reporting | The ‘When’ and ‘Who’ of Financial Statements | The Profit and Loss Statement | The Balance Sheet | The Cash Flow Statement | How the 3 Financial Statements Fit Together | Other Financial Reports | What Financial Statements are Missing | More Advanced Financial Statement Concepts
Welcome to the basics of financial statements. In this article you’ll find a brief guide to financial reporting designed for business owners, small business executives and startup founders. You’ve likely had some exposure to these statements as you consider your company’s financial performance. So we’ll focus on how they fit together. Then, we’ll provide some links to dive deeper into certain areas.
Importance of Financial Reporting
Company financial statements are one of the most important ways business owners and executives can keep watch on the financial health of the business. If done properly, they present an unbiased truth. “The numbers don’t lie” as they say. Business leaders who are committed to ensuring that their financial statements are accurate – and who are willing to confront the truth – will have a better chance at growing healthy companies.
Even if founders and company management aren’t invested in accurate reporting, external stakeholders will demand it. Investors, banks, government funding programs, and tax authorities require complete, up to date and accurate financials. Every time.
The ‘When’ and ‘Who’ of Financial Statements
Financial Statements can be compiled at any time and for any period. Just sign in to your accounting software (e.g. Quickbooks, Xero, Netsuite) and find your way to the reporting section.
Annual financial statements are typically compiled by an external accounting firm. These statements can then be shared with investors, banks, government programs and tax authorities.
Quarterly financial statements are required for public companies. These are disclosed to the public markets. Some larger private companies share quarterly reports internally.
For start-ups and other dynamic small businesses, each month can be like a quarter or a year in a large enterprise. A lot can change. Although there is no requirement for monthly financial reporting, it is a healthy practice to review financial statements at least monthly.
A financial report implies a disclosure to a stakeholder. The content of the report may include the standard financial statements in whole or in part and may include other reports and information. A financial update implies a short-form financial report. Delivered in between formal reports and may include interim financial statements. For instance, founders often provide monthly or quarterly financial updates to their investors in between the requisite annual financials.
It is important that for any report, the books be complete, correct and up to date. If you pull your own reports from your accounting software these are called “management financials” or “draft financials” as they’ve not been reviewed by an accountant. Disclose them as such if you must share them. Of course you may use any management financials internally, just beware that there are no material transactions as yet undocumented or explained in the books.
Now, onwards to the financial statements themselves. There are three:
- The Profit and Loss Statement
- The Balance Sheet
- The Statement of Cash Flows
The Profit and Loss Statement
Also known as the Income Statement. This statement sums up the revenues that have been earned and expenses that have incurred by the company over a given period of time. Subtracting expenses totals from revenue totals gives useful summations like Gross Profit, Operating Profit and Net Income. As the primary objective of most businesses is to earn profit (either now or in future periods) this statement is often the first stop for those analysing financial performance.
On the surface, the concepts of ‘Revenue’ and ‘Expenses’ may seem intuitive. Diving further in reveals that the decisions involved can be subjective and complex. Companies must decide when revenue has been earned. Companies must allocate expenses over months, or split them between departments or accounts.
The Balance Sheet
The balance sheet shows the companies financial position in terms of Assets, Liabilities and Equity. Essentially this means how much the company has, what the company owes, and how much is left over for the owner/shareholder. The balance sheet is always a snapshot at a point in time. Whereas the other two statements are summations over a period of time. Let’s dive in further on the types of things that show up on the balance sheet.
- Assets: can include physical assets like computer equipment, cash in the bank, or Accounts Receivable.
- Liabilities: can include short term debt like credit cards, or bank loans
- Equity: you’ll often see an account called retained earnings, along with accounts for each class of share (e.g. Class A Common Shares)
The Cash Flow Statement
The cash flow statement sums all the cash inflows and outflows for a company over a period. It contains an opening cash balance. It shows operating activities, investment activities and financing activities that affected the cash balance up or down. And finally it shows the closing cash balance.
How the 3 Financial Statements Fit Together – Examples
Let’s look at a few examples.
Invoicing Customers
- A company recognizes revenue by raising an invoice. This hits the P&L as Revenue and Accounts Receivable. Assuming the customer hasn’t paid in advance.
- When the customer settles the invoice, the company receives the cash. Cash is not revenue. This Reduces the Accounts Payable balance (balance sheet). It also increases the bank account balance (also balance sheet). This shows up on the statement of cash flows as increased cash.
Paying Bills
- A company receives a bill from a vendor and enters it into the accounting system. This increases the Accounts Payable balance (balance sheet). The bookkeeper codes the expense into one or more expense accounts in one or more time periods (P&L)
- When convenient, the company pays the bill. This reduces the bank account balance (balance sheet) and reduces the accounts payable balance (also balance sheet). This also shows up on the cash flow statement as a decrease in cash.
Investment Cash In
- Once cash comes in from an investor and shares are issued, the balance sheet is adjusted. The bank account balance goes up, as does the amount in the relevant shareholders equity account. The cashflow statement sees this as well, as cash from financing activities
These are simple examples where the transaction is clear cut. Sometimes it is less obvious. Let’s say you spend $300,000 over the course of a year developing core architecture for your SaaS application. You may want to capitalize some or all of this spend. So some of this might show up on your balance sheet as an asset and some as an expense on your income statement. You may want to recognize revenue in a different period than the invoice was issued. For example, if the work will take several months but the client paid up front. Talk to an accountant about these decisions, understand them, and ensure consistent treatment.
Other Financial Reports
There are other kinds of financial statements. For example, you may receive a statement of account from a vendor This should show all the bills you’ve received, all the payments against those bills and the current balance. Similarly you can issue a statement to your customers.
What Financial Statements are Missing
Financial statements are just numbers. They do not contain the ‘story’ of what happened and why. Many business owners have a strong sense of recent events, which provide some context. It takes a skilled accountant or CFO to marry that context to the numbers, see what can be explained, and tease out the hidden gems of truth that blindside
Financial statements are by definition historical records. They are out of date the instant they are generated. While it is important to record and understand the truth, if your business is incredibly dynamic, it may not be useful to look at months-old financial statements. For this reason, startups need to ensure their bookkeeping is as close to ‘real time’ as possible. Even better, startups should engage Financial Planning and Analysis (FP&A) experts to try to model and predict future conditions based on trends and planned events.
Financial statements are not the only indicators of business health. Companies should look to other areas of the business to set KPI. Customer churn, sales pipeline, employee turnover, etc. are all important and are completely missing from financial statements.
More Advanced Financial Statement Concepts
If you have multiple companies and you want to show the financial performance of the whole group, you’ll need consolidated financial statements. These need to consider inter-company transactions and transfer pricing.
If you do business in different currencies, you’ll need to consider currency exchange and your home currency.
There are also accounting practices and standards that influence how financial statements are put together such as GAAP and IFRS – these are particularly relevant for international companies and publicly traded companies.
There’s always more to learn.
Help with your financial statements
Even those who’ve worked with financial statements for years can still sometimes get confused about how certain transactions hit the balance sheet vs income statement. An accountant can help you navigate all this and more importantly, help interpret what the financial statements are telling you. Understanding the story behind the numbers will help you make better business decisions. Entreflow is here to help. Get our accountants in Vancouver or accountants in Toronto to help your small business or startup with financial statements.
Author: Helina Patience, Founder, CPA, CMA, BA (Hons), BEd
Helina is a CPA, CMA with over fifteen years of experience in finance & HR within multinational companies, across many industries. Also the CEO of entreflow consulting group where I help small to medium-sized businesses get organized, grow, and crush their goals. I hold vast global experience after living and working in Australia, India, the UK and Ireland. Connect on LinkedIn.
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