A financial statement can take many forms.
The first question to ask is whether the financial statement is for personal or business use. Individuals often have to prepare personal financial statements if they are looking to obtain credit, usually for a large purchase such as a vehicle or home. Often the lender will have a preprinted form that the individual will simply fill out with the necessary information, such as their checking and savings amounts, investments or real estate and their debts, such as credit card balances, car loans and mortgages. This financial statement is only required when needed.
Businesses prepare financial statements in a somewhat similar fashion but the information is much more detailed, prepared on a periodic basis rather than when needed and can contain information that is useful to both an outside party or the owner or management of the business itself. Here we will focus on the need of a business to prepare a financial statement and how it is prepared.
Business Financial Statements
Depending on the size and needs of the business, the financial statement may range from a few sheets of paper to a professionally prepared report that could be tens of pages long with various schedules and commentary on aspects of the business and its finances and operations.
The latter type is usually prepared by a large company that has its shares publicly traded on a stock exchange and is regulated by the Securities and Exchange Commission. Since these large companies have many shareholders, they must report all information deemed necessary or required so that anyone investing in the stock of the company can make an informed decision whether the investment is a good one.
Most small businesses will never need this kind of financial statement.
However, the small business owner or management still needs to prepare a set of financial statements to run their business properly. Whether the business prepares a simple financial statement or a large report, there is a process that needs to be followed and there are certain rules and guidelines, in either case, that help guide the process.
Successful businesses follow the accounting cycle. This can be done manually or with the use of bookkeeping or accounting software. The accounting cycle essentially works as follows:
- Identify financial transactions, usually from a receipt, invoice or other original document that is evidence of the transaction
- Record the transactions in a journal, also known as a book of original entry. There may be several different kinds of journals. Every individual transaction is recorded along with the date and the type (expense, sale etc.)
- Summarize (total) the journals and transfer the totals to a general ledger which summarizes the activity for each financial category (accounts)
- Make a list of all the accounts and their balances (trial balance) as of a certain period, usually monthly
- Review the balances in each account and make any necessary adjustments, such as for non-cash transactions like depreciation
- Prepare the financial statements from the trial balance
Steps 1-5 are normally referred to as bookkeeping and follow fairly standard procedures. Step 6, the preparation of financial statements, are often considered accounting because it requires application of certain rules and formats, which are often referred to as Generally Accepted Accounting Principles (GAAP), especially if the financial statements are going to be shared with users outside the business (banks, investors, government agencies, etc.).
Even if the information is only used by the owner or management, financial statements prepared in accordance with GAAP are important because they provide a common and consistent basis with which to analyze financial information, such as when comparing the business’ performance with industry standards or to prior periods.
It is important to note that information used internally by the owner and management doesn’t always have to conform to GAAP, but it should come from the same bookkeeping system mentioned above. This is the importance of having a proper set of books and making sure the numbers are right to begin with. Make sure you consult a Las Vegas small business accountant who knows these procedures.
Once that is done, the resulting data can be presented in a manner required by its user.
Financial Statement Format
The financial statement is the most common and accepted format for the meaningful presentation of information.
As noted above, the financial statement can be very simple or detailed. Most small businesses will need two basic financial statements, both of which are interrelated and typically prepared together on a timely and periodic basis (usually monthly).
Balance Sheet. A balance sheet is a snapshot of the financial position of the business at any point in time, such as the end of a month or the end of a year. It contains three main items:
- Assets. Items that the business owns which are used to conduct operations and produce revenue. Examples include:
- Cash and Savings
- Short-term investments
- Accounts Receivables (amounts owed to the business for sales on which credit has been extended)
- Inventory (items produced or purchased for resale)
- Fixed assets such as land, buildings (owned, not rented), equipment, furniture, office equipment etc.
- Liabilities. Obligations (debts) of the business, often incurred to purchase assets or finance operations such as:
- Accounts payable (amounts the business owes for the purchase of materials and other expenses required for which time has been given to make payment)
- Short term loans
- Payroll and sales taxes that are collected but not yet paid
- Unearned revenue for deposits made by customers for work not yet performed
- Long term debt and mortgages, normally for the purchase of fixed assets.
- Equity. The difference between assets and liabilities (hopefully more assets than liabilities) which can also refer to the book value of the business or be viewed as the claims of ownership on the remaining assets once liabilities have been subtracted. The makeup of equity will depend on the legal status of the entity:
- Common Stock and capital paid in by the shareholders of a regular corporation (C-Corporation)
- Reduced by any dividends paid to shareholders
- Owner’s equity in the case of sole proprietor or LLC
- Reduced by distributions taken by the owner(s)
- Partner’s equity in the case of a partnership
- Reduced by distributions taken by the partners
- Retained Earnings (profit or loss accumulated from prior years)
- Current period income (Net Profit or Loss) as determined from the profit and loss statement (see below)
- Common Stock and capital paid in by the shareholders of a regular corporation (C-Corporation)
In simple terms a balance sheet shows the following relationship:
Assets = Liabilities + Equity
It should also be noted that while Equity is referred to here as the “book value” of the business, it isn’t necessarily what the business is worth. The business is only worth what an outside party is willing to pay and it is often the case that a business will command a lower price if the books and financial statements aren’t in good order.
Profit and Loss. The profit and loss (also referred to as an income statement or statement of operations) shows the results of business operations over a period of time (as opposed to a point in time on a balance sheet), typically for a month, quarter or year.
It contains the following items:
- Sales (or revenue)
- Cost of Sales (the direct cost of generating sales such as labor and/or materials used to produce the product or service)
- Gross Profit (the difference between sales and cost of sales)
- General and Administrative Expenses
- Sometimes just shown as one line item or in much more detail depending on the preference of the owner or management
- Operating Income (Loss) – the difference between gross profit and the expenses
- Other Income and Expense (such as interest income or expense, sales of fixed assets or depreciation)
- Net Profit (Loss) – the difference between operating income (loss) and other income and expense. If positive, the business is making money, if negative, the business is losing money.
Note that the net profit or loss is also a component of the balance sheet because it is the result of operations over a period of time at that end of that specific period of time.
Also, while the financial statements will follow this general format, there is much room to add or remove detail on each statement depending on the needs and nature of the business.
There is sometimes a third financial statement, usually only prepared for outside users, known as a Statement of Cash Flows. Discussion of this statement is beyond the scope of this discussion as it is rarely required of small businesses.
Why Does My Business Need a Financial Statement?
The answer has been referred to several times throughout this discussion. In general, if a business owner or management doesn’t know what is happening financially with their business, they run the risk, at best, of not being as profitable as they could, not managing their cash flow properly, potentially paying too much in taxes and even not getting the maximum value for their business should they decide to sell it. At worst, the business could fail before anything could be done about it.
Be a Small Business Prepared for Anything
The preparation of timely and periodic financial statements is crucial to the success of any business, large or small. This can be done manually by the owner or management of the company or they can use a software program to help. Either way, if the books are not prepared properly (beware of bookkeeping software that thinks its smarter than you) there are risks that the financial health of the business may not be addressed.
A professional, such as a Las Vegas Certified Public Accountant (CPA) can help ensure that financial statements are prepared properly and can then be used to help the owner make good business decisions.