How to make a financial statement
What to know about these key indicators of your business’s health
Running a business can be tough, especially if you have to be responsible for many of the critical tasks businesses must perform. From payroll to inventory to financial reporting, there’s a lot that business owners like you need to know to be successful. As a business, your financial health is your lifeblood, and knowing how the company is doing financially can help ensure you keep your business on track – or signal to investors down the road that you’re a stable and high-performing business. These all involve financial statements. In this article, we’ll dig deeper into the various financial statements that you’ll need to know, as well as how to prepare a financial statement. First, let’s talk about financial statements.
What are financial statements?
Financial statements are written records that help convey both the business activities and the financial performance of a company. These statements convey the financial health of a business to a wide audience – from investors to government agencies. They’re used for taxes, investing prospectus and even lending purposes. There are three main financial statements a company normally prepares according to generally accepted accounting principles (GAAP): the balance sheet, the income statement, and the cash flow statement. The fourth financial statement, the statement of retained earnings, is a statement that a company would prepare for lenders and investors. Let’s take a closer look at each type of financial statement.
The balance sheet
This financial statement is a snapshot of the business at a given point in time. The balance sheet provides information concerning the company’s current assets, current liabilities and stockholders’ equity (if applicable). Often, a company will publish a balance sheet at the end of their reporting period. Let’s break down these categories even further.
- Assets – These include cash and cash equivalents, also known as liquid assets, that can include: Treasury bills and certificates of deposits; accounts receivable, which include the money owed to the company by its customers for products and services; inventory, which includes all of the finished products the company has in stock.
- Liabilities – These include debt (including long-term debt), wages payable to employees and dividends payable to investors.
- Shareholders’ Equity – The shareholders’ equity is a company’s total assets minus its total liabilities. Essentially, it’s the amount of leftover capital that shareholders would receive if the assets were liquidated and the company then paid off all its debts.
The income statement
In contrast to the balance sheet, an income statement covers a more broad range of time. This could be quarterly or annually depending on how income is reported at a company. This financial statement, sometimes referred to as a profit and loss statement, provides information on revenues, expenses, net income, and earning per share. Again, let’s take a closer look at each of these.
- Revenue – This includes both operating and non-operating revenue. Operating revenue is revenue that a company generates through their core business activities. Non-operating revenue includes revenues that fall outside the main function of the business, which can include interest earnings, rental income, income from royalty payments, and even income from advertising displays located on company property.
- Expenses – This includes many different types of expenses. Primary expenses are the largest category and include any expenses that a company incurs as a result of the primary business activity. Primary expenses can be the cost of goods sold (COGS), selling, general and administrative expenses (SG&A), depreciation, amortization, and research and development (R&D). Wages, commissions, and utilities are also common expenses. There are also expenses from secondary sources such as interest paid on loans or debt and losses from asset sales.
The cash flow statement
This financial statement helps measure the amount of cash a company generates. This cash can be used to pay a company’s debt obligations, fund operating expenses, and fund investments. The cash flow statement (sometimes known as a statement of cash flows) allows outsiders to understand how a company operates – where its money comes from and where it is spent. Based on the cash flow of a company, investors can get a good idea of a company’s financial footing. There are three components of a cash flow statement: operating activities, investing activities and financing activities.
- Operating activities – This piece of the cash flow statement includes sources and uses of cash from running the business. From changes made in cash, accounts receivable, depreciation, inventory and accounts payable to wages, tax payments, interest expenses, rent and more, this piece shows the cash flow for any operating activities.
- Investing activities – This piece shows sources and uses of cash from investments of the company. Purchases and sales of assets, loans made or received, or fixed asset purchases like property, plant and equipment (PPE) are all included in this section.
- Financing activities – This piece shows the sources of cash from investors or banks and any cash paid to shareholders. These activities also include debt issuance, equity issuance, stock repurchase, loans, dividends paid, and any repayment of debt.
The statement of retained earnings
This financial statement displays any changes made in earnings during a specific period of time. Again, all companies may prepare the other three types of financial statements but may not prepare a statement of retained earnings. This statement includes a prior period balance and then adds in any net income or subtracts any dividends paid to shareholders to arrive at the ending retained earnings balance. This statement is helpful for investors or creditors and can help your business secure bank loans or other financing.
Now that you have a better grasp of financial statements, let’s talk about why they’re important for your business.
Why are financial statements important for small businesses?
Financial statements give a great overview of a business’s activities, both in a snapshot of time and over a longer period of time. They show how a small business like yours operates and helps provide insight into how your business generates revenues, what your cost of doing business is, how efficiently you manage your cash flow and what sorts of assets and liabilities you have. It can give a broad overview of your company’s financial position to internal stakeholders and outside investors. These financial statements are also important for small businesses who are looking to expand their business because they can give potential investors a more comprehensive look at your business’s financial health – a key component of an attractive business. You’ll need to know how to put together each of these financial statements. Let’s discuss how to create each.
How to create a balance sheet
First, let’s learn how to build a balance sheet. Again, the underlying accounting equation for this financial statement is: Shareholders’ equity = Assets - liabilities
The first step is to determine and list all of your company’s assets. Again, this includes all cash and cash equivalents, fixed assets and more. You’ll need an actual dollar amount for each of your assets. Add up all of your assets to get your total asset amount.
Then, you’ll need to determine your liabilities. This includes all of the debt you owe, accounts payable, wages, and any long-term obligations. Just like your assets, you’ll need to list and account for all your liabilities, dividing them into current and long-term liabilities. You’ll add up all of your liabilities to get a total liabilities amount.
After you have your total assets and liabilities, you’ll subtract your liabilities from your assets. This gives you a shareholders’ equity amount. Now, let’s move to the income statement.
How to create an income statement
The next financial statement we’ll walk you through is the income statement. To make an income statement, you’ll need to first know your revenues for the given time period, whether that’s the quarter or the entire fiscal year. These revenues include total sales minus any returns, discounts or lost or damaged goods. Once you have your revenue (sometimes also known as net sales), you’ll then subtract the cost of goods sold. That will give you the gross profit amount for the given period.
Next, you will list the company’s operating expenses. This includes administrative costs, employee wages, and any cost of selling or advertising. Once you have the total operating expense amount, you’ll subtract it from gross profit to get operating income.
Then, you’ll need to calculate any non-operating expenses, which are the expenses that you incur not directly related to the operation of your business. Interest, amortization, depreciation and taxes are all non-operating expenses. Once you subtract this total number from operating income, you’ll arrive at the net income for your business. Next, we’ll look at the cash flow statement.
How to create a cash flow statement
To create the cash flow statement, you’ll need to complete an income statement and balance sheet for the current and past periods. As you learned above, the cash flow statement has three pieces – operating activities, investing activities and financing activities.
For operating activities, you’ll be looking at how much cash your business brought in. This statement focuses specifically on cash. The direct method is to add up all of your cash flows from scratch to get a total operating cash flow. However, you can start with net income and add back in a few things, including amortization and depreciation.
Then, you’ll need to see if you are bringing in or sending out cash with other operational aspects of the business. Selling fixed assets for a profit or loss, changes in accounts receivable, buying inventory, or income taxes payable are all factors that can increase or decrease operating cash flow.
For investing activities, you’ll need to list and examine how investing in your long-term investments has impacted your cash flow. These long-term investments include any equipment or buildings or even investments in the stock market that were bought or sold.
The last category is financing activities. In this section, you’ll need to list the money that finances your business, including loans, stock options, and shareholders.
Once all of these are listed, you’ll lay out the cash flow statement. Starting with your net income at the top, you’ll work your way down through each of the categories before reaching a net positive or net negative cash flow number. You’ll want to add in any cash from the previous period or note if you started the period with a deficit. Next, let’s look at creating a statement of retained earnings.
How to create a statement of retained earnings
Finally, you may need to create a statement of retained earnings for investors. Essentially, you’ll start with the previous period’s retained earnings and then show the changes since that previous period.
First, you’ll record the beginning retained earnings balance. Then, you’ll add or subtract your net income or net loss. You’ll also subtract any dividends your company paid out during the accounting period if applicable. Doing this will give your business an ending retained earnings balance. Again, this financial statement is most useful to lenders, creditors, or investors. For investors, they use the statement of retained earnings to see an increase of dividends or a rising share price. This statement is one of the main ways investors can examine their return on investment. For lenders or creditors, this statement helps show that your company will be able to settle debts and make repayments appropriately.
As you’ve seen, creating financial statements is an important part of running a business. Not only can the process give you insights into how your business is performing, it can also help you attract growth partners who see the potential in your business. By knowing the importance of these four financial statements as well as how to create each one, you’re well on your way to taking the temperature of your business’s financial health and positioning it for success in the future.
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