Financial statements explained: What they are and how to use them

Published Friday 12 December 2025

Table of contents

• Types of financial statements
• How to prepare financial statements
• Why financial statements are important for small businesses
• How to use financial statements to analyse your business
• Financial statement templates for your business
• Ways to use your financial statements
• FAQs on financial statements

Key takeaways

• Prepare the three core financial statements (balance sheet, income statement, and cash flow statement) regularly to gain a complete view of your business's financial health and make informed decisions about profitability, liquidity, and growth.

• Analyse trends by comparing financial statements across multiple periods to identify revenue growth patterns, expense changes, and potential problems before they become serious issues.

• Focus on cash flow management alongside profit tracking, as your business can be profitable on paper but still face cash shortages that prevent you from covering payroll and expenses.

• Utilise accounting software to automate financial statement preparation, reducing errors and saving time while ensuring accuracy for tax compliance and business decision-making.

Types of financial statements

Financial statements are formal reports that show your business's financial activities and performance over a specific time period. They help lenders and investors assess your business's financial health and earnings potential.

These statements typically cover monthly, quarterly, or annual periods. You can create them for any timeframe that suits your business needs.

Four main types of financial statements provide a complete picture of your business's financial health:

• Balance sheet: Shows what you own versus what you owe
• Income statement: Tracks your revenue, expenses, and profit
• Cash flow statement: Records money moving in and out of your business
• Statement of changes in equity: Shows retained earnings and business growth

Together, these statements help you make informed business decisions and demonstrate financial health to lenders and investors.

Balance sheet

A balance sheet shows your business's financial position at a specific point in time. It compares what you own (assets) with what you owe (liabilities).

Assets include:

• Machinery and equipment
• Patents and intellectual property
• Cash and inventory
• Accounts receivable

Liabilities include:

• Long-term debts
• Accounts payable
• Outstanding loans

The difference between assets and liabilities equals your business equity. This figure helps determine your business's value and financial stability.

Income statement

An income statement, also known as a profit and loss statement, shows your business's revenues and expenses over a specific period. It calculates your profit by subtracting total expenses from total revenue.

Example calculation:

• Revenue: £150,000
• Operating expenses: £50,000 (office rent, utilities)
• Cost of sales: £70,000 (materials, labour)
• Net income: £30,000 (£150,000 - £120,000)

This shows whether your business is profitable and helps you identify areas to reduce costs or increase revenue.

Cash flow statement

A cash flow statement tracks all money moving in and out of your business over a specific period. It is crucial, and many companies still find this an area they need to improve. It shows whether you can cover short-term expenses like bills and payroll.

Three types of cash flow activities:

• Operating activities: Customer sales and daily business transactions
• Investment activities: Buying and selling assets like machinery or equipment
• Financial activities: Loans, equity financing, and dividend payments

This statement helps you manage liquidity and ensure you have enough cash to operate.

Statement of changes in equity

This statement is also called a statement of owner’s (or shareholders’) equity, or a statement of retained earnings. It shows how much profit the business keeps rather than paying out to owners or shareholders after all costs and dividends.

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

How to prepare financial statements

Preparing financial statements might seem complex, but breaking it down into steps makes it manageable. Here's a simple overview of the process.

1. Gather your documents: Collect all relevant financial records for the period. This includes bank statements, credit card statements, receipts, invoices, and loan agreements.
2. Create your income statement: Start by listing all your revenue sources. Then, subtract your cost of goods sold and all operating expenses to find your net income.
3. Prepare your balance sheet: List all your business assets (what you own) and liabilities (what you owe). The difference between these is your equity.
4. Build your cash flow statement: Track the cash moving in and out of your business. Categorise it into operating, investing, and financing activities.
5. Review and finalise: Check your statements for accuracy. In fact, the Financial Reporting Council (FRC) notes that most errors can be avoided with robust reviews built into the preparation process. Ensure the numbers are consistent across all reports. For example, the net income on your income statement should link to your balance sheet and cash flow statement.

Using accounting software like Xero can automate most of this work, saving you time and reducing errors. For complete confidence, it's always a good idea to work with an accountant or bookkeeper.

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.

Understanding your financial statements helps you:

• assess financial health: see your profitability, cash flow and equity position clearly so you can make stronger financial decisions
• attract investors and secure loans: show lenders that your business is profitable and can repay debts
• comply with tax requirements: meet reporting obligations and prepare accurate tax returns
• track business performance: monitor trends and identify areas for improvement or investment
• manage cash flow: make sure you have enough money to cover expenses, payroll and unexpected costs
• make informed decisions: use accurate financial data to guide your business choices

How to use financial statements to analyse your business

The different types of financial statements help you assess and manage your business finances, and support accurate financial reporting so you comply with tax rules.

Analyse financial performance with the income statement

Use your income statement to:

• evaluate profitability: see whether your business generates profit by comparing total revenue to net income
• monitor expenses: identify overspending and opportunities to reduce costs across different expense categories
• track growth trends: compare current performance with past periods to measure revenue growth and changes in profit margin

This analysis helps you make pricing decisions, control costs, and plan for sustainable growth.

Manage assets and plan for growth with the balance sheet

Use your balance sheet to:

• assess liquidity: compare current assets to current liabilities to determine if you can cover short-term obligations
• evaluate solvency: examine long-term debt and equity ratios to gauge financial stability and risk levels
• track asset efficiency: monitor how well your inventory, property, and equipment contribute to revenue generation

Key ratios like the current ratio and debt-equity ratio help you make informed decisions about borrowing, spending and investing for growth.

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 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 bills and other commitments. The cash flow statement shows how much cash comes in and goes out, so you can act early if you need to improve it.

Use your cash flow statement to:

• analyse operating cash flow: determine if your core business activities generate enough cash to sustain operations
• evaluate investment quality: track capital expenditures to see if you're reinvesting wisely for future growth
• monitor financing activities: review how loans, equity financing, and dividends affect your overall cash position

Consistently negative operating cash flow signals problems, even when your business shows healthy profits on paper.

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

The retained earnings 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, which can be a warning sign of financial problems.

Financial statement templates for your business

Creating financial statements is simpler with templates. They help you (or your accountant or bookkeeper) create balance sheets, income statements and cash flow statements quickly, freeing up more time for your business.

Get started with Xero's free financial statement templates.

Ways to use your financial statements

Consider the big picture instead of 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

Checking the cash flow statement regularly helps you avoid cash shortages, even when the business is profitable. Use it to track your liquidity and make sure there is 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 financial statements across multiple periods to identify important business trends.

Analysing trends in your business's financial statements over time helps you:

• spot revenue growth patterns and seasonal fluctuations
• identify expense categories that are increasing or decreasing
• recognise liability trends that might affect cash flow
• make informed decisions about where to invest resources
• address underperforming business areas before they become problems

Regular comparison gives you the data needed to make strategic business decisions with confidence.

Get across your financial ratios

Financial ratios help you understand your business’s liquidity, profitability and overall 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 on financial statements

Here are some common questions and answers to help you get more value from your financial statements.

What are the 4 major financial statements?

The four major financial statements are the income statement, balance sheet, cash flow statement, and the statement of changes in equity. Together, they provide a complete view of your business's financial health and performance.

What is the difference between an income statement and a 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, the three main types of financial statements will boost a business owner's financial literacy: the balance sheet, income statement, and cash flow statement. 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.

How do I prepare financial statements if I'm new to accounting?

If you're new to accounting, using accounting software like Xero is the easiest way to start. It automates much of the process by pulling data from your bank accounts and invoices. You can also use templates or work with a bookkeeper or accountant to ensure your statements are accurate and compliant.