What Is a Financial Statement? A Plain-English Guide for Owners

The four main financial statements

Income statement, balance sheet, cash flow statement and statement of owner's equity. Most small businesses focus on the first three.

Here is what each one tells you:

• Income statement. Revenue, costs and expenses over a period, ending with net profit or loss.
• Balance sheet. What the business owns (assets), what it owes (liabilities) and what is left for the owner (equity), on a specific date.
• Cash flow statement. Cash generated or used by operations, investing and financing.
• Statement of owner's equity. How equity changed because of profit, investments and owner draws or distributions.

Each is built from the same bookkeeping records. Accurate bookkeeping comes first, as explained in our bookkeeping guide.

A simple example you can follow

Here is an illustrative income statement for a small service business. It shows how revenue becomes profit.

Gross margin here is 45 percent, and net margin is about 8 percent. These are example figures only. Learn the formulas in our guides to profit margin and net profit.

Reading a balance sheet in five minutes

Check cash, receivables, debt and equity. The accounting equation, assets equal liabilities plus equity, must always balance.

Look at four things first:

1. Cash. Do you hold enough for several weeks of costs?
2. Accounts receivable. Are balances growing faster than sales? That can signal slow collection.
3. Debt. Compare short-term and long-term obligations, and note the payments due.
4. Equity. Is it growing over time, or shrinking because of losses or large owner draws?

See the accounting equation and assets, liabilities and equity for the building blocks. Ratios such as the current ratio help turn the numbers into a quick health check.

Why cash flow shows what profit hides

A business can be profitable on paper and still run out of cash. The cash flow statement shows timing, loan payments and purchases that the income statement leaves out.

Profit includes sales you have not yet collected and excludes the cash you spent on inventory, equipment or loan principal. A business with $5,000 of monthly profit can still be short if customers pay in 60 days and suppliers want payment in 15.

Review the three sections: operating, investing and financing. Negative operating cash flow for several months is a warning sign even when profit looks fine. Our article on cash flow vs. profit explains the gap with examples.

Who asks for financial statements

Lenders, investors, landlords, bonding companies, franchisors and prospective buyers may ask for them, along with your tax preparer.

Each audience reads them differently. A lender looks at the ability to repay. An investor looks at growth and margins. A buyer looks at earnings quality. A landlord wants evidence you can handle the rent.

Keep at least two to three years of statements and the current year-to-date set. For financing, ask what the funder wants before you gather everything. See the small business loan application checklist for the usual items. Some products rely mostly on bank statements, which ROI Funder uses along with a short application.

How to prepare statements properly

Use accounting software, reconcile accounts monthly, apply one accounting method consistently and have an accountant review the year-end set.

A straightforward process:

1. Choose software and a chart of accounts. See bookkeeping software options.
2. Record transactions weekly and reconcile monthly.
3. Record journal entries for adjustments like depreciation or accruals. See recording journal entries.
4. Run statements and compare them with the previous period.
5. Have a CPA or bookkeeper review for errors before you share them externally.

Compiled, reviewed and audited statements are different levels of assurance from an outside accountant. Most small businesses use internally prepared or compiled statements. Ask your lender which level it expects.

Using your numbers to plan funding

Statements show how much payment the business can carry. Start from the profit the funding will produce, then check the payment against cash flow.

Before you borrow, ask what the money will produce. In an illustrative example, a $50,000 equipment purchase that adds $4,000 per month in gross profit pays back over about 12 to 13 months before financing costs. Compare that with the total repayment and the monthly-equivalent payment on your cash flow statement.

ROI Funder starts from that payback math and shows the true cost, payback period and monthly-equivalent payments before you sign. We consider 500+ FICO, 6+ months in business and $20,000+ monthly revenue. See total cost of a funding offer and term loans for fixed-payment options.

Finally, store each period's statements as dated PDFs in one folder, and note any adjustments your accountant made. A consistent archive saves hours when a lender, buyer or auditor asks for prior-period figures.