How to Read Your Business’ Financial Statements
The bottom line: The CPAs at Dugan & Lopatka—a leading accounting firm in Chicago’s suburbs—explain the three types of financial statements every business owner should know.
What are financial statements and why are they important?
Financial statements are like an MRI scan for your business. They look beneath the surface of your company to offer a more in-depth look at its financial position, operations, sustainability, and future outlook.
These statements are useful for stakeholders both within and outside the business.
For management, they are an essential tool for running the business. Before making a budget or planning a future investment, a manager will want to take an in-depth look at the company’s finances.
For investors, financial statements can be a way to gauge the health of an investment and decide when to invest, how much to invest, and when to pull back. Whether they are a current investor or a bank considering giving a loan, they need to look deeper into the business’ finances to make informed decisions.
Meanwhile, state and federal governments rely on financial statements to determine a business’ tax burden. These organizations rely on a special type of financial statement—called an audited statement—which we’ll review next.
How are financial statements prepared?
Although all companies have financial statements, not all financial statements are considered equal.
Financial statements may be:
- Internally Prepared: In this case, the statements are prepared by someone within the company. These statements are useful for interim reports, but they generally aren’t used for tax purposes or by investors in mid-sized or larger companies. Because they are internally prepared, the information within is unverified. An internally prepared report asks readers to trust that the data provided by the company is accurate.
- A Notice to Reader (NTR): These basic financial statements are prepared by an accountant. However, they generally rely on financial information provided by the company, and their quality varies depending on the accounting firm.
- Review Engagement: This is a financial statement prepared by an accountant who has carefully reviewed the data provided by the company and assured its validity. Banks and other investors often require a Review Engagement, as do outside parties looking to acquire the business.
- Audited Statement: Required by governments for tax filing and financial transparency, an Audited Statement has been thoroughly vetted by a CPA according to the generally accepted accounting principles (GAAP).
What are the three basic types of financial statements?
Depending on their size and complexity, businesses may produce a variety of financial statements. But every business—and every investor—should be familiar with the three most common: balance sheets, income statements, and cashflow statements.
Remember how we said that financial statements are like MRIs, allowing you to look deeper and in greater detail into the financial state of a business?
If we extend that metaphor, then the three types of financial statements are like three different types of scans: an MRI, an X-Ray and an angiogram. Each “scan” offers a different perspective on the business. None of them tell the full story.
However, each one is valuable in its own way. And when you look at the three together, you begin to see the bigger picture.
These are the three basic types of financial statements:
A balance sheet is a snapshot of the company’s assets, liabilities, and shareholders’ equity at a given point in time (the end of the reporting period). As the name suggests, a balance sheet is organized like an old-fashioned scale, with assets on the left and liabilities plus shareholders’ equity on the right.
Assets include all the things a company owns with value. That usually includes both physical and intangible property, from actual cash and investing activities to buildings and machinery.
Assets are listed on the left side of the balance sheet, usually in descending order of how quickly they are anticipated to generate cash. (Inventory, which is generally expected to generate cash within the next year, is up top. Fixed assets, like buildings and other investments that won’t generate cash anytime soon, are further down.)
Liabilities include bank loans, rent, payroll, taxes—all the money a company owes to others.
Finally, shareholders’ equity—also known as capital or net worth—is the money that belongs to the shareholders or owners of the company.
Similar to a balance sheet, an income statement shows what a company has earned (revenue) versus what it has paid as expenses. However, unlike a balance sheet, it shows how these profits and losses have occurred over a period of time.
An income statement is organized like a ladder. The top rung—the line item at the top of the sheet—is the gross revenue, the total amount of money earned during the accounting period. As you descend the ladder, each line deducts from that top value based on a different cost, such as operating expenses, depreciation of assets, taxes, and interest paid.
The bottom “rung” of the ladder is a number that represents how much money the company actually earned or lost during the period, with all the expenses deducted. This is the literal bottom line.
Our third and final basic financial statement is the cashflow statement. As the name suggests, a cashflow statement breaks down, in detail, how cash moves into and out of a company over a period of time, through operations, investments, and financing.
While balance sheets and income statements may speak to the overall health and sustainability of an organization, cashflow statements help businesses predict when they will need cash for anticipated expenditures and how much cash they can expect to have on hand at a given point of time. It’s a valuable tool for strategically planning investments and expansions.
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Whether you’re looking to better-understand your financial statements or need outsourced accounting in Chicago, IL, Dugan & Lopatka offers a comprehensive range of accounting services, business consulting, and tax services. As excellent communicators and industry experts, our CPAs help you achieve your goals in business and in life.