Financial statements: types, how to read and analyze

Published Thursday 26 February 2026

Table of contents

• What is a financial statement?
• Types of financial statements
• How to read your financial statements
• Why financial statements are important for small businesses
• How to prepare financial statements for your business
• How to use financial statements to analyze your business
• Ways to use your financial statements
• Financial statement templates for your business
• Streamline your financial statements with Xero
• FAQs on financial statements

Key takeaways

• Review all four financial statements together (balance sheet, income statement, cash flow statement, and retained earnings statement) to get a complete picture of your business's financial health rather than focusing on profit alone.
• Monitor key financial ratios like the current ratio (current assets divided by current liabilities) and debt-to-equity ratio to quickly assess your business's liquidity and financial stability.
• Track your cash flow statement regularly to ensure your core business operations generate positive cash, as you can be profitable on paper but still run out of cash if customers pay slowly.
• Compare financial statements across multiple periods to identify trends in revenue, expenses, and cash flow that help you make smarter decisions about where to invest in your business.

What is a financial statement?

A financial statement is a formal record of your business's financial activities and performance over a specific period. Lenders and investors use financial statements to assess your business's financial health and earnings potential.

Financial statements typically cover a month, quarter, or year.

Types of financial statements

Small businesses typically use four types of financial statements: the balance sheet, income statement, cash flow statement, and statement of changes in equity (also called retained earnings statement). Together, these documents give you a complete picture of your business's financial health.

Balance sheet

The balance sheet shows your business's financial position at a specific point in time by comparing what you own against what you owe.

• Assets: what your business owns (machinery, patents, intellectual property, cash)
• Liabilities: what your business owes (long-term debts, accounts payable)
• Equity: the difference between assets and liabilities, often used as a starting point for valuing a business

To find the equity, use the formula: Assets - Liabilities = Equity

This formula helps business owners evaluate the financial stability of their business.

Income statement/Profit and loss statement

The income statement (also called a profit and loss statement) shows your business's revenues and expenses over a period. Subtract expenses from revenues to calculate your net income.

For example:

• Revenue: $150,000
• Operating expenses: $50,000 (office space, utilities)
• Cost of sales: $70,000 (materials, labor)
• Net income: $30,000

Cash flow statement

The cash flow statement tracks cash and cash equivalents moving in and out of your business over a period. According to accounting standards, investments generally only meet the definition of cash equivalents if they have original maturities of three months or less.

Cash flow statements record three types of activity:

• Operating activities: cash from customer sales and day-to-day operations. Accounting standards provide a minimum level of required detail for these activities, which include cash paid to suppliers and employees in addition to receipts from customers.
• Investing activities: cash from buying or selling assets like equipment
• Financing activities: cash from loans, investments, or dividends

Statement of changes in equity

The statement of changes in equity (also called a retained earnings statement) shows how much profit your business keeps after paying all costs and dividends.

Businesses typically retain earnings to:

• repay debt
• reinvest in growth
• build a cash reserve for unexpected expenses

How to read your financial statements

Reading financial statements doesn't require an accounting degree. Focus on these key numbers and patterns to understand your business's financial position.

On the balance sheet, look for:

• Current ratio: Divide current assets by current liabilities. A ratio above 1 means you can cover short-term obligations.
• Debt-to-equity ratio: Compare total liabilities to equity. Lower ratios indicate less financial risk. For instance, the SEC explains that a 2-to-1 ratio means the company has $2 of debt for every $1 shareholders have invested.

On the income statement, look for:

• Gross profit margin: Subtract the cost of goods sold from revenue, then divide by revenue. Higher margins mean more money is left after production costs.
• Net profit margin: Divide net income by revenue. This shows how much profit you keep from each dollar of sales.

On the cash flow statement, look for:

• Operating cash flow: Positive numbers mean your core business generates cash. Consistent negative numbers signal trouble, even if you're profitable.
• Cash flow trends: Compare statements over time to spot patterns in how cash moves through your business.

Key indicators to monitor:

• declining cash reserves despite growing revenue
• increasing accounts receivable (customers taking longer to pay)
• rising debt levels without corresponding asset growth

Why financial statements are important for small businesses

Understanding your financial statements helps you make smarter decisions and grow your business. Financial statements help you:

• Assess financial health: See your cash position, profitability, and equity at a glance to make stronger financial decisions.
• Attract investors and secure loans: Show lenders and investors that your business is profitable and can repay debts.
• Comply with tax requirements: Meet reporting rules and tax obligations with accurate financial records.
• Track performance over time: Spot trends, identify what's working, and decide where to invest in your business.
• Manage cash flow: Plan for expenses, payroll, and unexpected costs with clear visibility into your cash position.

How to prepare financial statements for your business

Creating accurate financial statements takes organized records and a clear process. Follow these steps to prepare statements for your small business.

1. Gather your financial data. Collect bank statements, invoices, receipts, and payroll records for the period you're reporting on.
2. Choose your accounting method. Decide between cash basis (recording transactions when money changes hands) or accrual basis (recording when transactions occur). Most small businesses start with cash basis for simplicity.
3. Organize transactions by category. Sort income, expenses, assets, and liabilities into standard accounting categories. Consistent categorization makes statements easier to compare over time.
4. Use accounting software or templates. Tools like Xero automate calculations and reduce errors. If you prefer manual preparation, start with Xero's free financial statement templates.
5. Review and reconcile. Compare your statements against bank records to catch errors. Reconcile accounts monthly for the most accurate picture.
6. Consider professional support. Work with an accountant or bookkeeper if you have complex transactions, need help with tax compliance, or want an expert review of your statements.

How to use financial statements to analyze your business

Each financial statement gives you specific insights you can act on. Analyze each statement to gain specific insights you can act on.

Analyze financial performance with the income statement

Use the income statement to:

• Evaluate profitability: Compare total revenue against net income to see whether your business is making money.
• Monitor expenses: Identify overspending by reviewing categorized costs like goods sold and operating expenses.
• Track growth trends: Compare current statements with past periods to measure revenue growth, cost efficiency, and profit margin changes.

The income statement helps you calculate three key metrics: gross profit, operating income, and net income. These numbers show whether you need to adjust prices or reduce costs.

Manage assets and plan for growth with the balance sheet

The balance sheet helps you:

• Assess liquidity: Compare current assets to current liabilities to see if you can cover short-term obligations. Use the current ratio and quick ratio for a clearer picture.
• Evaluate solvency: Review long-term liabilities against equity. A high debt-to-equity ratio signals risk; a lower ratio indicates financial stability.
• Track asset management: Check whether assets like inventory, property, and equipment are contributing to revenue.

Your balance sheet is an important input into liquidity and solvency ratios like the current ratio, quick ratio, and debt-to-equity ratio. These ratios show you how much cash your business has to pay its bills.

The cash ratio liquidity formula helps you figure out if you have enough cash to cover payroll, expenses, and loan payments in the coming year.

The quick ratio measures whether you can cover your core costs over the next three months.

The current ratio formula, unlike the quick ratio, includes your business's inventory value (from your balance sheet). Use the current ratio to make decisions about your expenses and cash on hand.

Manage your cash flow with the cash flow statement

Strong cash flow means your business can meet its financial obligations. Use the cash flow statement to:

• Analyze operating cash flow: Check whether core business activities generate enough cash to sustain operations. Negative cash flow can signal problems, even when profits look healthy.
• Evaluate investment quality: Track cash spent on equipment or expansion to see if you're reinvesting for future growth.
• Monitor financing activities: Review cash from loans, equity, or dividends to understand how external financing affects your cash position.

Learn more about managing your finances and cash flow. For support in your area, check the SBA guide on managing your finances and FASB accounting standards.

Analyze growth with the retained earnings statement

The retained earnings statement helps you assess:

• Assess growth potential: Growing retained earnings suggest your business can reinvest profits without borrowing, whether for new equipment or paying off debts.
• Evaluate financial health: Declining retained earnings may indicate your business is using profits to cover losses or debts. This is a warning sign worth investigating.

Ways to use your financial statements

Apply these strategies to get the most value from your financial statements.

Consider the big picture, not just profit

Review all financial statements together, not just net income. The income statement, balance sheet, and cash flow statement each reveal different aspects of your financial health. Focusing on profit alone can leave you vulnerable to cash shortages.

Pay attention to your cash flow

Check your cash flow statement regularly to track liquidity. A profitable business can still run short on cash if you're not monitoring inflows and outflows.

Know the difference between revenue and cash

Revenue isn't the same as cash. Sales you've recorded may not have reached your bank account yet. Track accounts receivable separately so you know how much cash is actually available to spend.

Analyze trends by comparing your financial statements

Compare financial statements across multiple periods to spot patterns in revenue, expenses, and liabilities. Use these trends to invest in what's working and address areas that are underperforming.

Get across your financial ratios

Financial ratios like the current ratio and quick ratio give you quick insights into liquidity, profitability, and overall financial health. Use them to evaluate your financial position and make better business decisions.

Financial statement templates for your business

Pre-made templates save time when creating financial statements. Use them to quickly generate balance sheets, income statements, and cash flow statements.

Get started with Xero's free financial statement templates.

Streamline your financial statements with Xero

Automate your financial reports, get real-time insights, and integrate payroll and invoicing with Xero accounting software. Get one month free and simplify your financial reporting.

FAQs on financial statements

Find answers to common questions about financial statements.

What's the difference between the income statement and cash flow statement?

The income statement shows whether your business is profitable by tracking revenue minus expenses. The cash flow statement shows actual cash moving in and out of your business. A business can be profitable on paper but still run out of cash if customers pay slowly.

Does my small business need all four types of financial statements?

Most small businesses focus on three core statements: the balance sheet, income statement, and cash flow statement. These give you the essential view of financial health. Add the retained earnings statement if you're reinvesting profits into growth or paying off debt.

How often should I prepare financial statements?

Prepare financial statements monthly or quarterly for the clearest view of your business. Learn more about monthly financial reports. At minimum, create them annually for tax compliance. More frequent reporting helps you spot opportunities and problems faster.

Can I automate my financial statements?

Yes. Accounting software like Xero automates financial statement creation, which saves time, reduces errors, and simplifies tax compliance.

What's the difference between the 3 main financial statements and the 5 types?

The three main financial statements are the balance sheet, income statement, and cash flow statement. These are universally required for assessing business health. The fourth type is the statement of changes in equity. The "fifth type" typically refers to notes to financial statements, which provide additional context and disclosures. Most small businesses focus on the core three or four.

Do I need an accountant to prepare financial statements?

Many small businesses can prepare financial statements without an accountant. Accounting software like Xero can automate financial statement creation for most small businesses. However, consider working with an accountant if you have complex transactions, multiple revenue streams, or need help interpreting your statements. Many business owners use software for day-to-day reporting and have an accountant review statements quarterly or annually.