Understanding the Three Key Financial Statements Every Business Should Monito

Every business should regularly evaluate its three big financial statements, namely, Income Statement, Balance Sheet, and Cash Flow Statement to understand its true financial health and take corrective actions before minor issues end up in major problems. We can analyze any of these statements individually and also check how they can get connected.

Income Statement (Profit & Loss Statement)

The income statement measures a company’s overall profitability by separating revenue, costs, and expenses into distinct categories, this enables management to analyze business performance drivers and identify areas that need improvement.

Income statement has the following sections:

• Revenue [Business sales from goods and services]
• Cost of Goods Sold [Costs that are directly associated with the sales]
• Gross Profit [Revenue less Cost of goods sold]
• Operating Expenses [Expenses that are required to complete business transactions]
• Operating Income
• Interest & Taxes
• Net Income

By evaluating income statements, a company can get a deeper insight into the following areas:

• It can track the revenue streams based on seasonal and market conditions
• It can monitor how costs are changing overtime or what contributes the most to it’s rising cost
• It can analyze how profit margins are changing over time

By taking a look into any of the above, it can detect any change in company’s profitability and take corrective measures ahead of time.

Balance Sheet

The balance sheet shows the overall financial position of a business at a specific point in time, whereas income statement it’s for a specific period of time. It evaluates what the business owns (assets) versus what it owes (liabilities) plus owner’s equity.

Balance Sheet Equation/Formula

Assets = Liabilities + Equity

It has the following key components:

• Assets [includes everything owned by the business such as cash, bank balance, inventory, equipment, etc.]
• Liabilities [includes everything that business owes such as any payables and debts]
• Equity [includes what owners have a claim on business]

By evaluating balance sheet, a business can get a deeper insight into the following areas:

The balance sheet enables business management to assess both short-term and long-term liquidity by comparing assets and liabilities. Liquidity measures the company’s ability to pay its debts as it gets due and checks whether it can pay off its debt burden without any financial strains.

Short term liquidity is calculated by company business current assets and current liabilities whereas long term considers all assets and liabilities.

Balance sheet also allows the business to evaluate its financial risk or leverage by comparing its debt with the equity.

Cash Flow Statement

Cash Flow Statement shows the sources the business generates cash and the areas where it is spending it.

Cash flow statements can be evaluated from different perspectives. First perspective is from its main operating activities. In this situation cash inflow should be higher than cash outflow to allow the business to carry out its routine operations. Second perspective is whether business after covering its operating activities has sufficient funds to cover its capital expenditures [this is referred as free cash flow].

Connections Between These Statements

If company has a net profit during the period, then it is transferred to balance sheet in the form of retained earnings that show a strong cash flow for the business.