Financial Statements: The Different Types, Their Purposes, & More

Financial statements form a significant part of a financial report, and provide historical insight into the financial figures and data behind a business, revealing key information about profitability, cash flow, assets, and liabilities. They also play an important role in ensuring you meet regulatory requirements. Let’s take a look at each individually. 

Profit and loss statements

A profit and loss statement, also known as an income statement, is essential for assessing the profitability of your business over a set period, which could be monthly, quarterly, or annually. It’s a vital tool for both monitoring business activity and making informed decisions.

Key functions

For business owners, it highlights areas of success and potential struggle, helping to direct focus and resources effectively.

For investors, it provides a snapshot of financial health, helping in investment decisions or evaluating returns on existing investments.

Composition of a profit and loss statement

A profit and loss statement is usually split into two main sections: a revenue section, and an expenses section. 

Revenue:

• Includes income from primary business activities (like sales of products and services), secondary activities (such as bank interest), and other financial gains (like profits on asset sales).
• Focuses primarily on total sales, as secondary revenue can be less predictable.

Expenses:

This is split into two main categories:

• Cost of goods sold (direct labour and materials for products or services).
• Operating expenses (indirect labour and costs not directly tied to production).

It’s crucial to manage and minimise costs, adjusting for factors like rising material costs or inflation.

How to calculate your key profit metrics

• Gross profit = Total revenue – cost of goods sold. This figure indicates production efficiency and informs pricing and sales strategies.

• Gross profit margin = (gross profit ÷ total revenue) x 100. It shows the proportion of profit retained from each revenue dollar.

• Operating profit = gross profit – operating expenses. This represents profit from core operations, excluding interest and taxes (EBIT).

• Net profit = total revenue – (costs of goods sold + operating expenses + taxes and other expenses). Known as the ‘bottom line’, it’s the total earnings after covering all expenses.

Example scenario

Let’s look at a quick example to help you understand how to calculate a profit and loss statement better. 

Here are the figures for our hypothetical business:

• Total revenue: $300,000
• Cost of goods sold (COGS): $120,000
• Operating expenses: $70,000
• Interest and taxes: $30,000 (additional expenses not included in operating expenses)

In this case then:

Gross profit = $300,000 – $120,000 = $180,000

Gross Profit Margin = ($180,000 ÷ $300,000) x 100 = 0.6 x 100 = 60%

Operating Profit = $180,000 – $70,000 = $110,000

Net Profit = $300,000 – ($120,000 + $70,000 + $30,000) = $300,000 – $220,000 = $80,000

This is a very simplified example, but should help you understand how these metrics are calculated. 

Understanding your profit and loss statement

In order to fully understand your profit and loss statement, you should observe how sales change over time. Breaking down sales into individual products or lines can reveal which areas need attention. Watch for sudden spikes in expenses, differentiating them from gradual increases due to inflation or annual pay rises.

Understanding and regularly reviewing your profit and loss statement is crucial for gauging the financial health of your business, informing strategic decisions, and ensuring long-term success.

Balance sheets

A balance sheet, or statement of financial position, provides a snapshot of a business’s financial status at any given point in time. It details what the business owns (assets) and owes (liabilities), with the difference representing the owner’s equity.

Key components of a balance sheet

1.  The formula

Owner’s Equity = Assets – Liabilities

This equation must balance, hence the name ‘balance sheet.’

2. A tally of your assets

There are three types of assets: 

• Current assets. These are short-term assets expected to be converted into cash within a year. These include cash at bank, short-term investments, stock, trade debtors, and petty cash.
• Fixed assets. These are also known as non-current or capital assets, these are held for longer than a year. Examples are building improvements, plant and equipment, motor vehicles, and office equipment.
• Intangible assets. These are non-physical assets that add value to your business, such as intellectual property, trademarks, patents, and goodwill (like business value or reputation).

3. A tally of your liabilities

There are two primary types of liabilities: 

• Current liabilities. These are short-term debts or obligations due within one year, such as accounts payable, short-term loans, and taxes owed.
• Long-term liabilities. These are any debts or obligations due beyond one year, including long-term loans, mortgage payments, and bonds payable.

Example of a balance sheet formula

Assets

• Current Assets: $150,000
• Fixed Assets: $200,000
• Intangible Assets: $50,000

Liabilities

• Current Liabilities: $80,000
• Long-Term Liabilities: $120,000

Calculation of total assets and liabilities

Total Assets = Current Assets + Fixed Assets + Intangible Assets

• = $150,000 + $200,000 + $50,000
• = $400,000

Total Liabilities = Current Liabilities + Long-Term Liabilities

• = $80,000 + $120,000
• = $200,000

Calculation of owner’s equity

Owner’s Equity = Total Assets – Total Liabilities

• = $400,000 – $200,000
• = $200,000

In this example, the owner’s equity would then be $200,000. This figure represents the net value that the owner holds in the company after accounting for all assets and liabilities. It is a key indicator of the company’s financial health and the owner’s financial stake in the business.

Statements of changes in equity

A statement of changes in equity is another important financial statement for businesses. It provides a detailed account of the changes in a company’s equity over a specific period. This statement is particularly important for shareholders and investors, as it offers insight into how various business activities are impacting the company’s net worth.

Key components of a statement of changes in equity

Opening equity balance

This is the equity value at the start of the accounting period. It includes accumulated funds, such as retained earnings and any capital invested by owners or shareholders.

Comprehensive income 

This encompasses all changes to equity during the period that are not a result of transactions with owners. It includes net profit or loss (as reported in the profit and loss statement) and other items of income and expense, like revaluation of assets or foreign exchange adjustments.

Owner transactions

These are changes in equity resulting from interactions with owners. This might include new capital injections, dividends paid out, or repurchase of shares.

Closing equity balance

The final equity value at the end of the period, after accounting for comprehensive income and owner transactions.

Example scenario

Opening Equity Balance: $500,000

Total Comprehensive Income for the Year:

• Net Profit: $150,000
• Other Income: $20,000
• Total: $170,000

Changes due to Owner Transactions:

• New Capital: +$50,000
• Dividends: -$70,000
• Total: -$20,000

Closing Equity Balance:

• Opening Equity ($500,000) + Total Comprehensive Income ($170,000) + Owner Transactions (-$20,000) = $500,000 + $170,000 – $20,000 = $650,000

In this example, the company started the year with an equity of $500,000. Over the year, it generated a net profit of $150,000 and other income of $20,000, increasing the equity. However, owner transactions, including new capital and dividends paid, adjusted the equity further. By the end of the year, the company’s total equity increased to $650,000. This statement shows how the business’s performance and owner decisions have affected the overall equity, providing a comprehensive view of the company’s financial changes over the year.

Importance of the statement of changes in equity

The statement of changes in equity is an essential tool for tracking ownership changes, as it gives a clear view of how owner activities like issuing new shares or paying dividends have influenced the company’s equity. It also aids in understanding profit reinvestment by showing the portion of the company’s profits that are retained in the business compared to what is distributed to the owners. 

Furthermore, this statement is crucial for assessing company performance, as changes in equity can reflect on the company’s overall performance and the impact it has on shareholder value, providing deeper insights than what is typically gleaned from income statements and balance sheets.

Cash flow statements

A cash flow statement is a crucial financial document that tracks the movement of cash into and out of your business over a specific period, reflecting the business’s liquidity. It’s an essential tool for business planning, as it helps determine the company’s ability to settle debts, purchase materials, and invest in assets.

Key aspects of a cash flow statement

Cash flow from operations:

• This section details the primary cash-generating activities of your business, focusing on the daily operational cash flow.
• It includes net income from sales and changes in accounts receivable (money owed to you) and accounts payable (money you owe). A significant increase in accounts receivable compared to income might signal issues in debt management.

Cash flow from financing:

• This area measures the flow of cash between your business and its owners and creditors.
• It records cash inflows from borrowing funds or issuing shares and outflows like loan repayments, dividends, and repurchased shares.

Cash flow from investing:

• This section includes cash flow related to long-term assets, such as the purchase or sale of property and investment securities.

Example

Net cash flow from operations:

• = Net income + Decrease in accounts receivable + Increase in accounts payable
• = $120,000 + $10,000 + $15,000
• = $145,000

Net cash flow from financing:

• = Borrowed funds – Loan repayments – Dividends paid
• = $30,000 – $20,000 – $5,000
• = $5,000

Net cash flow from investing:

• = Sale of investments – Purchase of equipment
• = $25,000 – $40,000
• = -$15,000

Total net cash flow:

• = Net cash from operations + Net cash from financing + Net cash from investing
• = $145,000 + $5,000 – $15,000
• = $135,000

Closing cash balance:

• = Opening cash + Total net cash flow
• = $50,000 + $135,000
• = $185,000

In this example, the business started the year with $50,000. Operations generated $145,000, and financing activities added $5,000, while investing activities used $15,000. The total net cash flow for the year was $135,000, raising the closing cash balance to $185,000. This shows a healthy liquidity status, enabling the business to cover debts and invest in growth.

Interpreting a cash flow statement

In assessing a cash flow statement, the key figure is the net cash flow at the bottom, indicating total cash change over the period. Comparing this against previous periods is vital; a rising trend signals business health, whereas a consistent or declining trend, especially with low reserves, may point to potential cash shortfalls, necessitating prompt action.