Financial statements are the three reports that describe how a business is doing: the income statement, the balance sheet and the cash flow statement. They are not just for accountants. Even a one-person business gains a lot from reading them, because each answers a different question. This guide explains them with a single small example.
The three questions
The income statement asks: did we make a profit over this period? The balance sheet asks: what do we own and what do we owe on this date? The cash flow statement asks: where did our cash come from and where did it go? A business can be profitable and still run out of cash, which is why you need all three.
The income statement
Also called the profit and loss statement, it covers a period, such as a year. It starts with revenue, subtracts the cost of goods sold to get gross profit, then subtracts operating expenses to reach operating profit. Suppose a business earns revenue of 120,000, with a cost of goods sold of 54,000. Gross profit is 66,000, a gross margin of 55%. Operating expenses are 41,000, which leaves an operating profit of 25,000, about 20.8% of revenue, before tax and interest. Our guide on cost of goods sold explains the first step.
The balance sheet
This is a snapshot on one date. It lists assets, what the business owns, and liabilities, what it owes, and the difference is the owner's equity. Say the business has cash of 18,000, customers who owe it 12,000, inventory of 20,000 and equipment of 15,000. Assets total 65,000. It owes suppliers 9,000 and has a loan of 16,000, so liabilities are 25,000. Equity is 65,000 − 25,000 = 40,000. The balance sheet always balances, because equity is defined as assets minus liabilities.
The cash flow statement
This statement explains the change in cash over the period, in three parts: operating activities, investing activities and financing activities. Suppose the business started with cash of 10,000. Its day-to-day operations brought in a net 16,000. It spent 4,000 on equipment, which is investing, and repaid 4,000 of its loan, which is financing. Cash rose by 8,000, to 18,000, which matches the balance sheet above.
Why profit and cash differ
Profit counts income and costs when they are earned or incurred, and cash counts when the money moves. A sale on credit is revenue today and cash next month, so the 12,000 owed by customers in the example is profit that has not yet become cash. Buying stock uses cash before it becomes a cost, and a loan repayment is not an expense at all. This is why the three statements, read together, tell a fuller story.
A few simple ratios
You can learn a lot from simple ratios. Gross margin, gross profit divided by revenue, was 55% in the example. Net or operating margin was 20.8%. The current ratio compares what you own in the short term with what you owe in the short term. If current assets are cash, receivables and inventory of 50,000, and short-term liabilities are 9,000, the ratio is about 5.6, which suggests comfortable liquidity. Ratios mean most when you compare them over time and with similar businesses.
How often to prepare them
Many small businesses prepare them monthly or quarterly for their own use, and annually for tax or lenders. Monthly statements let you spot problems early, such as costs creeping up or customers paying slowly. Compare each period with the last, and ask what changed.
Standards and accountants
Formal statements follow accounting standards, such as IFRS or national rules, and there are details about how items are measured and presented. The simple versions here are good for managing a small business, but lenders, investors and tax authorities may expect statements prepared by an accountant. Ask what they require.
Common mistakes
Mixing cash and accrual methods, leaving out unpaid bills or customer debts, forgetting to include the owner's drawings, counting stock at the wrong value, and treating profit as cash. Another is looking at one statement alone, rather than all three.
Reading them together
Go through the three statements with a few simple questions. Did profit grow, and did cash grow with it? If not, where is the money stuck: in customers who have not paid, in stock, or in debt repayments? Are costs growing faster than revenue? Is borrowing rising? A short list of questions, asked every month, finds problems much earlier than a once-a-year review.
Who needs which statement
You, as the owner, will get the most from all three, ideally monthly. A lender will usually ask for the income statement and the balance sheet, and often the cash flow statement too. Tax authorities mainly want the income figures, in the format your country requires, and an investor will want the full set. Ask each what they need, since requirements vary.
Try it yourself
Our free financial report templates let you fill in an income statement, a balance sheet or a cash flow statement and calculate the totals for you. For keeping the numbers behind them in good order, see expense tracking. This guide is general information, not accounting advice.
