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Now that you know what accounting entails and the key principles that are used in accounting, let us have a look at financial statements. The whole of this book is based on preparing and interpreting financial statements. In this chapter, I am going to introduce you to financial statements, elaborate on their use, and help you know their importance in your business.

Financial statements are simply written records that are used to convey the activities of a business and the financial performance of the company. Financial statements are summarized information that is easy to interpret. The summary is made from data stored by bookkeepers. When a business operates on a day to day basis, the bookkeeper is required to keep records of all the transactions of the business. Over time, these transactions build-up and must be summarized to provide a clear view of the performance of the business. The information is summarized in key documents that are easy to interpret and follow the accounting principles mentioned above.

Financial statements must adhere to accounting best practices because they are legal documents. In other words, if the statements do not follow the set accounting principles, they may not be admissible in court in case of a legal battle. Further, financial statements are usually audited by responsible government agencies, accountants, other companies, etc. In other words, these summarized documents are important to many stakeholders. If you are running a business, your financial records will determine the amount of taxes you pay, the type of business partners you bring on board, and your credit worth, among other factors. It is, therefore, important for every business to prepare, organize, and file financial statements properly. The work of preparing, filing, and organizing records starts with proper bookkeeping, as already mentioned.

There are three main financial statements; the balance sheet, the income statement, and the cash flow statement. For any person who is new to the world of accounting, the focus should be on interpreting these key financial statements. However, there are other auxiliary financial statements that you may also want to prepare and interpret. You may be interested in the statement of owner's equity and statement of retained earnings, among others. In this book, we will mainly look at preparing and interpreting the balance sheet, the income statement, the cash flow statement, and the statement of owner's equity. These are the key financial statements that determine the future of any business. However, we will also look at the other financial statements and tools as we move on to help you have a clear understanding of your books.

The reason for picking out the four main financial records is that they can tell you everything you need to know about your business. The balance sheet provides an overview of the assets and liabilities of the company. From this overview, we are able to determine the position of the company in terms of financial stability. The income statement, on the other hand, focuses on the revenues and expenses of a company. As you can see, these two financial statements already cover everything you need to know about your business. The balance sheet helps you gauge the net worth of your business while the income statement helps you gauge the current performance of the business in terms of profits. The income statement will help you determine the net income of the business after deducting key expenses and taxes.

We will then look at the cash flow statement, which will help us measure how the company generates funds to pay its debts. The cash flow statement mainly focuses on operational costs and expenses. This statement tries to gauge the financial position of the company and the ability of the business to continue operating in the short term

The information provided in financial statements is important to many people. Investors, financial analysts, tax authorities, and shareholders rely on the information provided in financial records in making decisions. For publicly traded businesses, the financial statements are very vital in providing guidance about the performance of such companies in the stock exchange market.

As you can see, we have different types of financial statements. Each of the mentioned financial statements has its purposes and benefits.

The balance sheet is one of the most important financial statements for a business. It provides an overview of a company's assets, liabilities, and owner's equity. The balance sheet provides a picture of a company's net worth at a snapshot of time. This means that the assets and liabilities of the company are identified on the date when the balance sheet is prepared. Consequently, balance sheets have to keep on being prepared after some months to evaluate the growth of the company.

The balance sheet equation states that

As you can see, the assets are added together to equal the sum of liabilities and owner’s equity.

When we prepare the balance sheet, the aim is to recognize the growth of the business and determine its net worth. Assets are grouped on one side, and liabilities are grouped together with the owner's equity.

The balance sheet is a financial statement that can be prepared even before you start operating your business. As soon as you are ready to get started, prepare your first balance sheet so that it can help you gauge the net worth of your business in the future. From the equation, it is clear that a business's worth is its assets. However, the business's assets are either acquired from cash invested by the owner or cash borrowed. In other words, the cash invested by the owner at the start of the business represents the owner's equity, and cash borrowed represents liabilities. This is how simple a balance sheet can be at the start of a business. However, as the business starts operating and gaining profits or making losses, liabilities can grow or decrease; consequently, owners' equity can change, and assets will also change.

The main items included on a balance sheet in terms of assets include cash accounts, accounts receivable, and inventory. The liabilities to include to your balance sheet entail debts- both short term and long term, accounts payable, and dividends payable. The owner's equity is calculated separately after the income statement has been prepared, and all expenses paid.

While the balance sheet is prepared in a snapshot of time, the income statement is prepared over a period of time. The balance sheet is prepared on a specific date, and the items on the balance sheet represent the value of the company at that particular time. However, the income statement shows figures obtained over a specific trading period. The trading period in question may be 1 month, several months, or a year. Most businesses prepare their income statements quarterly, semi-annually, or annually. If you are running a small business, I will recommend preparing your financial statements in close succession to avoid prolonging mistakes. You could either prepare statements quarterly or semi-annually just to keep track of the performance of the business.

The formula for the income statement states that

The main aim of the income statement is to determine the total revenue, expenses, and net profit of the business. If you choose to prepare your income statement after 3 months, it will show you the amount of money spent, generated, and the profit that the business has made over that period. The information needed to prepare the income statement is obtained from the general ledger. It is the general ledger that will record all your transactions (Expenses and revenues), which are needed to determine the net income of the profit. However, you must ensure that the information in the general ledger is accurate to help you prepare an accurate income statement. To test the accuracy of the general ledger, a trial balance is prepared.

When preparing the income sheet, you must first classify your revenue and expenses. Some businesses only have one source of revenue, which makes the entire process easy. If you are selling cars and do not have other sources of revenue, the process of preparing your income statement will be straight forward. The primary source of revenue for a business is the Operating Revenue (OR). This refers to the revenue obtained from the main business activity, such as selling cars in the example above. We also have other sources of revenue, such as interest earned on cash in the bank, rental income on a property, income from advertisement, and display, among others. Revenues can also be collected from the sale of long term assets such as land or vehicles. All these types of revenue are accounted for in the income statement.

Expenses can also be classified into primary and secondary expenses. Primary expenses include those that directly lead to the revenue generated. The primary expenses include the cost of goods sold and operational costs. The secondary expenses may include general administrative expenses, depreciation, research and development costs, among others.

The third important income statement is the cash flow statement. This document offers a summary of the cash that flows into the business and out. The statement summarizes the debt of the business, its expenses, revenue, and fund investments. The document is mainly prepared as a complementary addition to the income statement and the balance sheet.

The information provided in the cash flow statement is mainly used by investors, especially potential partners. It provides information on whether the business is in a position to pay its debts and continue operating. There is no formula for the cash flow statement, but it is distributed into three sections: operating activities, financing activities, and investing activities.

The operating activities of the cash flow statement determine any sources of cash or uses of cash that occur due to running the business and selling goods and services. The operating CFS may include changes made in accounts receivable and payable, depreciation, and inventory. You should also include wages, taxes, and rent on this list.

Investing activities, on the other hand, include any uses and gains of cash from long term investments. For instance, if the company made a loan to another company, and interest is being paid, such cash will be recorded under the investment activities. At the same time, if you have to pay interest on loans you acquired earlier, the amount will also be classified under investing activities.

The financing activities include the sources of cash from investors, such as other companies or from banks. This section mainly deals with cash injection into the business other than what the business owns or dividends paid to shareholders. You may also include items such as stock purchases, equity issuance repayment debt, among others.

Finally, we have the statement of owner's equity. This is a financial statement that shows the portion of the company that belongs to the owners of the company. As we have already seen, the portion of the company owned by the founder of business on the day of starting is the capital invested. However, as days go by, the business may make profits and retain some of the profits in the business ( Retained Earnings), which will increase the stake of the owner ( Owners’ Equity). The owner's equity is, therefore, calculated by adding retained earnings to the previous owner's equity.

The statement of owner's equity mainly shows the increase or decrease in the owner's capital at the start of the trading period. This means that the capital plus retained earnings at the end of the period is what we call the owner's equity. When preparing a statement of owner's equity, you will start with a heading, which will show the name of the company, the title of the report, and the period covered. If you are a sole proprietor, the title of your report should read “The Statement of owner's equity." If you are operating a partnership, the title should read “The statement of Partner's Equity." In corporations and public limited companies, we use the terms “The Statement of Stockholders' Equity.”

Just like the income statement, the owner's equity is prepared at the end of a certain trading period. After preparing your income statement and determining your net income, you can proceed to distribute the income accordingly. Once all the income is distributed, and a portion is retained to be invested back to the company, add it to the owner's equity brought forward from the previous trading period.

The statement of owner's equity mainly depends on what happens in the income statement. Since we have established that the owner's equity is equal to the capital invested by owners of the business at the start, expenses will decrease the capital. At the same time, revenues will increase the capital. Given that the income statement aims at providing a net income figure, you can see that if the expenses are more than revenue, the income is likely to be negative. This will mean that capital will reduce, consequently leading to a reduction in owner's equity.

Financial statements are very crucial to businesses. Although each of the financial statements has its uses, let us look at the overall benefits of preparing financial statements for your business.

1. Track Financial position of the company: The balance sheet is a document that shows the position of the company financially. Without the balance sheet, it would be impossible for the company owners and other parties to know its net worth, its liabilities, and, as a result, the future of the business.

2. Evaluate the performance of a business: The other importance of income statements is that they help evaluate the past performance of the company. The income statement is particularly important in conveying information about the revenue and expenses of a company. Through this document, any interested party can determine the profits of the company and the sustainability of the business model. This information is important to investors, lenders, and government agencies. If you do not have credible financial statements to show the performance of your business, you may not be able to get funding even if you apply.

3. Show the current financial position of the company: The statement of cash flow is particularly important in displaying the current position of the company. When investors such as suppliers want to partner with your business, they must be assured that the company is in a position to pay its debts. The statement of cash flow helps show the strength of a business and its ability to finance debts. This is important to you as a business owner if you wish to secure trading partners too. If you do not provide accurate statements about your business's performance, chances are that your business will not be in good terms with lenders.

4. Shows net worth of the company: The other benefit of preparing financial statements is that you can determine the net worth of the company. From the balance sheet, we can have a look at the assets, liabilities, and owner's equity. The company's worth will only grow if the business is making profits and retaining them. All these factors will only be determined by looking at the various financial statements, including the balance sheet and the statement of owner's equity.

5. Planning for the future: The other importance of the financial statements is that they provide information that will help the management plan for the future. As the business owner or manager, you should think about future investments and make informed decisions to help the company grow. Without having a clear understanding of the current company's financial position, you cannot make such key decisions. The income statement helps the management by providing information that makes the work of decision making easier.

6. Guide shareholders in making investments: The income statement can also be used by shareholders to make key decisions. If you are a shareholder, you want to invest in a business that is making profits and is showing prospects of growth for the future. This information can only be obtained by looking at the financial statements. The income statement and the balance sheet will help you know if the company is on an upward growth trend or on a downward spiral. These statements are very vital for both current and prospective investors. Even though an individual might not have any shares in the company, the information provided may help any prospective investors make the best decisions.

7. Guide for creditors and lenders: Besides prospective investors and shareholders, lenders and creditors also need to look at financial statements. The income statement and the statement of cash flow are very vital for creditors and debtors. They determine the financial liquidity of a company, the debt ratio, profitability, and the return on investment of the company. All these indicators will determine how the business operates in the future.

If a business has more current debts than current assets, it means that it lacks operating capital. In other words, it might not be able to meet its short term liabilities. For such a business, creditors and lenders may not want to engage in business. It is therefore vital that all this information is made available by providing accurate financial statements.

8. Employees Compensation: The income statements also provide guidance on employee compensation. When we look at the financial statements, we can tell that a business is operating in profit or loss. The employees of a company use such information to review their wages and possibilities of a future appraisal. If you are working for a company that keeps on making losses year in year out, chances are that you should be looking for another job. Such information by companies helps employees plan for their future with the current employer.

9. Calculating taxes to be paid: Without financial statements, it is not possible to determine the amount of tax a company is supposed to pay. For this reason, all businesses are required to prepare financial records. The government uses the provided financial records to arrive at the decision of how much tax business will pay. As a company, you may also be overtaxed if you do not provide accurate financial information. In this regard, it is important to prepare the most accurate financial statements for your business.

10. Debt management: The information available in financial statements is also very important to the management of the company. If you are the manager, you need to know the company's debt level, liquidity, cash flow, among other factors. The information provided in financial statements will help you start managing your debts properly, control lending and borrowing.

11. Trend Analysis: For every business, it is important to look at the trends and try to invest based on the performance of the business. Without financial reports, it would be difficult to determine the trend of the business. For instance, the profit and loss statement provides figures about sales and expenditure. Through such statements, you can determine areas of expenditure that are hurting the company and the products that bring in the most revenue. This Way, you can make informed marketing and production decisions that will foster the growth of your business.

12. Tracking: The management of the business also enjoys a clear view of the future. Financial tracking will help eliminate possible roadblocks before they happen. You can detect the possibility of supply chain problems just by looking at your cash flow reports and making decisions that will facilitate smooth operations of the business in the future.

13. Compliance: Last but not least, every business must be able to comply with government authorities in many areas. The main area of concern when it comes to business finances is the payment of taxes and employee wages. Without financial statements, it is not possible to detect the amount of tax a company is required to pay.

For this reason, it is a government requirement that all businesses prepare accurate financial statements and make the public. Every company is required to audit its finances, verify the information, and make it readily available for government audits. This helps to ensure that there is transparency.

We have already looked at some of the parties who may be interested in your financial statements. However, the list of interested parties is longer than you may imagine. Some of the parties interested in seeing your financial statements may not have good intentions, but you are required to make your information freely available. The parties that will need the financial statements include:

1. Company management: The management team of the company is the first beneficiary of financial statements. They need the information to determine the liquidity of the company, profitability, and determine cash flows. This information is necessary to help maintain day to day operations of the company.

2. Competitors: Competitors and brands that are similar to yours will try to gain insight into your financial information. The information obtained from financial reports can be used in a competitive market structure. For instance, if your competitor notices that you are gaining a lot of revenue from a certain line of products, they may choose to invest in the same line and compete for your market share.

3. Customers: When most people prepare financial statements, they don't consider the implications they may have on customers. However, customers are among the parties that need financial statements. Most customers review financial statements before awarding tenders to suppliers. From the financial statements, the customer can tell the company that will meet the quality and quantity of goods needed.

4. Employees: As we have already seen, employees also need to monitor the financial position of a company. If the company keeps on making losses, an employee may choose to take off before they are left jobless. From the financial reports, employees can also find a reason to bargain for better terms.

5. Governments: Government agencies also need to review financial reports for the purposes of taxation. Any company that makes profits is required to pay taxes to government agencies in the regions where it is located. For this reason, governments will be required to look at the financial documents of your business.

6. Investment analysts: If you happen to hire an investment analyst for your business, he/she cannot offer any analysis unless you provide the right data. The information needed to make key investment decisions is only available in financial statements. For this reason, you must ensure that you prepare accurate financial statements for your business.

7. Investors: Investors who wish to partner with your business or inject capital must also look at financial statements. As already mentioned, you will not be able to secure lending for your business unless you have the proper financial statements. Be it banks, individuals, or other credit facilities, the main point of reference when investing in a business is the financial statements.

8. Rating agencies: All businesses undergo ratings at some point. The ratings determine the success of a business in terms of its creditworthiness. If a credit rating company deems your company unworthy of receiving credit, you will not survive for long. Such agencies depend on the financial data provided to calculate your credit. They base your credit on the available resources such as assets, capital, and owner's equity.

9. Suppliers: The other group of people who will benefit and must look at your financial statement is that of suppliers. Suppliers mainly use financial statements to determine whether a client is the right fit for a business corporation.

10. Unions: Lastly, unions also use the information provided in financial statements. They must be sure that a company is in a position to pay union fees to retain its membership. Employee unions also look at accompanying books when lobbying for employee rights. They must prove that a company is making sufficient money before demanding a pay rise and other perks.