The Complete Guide To Preparing Financial Statements

If you've ever wondered how to measure the financial health of a business or make informed decisions about where to invest your money, understanding financial statements is essential. This blog isn't just a technical breakdown of terms; it's your guide to seeing the bigger picture. Financial statements provide insights into a company’s performance, strategy, and future potential. By the end of this blog, you'll know how to read and analyze these crucial documents in ways that make sense, even if you're new to finance. 

Let’s dive into the 12 most important things you need to know about financial statements, explained in a simple, clear manner. 

1. Financial Statements Are Scorecards 

Think of financial statements as a report card for businesses. Just like in school, companies get graded, except their grades are shown through balance sheets, income statements, and cash flow statements. Financial statements help investors, creditors, and analysts assess whether the company is performing well. For example, a company with increasing revenues and positive cash flow is like a student getting straight A’s in their subjects. 

According to a 2022 survey, more than 70% of investors say they regularly check a company’s financials before making investment decisions. This shows that understanding these scorecards is a must if you want to evaluate a business properly. 

2. The Three Main Types of Financial Statements 

There are three primary financial statements you’ll encounter: 

Income Statement: This shows how much money the company made or lost during a specific period (often referred to as profit and loss statement). 

Balance Sheet: This gives a snapshot of what the company owns (assets), what it owes (liabilities), and what remains after debts (equity). 

Cash Flow Statement: This tells you how much cash is flowing into and out of the business. It's vital to know if a company is generating enough cash to cover its operations, debts, and investments. 

Each of these reports plays a critical role in providing a full picture of a company’s health. Ignoring one can give you an incomplete understanding. 

3. Revenues and Profits Are Different 

One common mistake many beginners make is assuming that revenue equals profit. Revenue is the total amount of money a company earns before any expenses. In contrast, profit (or net income) is what’s left after paying for all the costs like wages, materials, and taxes. 

For example, if a company earns $100,000 in sales but spends $80,000 on expenses, its profit is only $20,000. Knowing this difference helps avoid overestimating a company’s financial success. 

4. The Balance Sheet Shows What the Company Owns and Owes 

The balance sheet is like a snapshot of a company’s financial position at a specific moment in time. It lists: 

Assets: What the company owns, such as cash, inventory, and equipment. 

Liabilities: What the company owes, like loans, mortgages, and unpaid bills. 

Equity: What’s left after subtracting liabilities from assets, essentially the shareholders' stake in the company. 

A healthy balance sheet typically shows more assets than liabilities. For example, Apple’s balance sheet in 2023 showed that it had over $300 billion in assets, illustrating its strong financial position. 

5. Cash Flow Is Crucial 

A profitable company doesn’t always have enough cash. That’s why the cash flow statement is so important. It breaks down how cash moves in and out of the business through operating, investing, and financing activities. 

A business can make a profit on paper, but if it can’t pay its bills because of cash shortages, it might be in trouble. Knowing how to interpret this statement can help you predict whether a company will face liquidity problems. 

6. What’s Behind the Numbers? Interpretation Matters 

Numbers in financial statements don’t tell the full story unless you understand the context. For example, a company's declining profit margin might look alarming at first. However, upon closer inspection, it might be the result of a strategic investment in expanding its market. 

Look at industry benchmarks, economic conditions, and the company’s own business model to interpret the numbers correctly. This ensures you’re making informed decisions based on the bigger picture, not just raw data. 

7. The Role of Notes to Financial Statements 

Financial statements often include footnotes or notes to the accounts, which provide additional details about the figures in the main reports. These notes may explain accounting policies, unusual transactions, or potential risks. 

For instance, the notes may reveal whether a company has legal issues or significant debts that aren’t immediately obvious from the balance sheet alone. Always review these notes as they provide key insights that could influence your understanding of the company’s finances. 

8. Auditors Add an Extra Layer of Credibility 

Auditors review financial statements to ensure they are accurate and comply with accounting standards. An auditor’s report is usually included in a company’s annual financial report. 

If an auditor flags issues or gives a “qualified opinion” (meaning there are concerns), this is a red flag for investors. Conversely, a clean audit boosts confidence in the company’s numbers. In 2021, several high-profile companies were scrutinized after auditors found discrepancies in their financial statements, underscoring the importance of a thorough audit. 

9. Equity and Retained Earnings: What’s Left Over 

The statement of shareholders’ equity shows how much equity the company’s shareholders have in the business. Retained earnings, part of this statement, represent the profits the company has kept after paying dividends. 

A company that consistently reinvests its retained earnings into growth opportunities is often more attractive to investors. For example, Google has historically reinvested a large portion of its earnings into developing new technologies, which has driven its long-term growth. 

10. Comparing Financial Statements Over Time 

One of the best ways to evaluate a company’s performance is by comparing its financial statements over multiple periods. This is called trend analysis, and it helps you identify patterns, such as growing revenues or increasing debt. 

For example, a company may show steady revenue growth for five years, but if its debt has increased at a faster rate, this could signal future financial problems. By tracking these trends, you can get a clearer sense of whether a company is truly growing or merely inflating its numbers. 

11. Ratios Help You Understand the Numbers 

Financial ratios are key tools for analyzing financial statements. Here are a few basic but essential ones: 

Current Ratio: Measures liquidity by comparing assets to liabilities. A ratio above 1.0 suggests the company can cover its short-term debts. 

Debt-to-Equity Ratio: Shows how much debt the company has relative to its equity. A high ratio could mean the company is heavily reliant on borrowing, which might be risky. 

Return on Equity (ROE): Shows how effectively the company is using shareholders’ money to generate profits. A higher ROE is generally a good sign. 

These ratios can help you quickly assess a company’s financial health without diving into complex calculations. 

12. Industry Context is Key 

Lastly, always consider the industry context. Comparing a retail company's financials to those of a tech company doesn't make much sense because different industries have different norms. 

For example, companies in capital-intensive industries, like manufacturing, often carry more debt than companies in service-based industries. Likewise, profit margins can vary widely depending on the sector. Knowing the specific benchmarks for the industry helps you better assess whether the company is performing well relative to its peers. 

Actionable Insights: How to Apply What You’ve Learned 

Now that you’ve learned the essentials of financial statements, the next step is to apply this knowledge. Whether you’re looking to invest in a company, start your own business, or simply understand how companies operate, having this foundation will help you make smarter financial decisions. 

Start by analyzing the financial statements of companies you’re interested in. Use the ratios, examine trends, and don’t forget to check the notes and auditor reports. Over time, you’ll become more comfortable with these concepts, and you’ll see how they can guide your decision-making processes. 

Financial statements are not just numbers, they’re the key to unlocking the full picture of any business. 

Harness Financial Statements for Strategic Business Growth with Global FPO 

Understanding financial statements isn’t just for investors or accountants—it’s valuable knowledge for anyone interested in how businesses work. These documents offer a window into a company’s operations, strategies, and potential future success.  

Global FPO is the right choice to help your business with its financial needs. We offer expert services in accounting, bookkeeping, and financial reporting. Whether you run a small business or a large company, we tailor our services to fit your specific requirements. 

Global FPO makes sure your financial statements are correct and follow global standards. We don’t just help you understand your numbers; we also give you advice to make smart business decisions. With Global FPO on your side, you’ll have a team that works to improve your company’s financial health and overall success. 

FAQs 

1. What are financial statements? 

Financial statements are reports that show how a company is doing financially. They are like a report card for a business, showing if it's making money, what it owns, and what it owes. 

2. What are the three main types of financial statements? 

The three main types are: 

Income Statement: Shows how much money the company made or lost. 

Balance Sheet: Lists what the company owns (assets) and what it owes (liabilities). 

Cash Flow Statement: Shows how cash is coming in and going out of the company. 

3. How is revenue different from profit? 

Revenue is the total money a company earns. Profit is what’s left after subtracting all the costs and expenses from the revenue. So, a company can have high revenue but low profit if its expenses are also high. 

4. Why is the balance sheet important? 

The balance sheet gives a snapshot of a company’s financial health at a specific time. It shows what the company owns, what it owes, and what’s left over, helping to understand if it is in a good financial position. 

5. What does the cash flow statement tell us? 

The cash flow statement shows how money is moving into and out of the company. It helps to see if the company has enough cash to pay its bills and invest in its growth.