The Four Basic Financial Statements And Their Purposes

If you are a business owner, you will probably be aware that there are four financial statements you need to prepare for your company. These four financial statements provide you complete information regarding your business activities and can aid you, your investors, or other stakeholders in understanding the financial health of your business.

What Are The Four Basic Financial Statements?

The four basic financial statements that you need to prepare for your business are:

  • Income Statement: It is considered by many as the most important out of the four financial statements. It shows the revenues earned, expenses incurred, and profits or losses for the reporting period (the duration for which the statement is prepared).
  • Balance Sheet: It is a statement that shows all your assets and liabilities, along with details of the owner’s and shareholder’s equity.
  • Cash Flow Statement: This statement shows the inflow and outflow of cash in the business. It helps provides basic information on whether the business is earning more or spending more.
  • Statement of Retained Earnings: Also referred to as the statement of owner’s equity, it helps to track changes in equity during the period. It tells you about the retained earnings or profits that you can use.

1. The Income Statement

The first of the four basic financial statements is the income statement. It is also referred to as a profit and loss (P&L) statement. The statement details the revenue earned during a specific period and the expenses. It also shows whether there is a profit earned or loss incurred. It is an important tool that you can use for your financial planning. The income statement would show sales, operating expenses, and non-operating expenses.

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If an investor wants to know more about your revenue earning and profitability, this is the statement they will refer to. While it shows whether you are making profits or losses, ultimately the revenues matter more, as there are many businesses that continually make losses but are still valued high. The income statement also helps you in forecasting risks and making informed financial decisions since you have all the required data on hand.

2. Balance Sheet

The balance sheet is highly important amongst the four financial statements. Many business owners give so much importance to the income statement that they tend to ignore this statement. The balance sheet is used by external entities like investors and creditors to understand the financial health of your business. If you want a bank loan, then this is a mandatory statement that you must produce. It lists out the assets of your business, like cash, property, inventory, etc. In the list, the liabilities of your accounts payable, taxes payable, mortgages, etc. are listed as short-term and long-term liabilities simultaneously.

The key aspect of the balance sheet is the equation: equity + liabilities = assets. The report is structured in such a way that the total assets equal all the liabilities and the equity. The balance sheet gives you a snapshot of your financial position, hence it is highly instrumental in budgeting as well. Apart from your present financial health, the balance sheet can also give you an idea of your future financial health. It can help you in understanding if the pricing strategy you are currently implementing is effective and also helps you find out if there are any spikes in the spending of your business.

3. Cash Flow Statement

As proper cash flow is the lifeline for any business, a cash flow statement aids you in keeping track of where your cash is going. This statement is very important in helping businesses understand how the inflows and outflows of their cash are happening. The inflows and outflows can be organized in the report in categories like operating activities, investing activities, financing activities, and other information. While the income statement tells you the profit or loss, it does not explain the flow of cash.

You may have money shown as revenue in your income statement, but it may not be reflected in your cash flow. These are discrepancies that can be problems for a business if they are not taken care of.  It is required by investors or lenders as it helps them to understand if your company is financially viable to be conducting any business with.

4. Statement of Retained Earnings

This statement explains changes in equity during the period for which the statement is made. Information in this statement includes the sale of shares, repurchase of shares, payment of dividends, etc. Ultimately, it helps you understand changes in the owner’s equity. It shows your retained earnings, which is the profit that you can use to clear your liabilities to invest. The retained earnings are the net income left after you have paid out dividends. A business may choose to reinvest the earnings, thereby increasing the value of the business.

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However, anyone who lends to you may want to examine this statement to understand more about your profitability. This is because an investor would like to know how you are making use of profits. They would need to know this to understand whether the money they invest will fetch them reasonable returns. A creditor will view with concern if your statement shows very low retained earnings. In such situations, they may either refuse to offer credit or charge a much higher interest rate.

The Importance of the Four Financial Statements

Whether it is the board of directors of a company, investors, shareholders, or lenders, financial statements offer valuable information to all of them. All the four financial statements can give a clear indicator of the financial health of a business. Therefore, you need to ensure that these statements are prepared accurately.