What are financial statements and how are they used?
What is a financial statement?
Financial statements are a set of formal written records that show a company's financial activities, position and performance at a specific time. Financial statements include the balance sheet, the income statement and the cash flow statement.
Business owners, creditors, investors and market analysts use these reports to review a company's financial performance and project potential earnings.
What’s the purpose of financial statements?
Unfortunately, 51% of Australian business owners have cash flow issues — many of them serious. Financial statements can help you better understand the health of your business and spot potential problems before they become unmanageable.
Let’s consider some common use cases of financial statements.
Reporting to stakeholders
Stakeholders can use financial statements to guide their decision-making around equity investments. For example, after a current partner assesses the statements, they might decide to sell their stake in the company.
Soliciting investors
Potential investors can review financial statements to decide whether they want to become a partner or buy shares in the company. Similarly, anyone considering a merger or takeover bid can use the information to guide their bidding price.
One statement isn't enough to convince investors — they look for quality companies with meticulous records. Any potential investors will want to compare the past few years' financial statements. If you have strong balance sheets and healthy cash flows, venture capitalists will be able to see trends that indicate stability and steady growth.
Securing credit
As banks and other financial institutions don’t have ongoing access to the day-to-day operations of a company, they rely on financial statements to determine a business’ creditworthiness.
Similarly, creditors can use the most recent financial records to restrict or cancel existing credit lines. For example, if a company has a poor year, a bank may close an outstanding loan or deny any applications to extend the company's line of credit.
Fulfilling ASIC requirements
While all companies should keep financial records, certain types of businesses have additional reporting requirements with the Australian Securities and Investments Commission (ASIC). This financial regulator aims to provide accurate financial information for public access.
The following types of companies need to prepare financial statements and lodge reports with ASIC under the Corporations Act 2001:
public companies
large companies limited by guarantee
all registered managed investment schemes
foreign-controlled small proprietary companies
all disclosing entities (e.g. tax agents)
all large proprietary companies that are not disclosing entities
small proprietary companies with 1 or more crowd-sourced funding shareholders at any time during the year.
What are the main types of financial statements?
Income statements
An income statement — also known as a statement of profit and loss - shows the profitability of your business over a specific period, like a year or quarter. This overview includes revenues, expenses, net income and earnings per share.
This report helps business owners identify areas where the company is succeeding or struggling. Also, investors can use a profit and loss statement to project potential returns.
Income statements include two core aspects — revenue and expenses.
Revenue
Business revenue is the top line on an income statement, and it includes all income from:
sales of products and services
secondary earnings, like interest on savings accounts
As secondary revenue and other financial gains are unpredictable sources, it’s best to focus on growing sales revenue from core operations.
Expenses
Business expenses are everything the company spends on running the business. The expenses include:
labour costs
raw materials
operating expenses, such as utilities, rent, administrative costs and the cost of selling and advertising products.
While the cost of raw materials and labour may be negotiable, managing your spending on operating expenses is often tricky. For instance, if the rent for your warehouse increases, you might be unable to find a new space in the right area that’s more affordable.
Balance sheets
A balance sheet is an overview of a company's assets and liabilities as a snapshot in time. The date on the document is usually the end of the reporting period.
A balance sheet has two core aspects — assets and liabilities.
Assets
Assets are all the valuable items your company controls that you expect to yield some financial gain or benefit from in the future. On a balance sheet, assets can include:
cash and cash equivalents
intellectual property (e.g., patents or trademarks)
prepaid expenses
property, plant and equipment (PPE)
Liabilities
Liabilities are the outstanding debts and financial obligations you owe to other parties. On a balance sheet, liabilities include:
accounts payable, including utility bills and supplier invoices
employee-related provisions
shareholder dividends payable
credit card balances
long-term debt, including bond funds, mortgages, or other loans or lease agreements.
The balance sheet shows you how much money you would have at a specific time if you sold all your assets and paid all your debts. This remaining amount is called owner's equity.
Cash flow statements
A cash flow statement is a financial report that shows how cash moves in and out of a company during a specific period. This type of financial statement offers insights into the liquidity of a business by explaining how the company generates cash through operations, investment and financing activities.
Owners and investors can use cash flow statements to gauge the health of business operations. At a glance, you can see how the business gets money and where it spends it.
There are 3 key elements of a cash flow statement:
Operations
Operating activities on a cash flow statement detail all money you earned or spent while running your business. The biggest figure on this statement is usually net income, which is the money you earn from selling your goods and services.
The operating activities section covers incoming cash flow from sales and settled accounts receivable, interest payments and dividends, as well as outgoing cash flow on cost of goods sold (COGS), salaries and wages, accounts payable and more.
Financing
The financing activities on a cash flow statement detail how money moves between a business and its owners, investors and other creditors. This section covers cash you pay to shareholders, public issues of stocks or bonds, stock repurchases, loan repayments, dividends and debt repayments.
Investments
Investing activities on a cash flow statement detail how the company invests for the future. This category includes buying and selling long-term assets like property, plant and equipment (PPE), acquisitions of other businesses, and investments in stock and bonds.
Statement of changes in equity
A statement of change in equity is a financial statement that measures changes in owners’ equity throughout a specific accounting period.
Also called a statement of retained earnings, this summary relates to the balance sheet for the same period. The ending balance on the statement of change in equity is equal to the total equity on the balance sheet.
Here are the key elements of a statement of retained earnings:
Beginning equity is the value of an investor's stake at the end of the last period.
Net income is the proceeds you earn from running the business. Any retained earnings become equity in the company.
Dividends are periodic shareholder payments from company profits. Typically, companies will pay dividends every quarter or semi-annually.
Other activities — such as corrections to previous accounting periods — may cause an increase or decrease in company equity on the financial statement.
How to read financial statements
Although financial statements are useful tools for owners, accountants, creditors and investors, they have some limitations. These statements focus on past performance and rely on accurate reporting. But when it comes to projecting future potential, the statements are open to interpretation.
With that in mind, it's important to read more than one quarterly statement for a company. For investors, it's prudent to read several years of statements to get a better understanding of the company's history.
When reading financial documents, you can compare the most recent data to prior periods to understand changes over time. By evaluating year-on-year changes, you can spot patterns of growth or decline in the company.
How do you create financial statements?
Typically, an accountant or bookkeeper prepares financial statements. But if you want to create your own reports to assess your business’s financial standing, it’s possible with the help of accounting software.
If you don't use accounting software, here’s how to create a profit and loss statement manually:
1. Start with net sales
The first figure in a profit and loss statement is always net sales. When calculating your total sales for the period, remember to allow for returns, discounts and lost or damaged goods.
2. Calculate the cost of goods sold
While producing your products or supplying your services, you incur costs for materials and labour. Together, these items are the cost of goods sold (COGS).
3. Calculate gross profit
You can figure out your gross profit by subtracting the costs of goods sold from your net sales.
4. Subtract total operating expenses
Aside from COGS, you must consider operating expenses, like sales operations, rent, utilities, travel, wages, management salaries, and more. Gather the costs for each type of operating expense in the period, then add them together to find your total operating expenses.
5. Consider non-operating expenses
A profit and loss statement also includes costs that don’t relate directly to business operations. Non-operating expenses include:
interest
amortisation
tax expenses.
You can also include costs for "extraordinary gain or loss," such as extensive product loss due to a natural disaster.
6. Create your income statement
As you work out the figures for each element, you can lay out the profit and loss statement. The ideal order is as follows:
net sales
cost of sales
gross profit
operating costs
operating income
interest
taxes.
Some business owners lump all operating expenses together, while others prefer a detailed breakdown by category.
It’s a good idea to put each material or significant item on a separate line for clarity. Also, white space between sections makes it easier to read your financial statement.
7. Calculate net income
The bottom line on a profit and loss statement is net income or net profit. After you lay everything out on the financial statement, you can deduct your total expenses from your gross profit. The remainder is your net income.
Generate financial statements with MYOB
While you can prepare a profit and loss statement yourself, there are challenges with creating financial statements. If you don’t have experience in accounting or financial analysis, it’s easy to make mistakes. Even with experience, these evaluations are arduous and time-consuming.
If you’d rather focus your energy on other areas of your business, choose accounting software that'll help you automatically generate financial statements. With financial reporting and insights built into every MYOB plan, you can choose the package that’s right for you.
Get started with the MYOB business management platform today.
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