How financial statements boost your small business

Published Wednesday 18 May 2022

What is a financial statement?

A financial statement reports on financial activities and performance of a business over a certain period in the past. Lenders and investors use it to judge a business’s financial health and earnings potential.

Although financial statements can cover any time period, they most commonly cover a month, a quarter, or a year.

Types of financial statements

There are three kinds of financial statements: the balance sheet, income statement, and cash flow statement. These, together with retained earnings statements, give you a broad picture of your business’s financial health.

Balance sheet

A snapshot of your business’s financial condition at a point in time, the balance sheet compares what you own (your assets) with what you owe (your liabilities).

Assets include things like machinery, patents, and intellectual property. And, liabilities are things like long-term debts the company owes, and accounts payable. The difference between the two – the business’s equity – is often used as a starting point for valuing a business.

To find the equity, use the formula:

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

Income statement /Profit and loss statement

The income statement is a type of financial document that shows your business’s revenues and expenses. Subtract expenses from revenues to show your business’s profit and loss figure (also known as net income).

For example, in a certain period a manufacturing business might have:

$150,000 in revenue

$50,000 in operating expenses (like office hire and utilities)

$70,000 in cost of sales (materials and labour costs)

In this situation, the business has $30,000 net income.

Cash flow statement

Also called a statement of cash flows, the cash flow statement shows changes in the amount of cash passing in and out of your business over a period of time.

The cash flow statement shows whether a business can cover its short-term expenses, like bills and payroll. It typically records customer sales (operating activity), purchases and sales of assets like machinery (investment activity), and financial activity like money earned from stocks and bonds.

Statement of changes in equity

This statement is also called a statement of owner's (or shareholder’s) equity, or a statement of retained earnings. It demonstrates a business’s growth and performance potential by showing how much money the business keeps, instead of paying out to shareholders or owners once all costs and payments, including dividends, have been accounted for.

A business might retain earnings to repay debt, reinvest in the business, or to keep as a rainy-day fund.

Why financial statements are important for small businesses

You’ll make better financial and business decisions if you know how to read financial statements and understand your business’s financial health.

By understanding your financial statements you’ll be better able to:

• Assess financial health: Financial statements help you focus on profitability, cash flow, and equity. You’ll make stronger financial decisions if you can clearly see your cash position and what your costs are.
• Attract investors and secure loans: Investors and lenders use financial statements to gauge whether a business is profitable and can repay its debts.
• Comply with tax and reporting requirements: Tax authorities require financial statements from businesses to determine tax rates. If you understand your statements, you’ll be more confident you’re meeting reporting rules and complying with tax laws.
• Track business performance: Regular financial reporting helps you track your business’s performance over time. Your financial statements can highlight trends, such as a product or business area that’s doing well or needs improvement, and help you make informed decisions on where to invest in your business.
• Manage your cash flow: The cash flow statement helps businesses manage cash for their expenses, payroll, and unexpected costs.
• Make informed decisions: Complete, accurate financial statements give you the essential data you need to make informed business decisions that will grow your business.

How to use financial statements to analyse your business

The different categories of financial statements each help you assess and manage your business’s finances, and as well as aid accurate financial reporting so you comply with tax rules.

Analyse financial performance with the income statement

Use the income statement to:

• Evaluate profitability: Give yourself a clear picture of your total revenue and net income, showing you whether your business is profitable or not.
• Monitor expenses: The income statement categorises your expenses (like cost of goods sold and operating expenses) so you can identify where your business may be overspending and where to reduce costs.
• Track growth trends: Understand long-term factors affecting your business by comparing your current income statement with statements from past periods. You can then judge your revenue growth, cost efficiency, and any changes to profit margins over time.

Information from the income statement is used, in particular, to calculate three important metrics: gross profit, operating income, and net income – calculations that indicate whether you need to adjust prices and reduce costs to improve profitability.

Manage assets and plan for growth with the balance sheet

The balance sheet helps you:

• Assess liquidity by comparing your business’s current assets to its current liabilities. Use liquidity ratios like the current ratio and the quick ratio (see below) to decide whether you can cover your short-term obligations.
• Evaluate your business’s solvency by examining its long-term liabilities and equity. A high debt-to-equity ratio may signal a risk to the business’s financial stability, while a healthy equity base (a lower ratio) indicates strong financial health.
• Track asset management by examining how efficiently you’re managing assets like inventory, property, and equipment, and whether they’re contributing to your revenue.

Your balance sheet is an important input into liquidity and solvency ratios like the current ratio, quick ratio, and debt-to-equity ratio, which 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 3 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

A strong cash flow means your business can meet its financial obligations. The cash flow statement shows you the strength of your business’s cash flow, so you can bolster it if you need to.

In particular, use the cash flow statement to:

• Analyse cash flow from operations by determining if the core business activities generate enough cash to sustain operations. Consistently negative cash flow can indicate a problem, even if profits are healthy.
• Judge the quality of investments by tracking how much cash you’re using for capital expenditures like equipment or expanding your operations. This shows whether the business is reinvesting to stimulate future growth.
• Monitor financing activities by reviewing cash flow from loans, equity financing, or dividends to see how external financing affects the company’s cash position.

Here’s more advice on managing your finances and cash flow. For support in your area, check your local accounting standards.

Analyse growth with the retained earnings statement

This statement is useful for demonstrating your business’:

• Growth potential: If your business’ retained earnings grow from one financial period to the next, it suggests your business can comfortably retain profits and reinvest in itself without borrowing, perhaps by purchasing new equipment or paying off debts.
• Financial health: A decline in retained earnings suggests a business is using profits to cover losses or debts – a warning sign of financial problems.

Financial statement templates for your business

Creating financial statements is easier with pre-made templates. They help you (or your accountant or bookkeeper) easily create balance sheets, income statements, and cash flow statements over and over, giving you time to put back into your business.

Get started with Xero’s free financial statement templates.

Ways to use your financial statements

Consider the big picture – not just profit

A focus on net income at the expense of other areas, like cash flow, can leave your business financially vulnerable.

So, consider all financial statements – the income statement, balance sheet, and cash flow statement – together to get a comprehensive view of your business’s financial health.

Pay attention to your cash flow

Overlooking the cash flow statement can result in cash shortages, even if the business is profitable. So, check these statements to track your liquidity and make sure there’s enough cash to cover short-term costs.

Know the difference between revenue and cash

Recorded revenue (from sales, for example) isn’t the same thing as cash on hand – revenue you’ve recorded may not have hit your business’s bank account yet.

Make sure you distinguish between sales (revenue) and actual cash inflows so you know how much your business can spend. Tracking accounts receivable separately will keep this distinction clear.

Analyse trends by comparing your financial statements

Compare your financial statements across multiple periods to identify patterns in revenue, expenses, and liabilities, so you can invest in the parts of your business that are performing well and make smart choices about parts of the business that are stalling.

Get across your financial ratios

Financial ratios are accounting tools for deep insights into business liquidity, profitability, and financial health.

Learn how to use and analyse key financial ratios, such as the current ratio and quick ratio, to help you to evaluate the company’s financial position, aiding you in making better business decisions.

FAQs about financial statements

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

The income statement tracks profitability, while the cash flow statement details the movement of money in and out of the business.

Understanding these financial statements and their differences helps you get to grips with your business’s finances.

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

Each of the four financial statements helps you grasp an aspect of your business’s financial health. But, it’s the three main types of financial statements – the balance sheet, income statement, and cash flow statement – that will boost a business owner’s financial literacy. The retained earnings statement is useful for businesses that plan to reinvest their profits – such as paying for growth projects or paying off debt.

How often should I prepare financial statements?

That depends on your business needs. It’s good to prepare financial statements regularly (monthly, quarterly, or annually) so you can react faster when an opportunity or problem arises.

Can I automate my financial statements?

Yes – accounting software like Xero automates the creation of financial statements – saving you time, reducing the risk of errors, and making tax compliance easier.

Streamline your financial statements with Xero

Your business has a better chance of success if you know how to manage your finances. Xero accounting software automates the creation of financial reports, gives you real-time insights into your business, and integrates payroll and invoicing, so your financial management is a breeze.