Key Takeaways:
- Financial statements offer insight into a company’s operations, performance, and position.
- The are four main types of financial statements — balance sheet, income statement, cash flow statement, and equity statement — and each serves a unique purpose.
- Interpreting financial statements requires an understanding of basic accounting principles and financial ratios.
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Understanding financial statements is a fundamental skill for business owners, investors, and anyone who wants to make informed financial decisions about a company or organization. These reports provide an overview of an entity’s financial health and help stakeholders measure profitability, liquidity, cash flow, and long-term viability.
Whether you’re running a small business or deciding where to invest, knowing how to read and analyze financial statements can help you evaluate performance and make smarter choices. This guide covers the essential components of financial statements and how to interpret them.
What Is a Financial Statement?
Financial statements are standardized reports that provide a snapshot of an entity’s financial position, performance, and cash flows. They offer insight into how the company generates revenue, spends money, and manages its resources.
Several different stakeholders use financial statements — including business owners and executives, investors and lenders, government agencies, employees and unions, and financial analysts and advisors.
There are several methods for preparing financial statements. In the United States, most large companies follow Generally Accepted Accounting Principles (GAAP), while large companies in other countries follow International Financial Reporting Standards (IFRS).
For smaller companies, GAAP and IFRS may be overly complex and expensive to implement and maintain. Fortunately, there are simpler alternatives. These are known as “other comprehensive basis of accounting“, or OCBOA.
OCBOA includes:
- Cash or modified cash basis
- Income tax basis
- Regulatory basis
Types of Financial Statements
There are four primary types of financial statements, each serving a distinct purpose. Let’s look at each of these four statements in more detail:
Balance Sheet
The balance sheet, also known as “the statement of financial position”, provides a summary of a company’s financial position at a specific point in time. It follows the fundamental accounting equation:
Assets = Liabilities + Equity
Assets are the things a company owns — including cash, inventory, and property. Liabilities are what it owes to others — including accounts payable and loans. Equity is the value belonging to the company’s owners after subtracting the book value of liabilities from assets.
A healthy balance sheet demonstrates strong liquidity, indicating the ability to meet short-term obligations and manage debt.
Income Statement
The income statement is also called a profit and loss statement (P&L). It shows the company’s revenues and expenses over a specific period — typically monthly, quarterly, or annually. The basic formula of the income statement is:
Net Income = Revenue – Expenses
This financial statement highlights the revenue a company earns, expenses like cost of goods sold (COGS) and operating expenses, and shows the company’s net income or net loss.
This report helps assess profitability and performance over time.
Cash Flow Statement
The cash flow statement tracks the inflow and outflow of cash in three main areas:
- Operating activities: Cash from sales and payments to suppliers
- Investing activities: Buying equipment, selling assets
- Financing activities: Taking out loans, repaying debt
Unlike the income statement, which can include non-cash items like depreciation, the cash flow statement focuses solely on cash coming into and going out of the business. Understanding the amount of cash on hand can help you assess liquidity and solvency.
Statement of Changes in Equity
The statement of changes in equity (also known as the statement of owners’ equity or statement of shareholders’ equity) explains changes in the company’s equity over a reporting period.
The general formula for this financial statement is:
Beginning Equity + Net Income – Dividends +/- Other Changes = Ending Equity
While people tend to overlook the statement of changes in equity, it provides valuable insights into how the company retains or distributes profits.
How to Read Financial Statements
Reading financial statements effectively means looking beyond the numbers. Here’s a step-by-step breakdown of how to read these reports:
Step 1: Start with the Income Statement
The income statement is often the best starting point because it shows how much money the company brought in and how much it spent over a given period.
Begin by looking at total revenue. Has it grown or declined compared to previous periods? Next, review the major expense categories — including cost of goods sold (COGS), operating expenses, and interest. See how they impact profitability.
Net income, located at the bottom of the statement, indicates whether the business ended the period in the black (i.e., it generated a profit) or in the red (i.e., it incurred a loss).
For additional insight, calculate profitability margins — like gross margin or net profit margin — to understand how efficiently the company converts revenue into profit.
Step 2: Review the Balance Sheet
Next, take a look at the balance sheet — which offers a snapshot of assets, liabilities, and equity at a specific point in time.
Begin by examining current assets and current liabilities to assess the company’s liquidity. Does the company have enough resources to cover short-term obligations? Next, look at long-term liabilities and total equity to understand the business’s capital structure.
A strong balance sheet has a healthy ratio of assets to liabilities, manageable debt levels, and a solid base of retained earnings or shareholder equity.
Step 3: Analyze the Cash Flow Statement
The cash flow statement shows how cash actually moves through the business — critical information for assessing liquidity and solvency.
Focus first on cash from operating activities. Ideally, it should be positive and sufficient to sustain day-to-day operations. Next, review cash from investing activities to understand how the company allocates cash for growth — such as purchasing equipment or investing in new ventures. Finally, consider financing activities to know how the business manages debt, issues stock, or pays dividends.
Even profitable companies can face financial trouble if their cash flow is weak.
Step 4: Review the Statement of Changes in Equity
For the statement of changes in equity, look at how different equity accounts changed over the accounting period. Did equity grow from net income or did the owners have to contribute more capital or issue additional stock to make ends meet?
Does the company keep profits in retained earnings, or pay them out to owners in the form of dividend distributions? Tracking changes in retained earnings reveals whether the business is reinvesting profits or returning value to shareholders.
Step 5: Use Ratios for Deeper Insight
After reviewing the individual statements, use financial ratios to compare performance over time or against industry benchmarks.
Some useful financial ratios include:
- Current Ratio = Current Assets / Current Liabilities (measures liquidity)
- Debt-to-Equity Ratio = Total Liabilities / Shareholder Equity (measures how leveraged the company is)
- Net Profit Margin = Net Income / Revenue (measures profitability)
Compare these ratios across periods and against industry benchmarks. You can find benchmarks for your industry through industry associations or peer networks, online resources such as BizStats, or by consulting with an advisor.
How MGO Can Help
Whether you’re leading a business, evaluating stock market investments, or managing your personal finances, understanding financial statements helps you make more informed financial decisions.
However, compiling and interpreting the numbers isn’t always straightforward. That’s where MGO comes in. Our professionals work closely with business owners and leaders to prepare financial statements and interpret the financial data in context. We can help you connect the dots between reporting and real-world decisions.
If you’re ready to get more from your financial statements or just need help making sense of what you’re seeing, reach out to our team today.