Financial Statements in Simple Words
Financial Statements are reports that summarize how well a business is doing financially.
Instead of long explanations, Financial Statements use numbers to convey a company’s performance to the investors or stakeholders. They tell us how much money the company makes, how much it spends, and what it owns versus what it owes. All this information helps people decide what to do next with the company.
Four Types of Financial Statements
There are four types of financial statements commonly used by businesses.
- Balance sheet – showing what the company owns, what it owes, and what’s left over. See here for a simple example.
- Income Statement – showing how much money a business has made and how much they have spent on expenses. See here for a simple example.
- Statement of Cash Flows – showing how much cash a business has collected and where they have spent the cash. See here for a simple example.
- Statement of Changes in Equity – showing what caused the business owner’s equity to increase or decrease in a certain period. See here for a simple example.
Out of the four Financial Statements, Balance Sheet and Income Statement are the most standard set that almost every business would prepare. Statement of Cash Flows is also required in many situations but isn’t always needed for small businesses where owners already have a good sense of their cash activities. Statement of Changes in Equity is the least required as only large, publicly traded companies need to prepare it.
Purpose of Financial Statements
Each financial statement serves a unique purpose in reporting a company’s overall financial health.
- Balance Sheet – showing a company’s ability to manage what it owns (assets) and what it owes (liabilities). Managing these parts is critical because a business would go bankrupt when the assets can’t cover the liabilities.
- Income Statement – calculating how profitable a business is.
- Statement of Cash Flows – showing how the business handles its cash.
- Statement of Changes in Equity – showing how the company’s ownership has changed and how it distributes profit.
Difference between the Financial Statements
Balance Sheet vs. Income Statement
Balance Sheet shows what a company owns. Income Statement shows how much profit a company has earned. What a company owns (Balance Sheet) has nothing to do with its profitability (Income Statement). I can inherit $1M from a family member to start a business, but it doesn’t mean the company is profitable, and vice versa.
Income Statement vs. Statement of Cash Flows
Income Statement shows how much profit a company has earned. Statement of Cash Flows shows a company’s cash inflow and outflow activities. A company’s profitability (Income Statement) has nothing to do with how it handles its cash (Statement of Cash Flows). I can earn $1 million a year, but I gambled it all away in one day. I excel at making money but could be terrible at decision-making with my cash.
Balance Sheet vs. Statement of Cash Flows
Balance Sheet shows what a company owns.Statement of Cash Flows shows a company’s cash inflow and outflow activities. By nature, these two are more linked because cash is an asset presented in the Balance sheet. However, Balance sheet only shows a “Balance” at a point in time but doesn’t explain the activities, while the Statement of Cash Flows details how the cash came in and out. Using a bank statement of your checking account as an example; on the first page, it says how much balance you have at the end of the month – that’s what a balance sheet does. The following pages likely detail how you swiped your credit card or paid off the balance – that’s what a Statement of Cash flow does.
In addition, Balance sheet includes all assets, liabilities, and equity accounts of a business, while Statement of Cash Flows only focuses on the activities of Cash.
Statement of Changes in Equity vs. Other Financial Statements
Statement of Changes in Equity is more distinctive than the other three statements because it doesn’t directly signal how well a business is doing. It only reports what’s changed to the equity portion of the company or the ownership structure. For example, has anyone made additional investments or withdrawals from the business? The Statement of Changes in Equity would show it. It is also often seen as an expansion to the equity section of the balance sheet, as the Statement of Changes in Equity shows activities similar to the Statement of Cash Flows, which is essential for businesses with multiple owners or complex ownership structures such as those publicly traded companies.
Frequency and Timing of Preparing Financial Statements
Frequency: Financial Statements are often prepared annually – so once a year. For publicly traded companies, Financial Statements are also prepared every quarter. That way, investors can gain more insights into how a company is doing throughout the year. It is extremely uncommon for a company to prepare financial statements covering more than 12 months as numbers would become irrelevant for decision-making.
Timing: Typically, financial statements are prepared after the conclusion of the quarter-end close, when the trial balance is finalized. That way, the preparer of Financial Statements won’t have to go back and forth updating the numbers.
Order of Preparing Financial Statements
Income Statement is prepared First. The reason is that in order to prepare the equity section of the Balance Sheet, you need the number for retained earnings, which in most cases is your net income from the Income Statement. Therefore, the Income Statement should always be prepared before the Balance Sheet.
Either the Statement of Cash Flows or the Statement of Changes in Equity is prepared last, just because they both are seen as an expansion to the Balance Sheet, where Statement of Cash Flow presents activities of Cash and Statement of Changes in Equity shows the activities of the equity section.
Q: What are the 3 most important Financial Statements?
Q: Which Financial Statement is reported as of a specific date?
A: Balance Sheet. Balance Sheet is the only Financial Statement that reports as a snapshot in time instead of activities. It often captures the last day of an accounting period, such as 12/31/24.
Q: Are tax returns considered Financial Statements?
A: The quick answer is No. Fundamentally, tax returns and Financial Statements have many differences and should not be used interchangeably. A simple example is fines & penalties. Fine & penalties are legit expenses that should be included in the Financial Statements. However, they should be generally excluded from your tax return as they are not tax deductible.
Q: Who needs to prepare the Financial Statements?
A: Companies that need to deal with external parties where disclosure of financial information is required. For instance, companies looking for investors, getting loans from banks and filing for IPO, etc. Generally, the accountants of the business should prepare the Financial Statements. Or they can hire accounting firms/CPAs to help them with the task.
Q: Are Financial Statements Mandatory?
A: Generally speaking, for publicly traded companies – Yes. For private companies – not really, unless they are requireto disclose their financial information by the investors or banks
Q: Are Financial Statements public information?
A: For publicly traded companies – Yes. They can be found on government-owned security exchange websites. For private companies – usually no. There is generally a lack of points for stakeholders to disclose private company financial information to the public.