What are the three basic financial statements?

There are numerous financial report options available to small business owners and managers running the business. You may be the person preparing the reports using software or may have a bookkeeper or accountant preparing them. When navigating through all these reports, how do you determine what to review to assess the business's performance?  How often should you review them?  Well, the answer to that question is that it depends.  It depends on the size of the business, its industry, its goals, and the management style employed.  However, it is good practice to review financial reports at least monthly and, more importantly, to review them with your accountant.  It is essential to understand the basis of accounting used to prepare the reports, as this may impact what is reported on the financial statements, such as accrual basis vs cash basis (which is a different topic).  Although every business may be different, there are several standard financial reports that every small business owner should review regularly, and those are the three main financial statements.  The three main financial statements are the Profit and Loss, Balance Sheet, and Cash Flow Statement.  We will take a deeper look at what the reports are, how it's used, why they are important, and what periods they cover.

1. Profit and Loss (Income Statement)

   1. What is it:

      1. This is the most common financial report that most small businesses see.  The profit and loss shows the income (revenue) coming into the business and the expenses going out to see if the business is making or losing money. 

   2. How is it used:

      1. The report will usually contain the following, but it will depend on your industry and how your company works:

         1. Revenue (Sales): which are the revenues or sales your company has earned or received. For example, a therapy counseling business will incur revenue-based therapy services it performs and invoices or collects from its patients.

         2. Cost of goods sold: These are the direct costs associated with generating revenue.  Depending on your business's industry, there may be no cost of sales applicable to your business.  For example, an IT business that performs computer purchasing, selling to its clients, and installations for its clients will incur the cost of sales for the computers the business purchases for re-sale to its clients.

         3. Gross profit:  which are the profits after deducting the cost of goods sold from the revenues.  Depending on your business's industry, there may be no cost of goods sold and gross profit breakdown applicable to your business.  For example, a distributor business selling an item for $100 to a customer but paid $40 for that item for a vendor will have a $60 gross profit for that item sale.

         4. Operating expenses: these are the costs incurred to maintain the business's operations.  For example, payroll expenses, marketing and advertising expenses, and general and administrative expenses.  All of these expenses can be broken down into more detailed line items on the profit and loss report to provide the reader with the necessary information to understand the expenses better.

         5. Operating profit:  which are the profits after deducting the operating expenses from the gross profit or revenues.

         6. Non-operating income and expenses:  these are the ancillary or one-time income or expenses incurred by the business that is not part of its normal operations.  For example, if the therapy counseling business sells one of its office furniture because it wants to replace it, the business would report the net profit or loss from the sale as non-operating income or expense.

         7. Taxes:  these include federal, state, local, or foreign taxes applicable to the business.  For example, suppose the company is a corporation and has to pay income taxes to the IRS. In that case, the taxes it incurs or pays is reported on the profit and loss statement.

         8. Net profit:  which are the profits or losses after including or deducting the non-operating income or expenses and taxes from the operating profit.  This is typically the last line item on the profit and loss report, reflecting the amount the business incurred as a net profit or net loss.

   3. Why is it important:

      1. This is a crucial report that enables the reader to understand how the company performed during the specified period.  It helps evaluate the company's:

         1. financial performance

         2. profitability

         3. efficiency for the use of its assets

   4. What period does it cover:

      1. The report is usually prepared for a specific period, such as a year, quarter, or month.   

1. Balance Sheet

   1. What is it:

      1. The balance sheet is a powerful yet, at times, underrated report that many small business owners unfortunately underappreciate.  The balance sheet shows the reader the assets (what the company owns, has legal rights to, or has future economic value to the company), liabilities (what the company owes, has a legal liability to, or has future economic cash outflow), and the equity (net remaining balance of the assets less the liability). 

   2. How it is used:

      1. The report typically includes the following.

         1. Current assets:  which typically includes the company's cash, bank accounts, customer accounts receivable, inventory, and other assets expected to be used or converted to cash within one year

         2. Fixed assets:  typically include the physical assets the company owns, like any real estate, machinery and equipment, computers, and furniture, less any depreciation on certain fixed assets

         3. Other long-term assets  typically include any long-term receivables,  security deposits, intangible assets, and other assets expected to be used or converted to cash longer than 1 year

         4. Current liabilities:  typically include accounts payable, credit cards payable, accrued expenses, payroll liabilities, lines of credit, and other short-term liabilities expected to be paid or the obligation will be satisfied within one year

         5. Long-term liabilities:  typically include long-term notes payable, mortgage payable, and other long-term liabilities expected to be paid or the obligation will be satisfied longer than 1 year

         6. Equity:  typically includes the capital investment, retained earnings, owner dividends,  and other comprehensive income or losses

   3. Why is it important:

      1. This is a critical report that helps the reader understand what the company owns, owes, and what remains available for the owners.  It helps evaluate the company's:

         1. liquidity (Does the company have enough to cover the immediate bills/liabilities)

         2. solvency (Does the company own more than what it owes)

         3. leverage (Is the company utilizing its operating assets to generate enough revenue and profits)

         4. net book value (How much does own less what it owes)

   4. What period does it cover:

      1. The report is typically prepared at a specific point in time, such as the end of the month or year, for example, December 31st or any other designated date, to capture a snapshot of the company's assets, liabilities, and equity.   

1. Cash Flow Statement

   1. What is it:

      1. This report is crucial for reviewing the movement of the cash flow, the lifeblood of the business.  The cash flow statement shows the reader the changes in cash flow from operations, the changes in cash flow from investing, and the changes in cash flow from financing, as well as the beginning and ending cash balances.  The report can sometimes be prepared in one of two ways: the direct method or the indirect method.

   2. How it is used:

      1. The report typically includes the following.

         1. Changes in cash flow from operations: which typically includes the cash coming in or going out from the operations of the company

         2. Changes in cash flow from investing:  which typically includes the cash used to purchase fixed or long-term assets and cash coming in for the sale of fixed or long-term assets

         3. Changes in the cash flow from financing:  which typically includes the cash received from creditors or lenders and cash going out to pay credits, lenders, or owners (via dividends)

   3. Why is it important:

      1. This is a crucial report that helps readers understand how the company manages its cash. 

         1. It helps evaluate the company's:

            1. cash inflows and outflows from its operations (running day-to-day operations, collecting sales, paying expenses, etc.)

            2. cash inflows and outflows from its investing (investing in major equipment, buildings, fixed and intangible assets, etc.)

            3. cash inflows and outflows from its financing (borrowing money for long-term financing, paying off loans, paying distributions or dividends, etc.)

   4. What period does it cover:

      1. Like the profit and loss report, the report is usually prepared for a certain period, such as a year, quarter, or month. 

When reading financial statements, certain companies (usually public companies) may also report other important financial statements, such as the statement of changes in stockholder's equity and the Notes to the financial statements, which are not typically prepared for small business financial statements.  For small businesses, the three main financial statements listed above can provide owners or managers with vital information to help them assess the business's performance.  Understanding and reviewing your financial statements is about providing you with financial clarity, control, and confidence in running your business.  By regularly reviewing your profit and loss statement, balance sheet, and cash flow statement, ideally with your accountant, you gain the insights needed to make better and informed decisions.  No matter what stage you are in business, these financial tools are your roadmap. Make it a habit to stay financially informed, and your future self will thank you.