What are Financial Statements? Definition, Examples & How To Use Them

Financial statements are an essential part of business management. By summarizing your bookkeeping records, financial statements let you monitor financial trends, forecast performance, and make evidence-based business decisions. Understanding the main types of financial statements and how to use them can help you create smarter strategies and run your business effectively.

What are Financial Statements?

Financial statements are formal business documents that report critical financial information. They summarize the company’s financial health and activities using records from journal entries and other bookkeeping documents.

Purpose of Financial Statements

Financial statements summarize past financial activity to help business owners make informed strategies and decisions. You can use financial statements to assess your company’s financial health, forecast future performance, or prove your value to creditors, investors, and job applicants.

Empowers Smarter Decision-Making

When reported consistently, financial statements provide a clear picture of your financial performance and health. They help illuminate trends in expenses, revenue, and cash flow. Comparing current financial statements to past financial statements also shows you the impact of ongoing business decisions.

Examples of strategies decisions financial statements can help with:

• Setting realistic goals based on historical information
• Managing expenses based on trends
• Determining the company’s capacity to take on additional debt
• Managing investments based on past ROI trends

Attracts Investors

Financial statements show investors the value your company can provide. For example:

• Balance sheets show your overall business value.
• Income statements prove your business’ profitability. Investors can compare stock prices to net income to determine if your company is worth investing in.
• Cash flow statements show your ability to generate cash for expenses, debt, and profit. Investors also compare your stock prices to your cash-generation capacity to determine if you can quickly provide ROI.

Proves Creditworthiness to Lenders

Financial statements measure your capacity to cover liabilities. Creditors are more likely to lend money to companies that can prove their ability to pay off debt on time.

Attracts Top Talent

Job applicants want to work for companies that can sustain themselves effectively and pay adequate compensation. Financial statements can help prove your company’s ability to keep itself running. They also help illuminate how much money you can allocate for wage payments and other benefits.

Types of Financial Statements

There are three primary financial statements: the balance sheet, the income statement, and the cash flow statement. All information is derived from the general ledger and is necessary for running a business effectively.

• Balance Sheet: The balance sheet provides a snapshot of your financial position at a given point in time. It tracks the value of all assets, liabilities, and equity.
• Income Statement: The income statement shows financial performance and profitability over a given reporting period. It tracks revenue and expenses.
• Cash Flow Statement: The cash flow statement tracks the movement of cash inflows and outflows over a given period of time. It shows a company’s effectiveness at generating cash.

Some companies might produce additional types of financial statements, such as the statement of retained earnings and the notes to financial statements.

• Statement of Retained Earnings: Also known as the statement of changes in equity, the statement of retained earnings reconciles the changes in retained earnings over a range of time after paying out dividends.
• Note to Financial Statements: The notes to financial statements aim to clarify all financial statements’ contents. They explain the figures listed in each financial statement, providing additional context and assumptions.

We’ll talk more about the five types in more detail below.

Balance Sheet

The balance sheet is a financial document that summarizes everything your business owes and owns at a given point in time. It uses your asset, liability, and account balances to calculate your business “book value.” The information it provides helps owners, investors, and creditors evaluate the company’s financial standing.

The balance sheet is composed of three main components:

• Assets are resources the business owns or controls. They are listed on the balance sheet in descending order of liquidity. Examples of assets include cash, accounts receivable, marketable securities, inventory, vehicles, equipment, and property.
• Liabilities consist of money owed to creditors. They are listed on the balance sheet in order of due date. Examples of liabilities include accounts payable, unearned revenue, long-term debt, and post-employment benefits.
• Shareholder’s Equity refers to funding offered by shareholders and other investors. Examples of equity include owner’s capital, common stock, preferred stock, treasury stock, and retained earnings.

The balance sheet is built on the accounting equation, which states that assets are equal to the sum of liabilities and equity. The equation states that everything a business owns is funded by either debt or investments. A balance sheet’s failure to match assets with liabilities and equity indicates errors in recording or calculation.

Balance Sheet Example

Below is an example of a balance sheet. It is divided into three components: assets, liabilities, and equity. Total assets are equivalent to the sum of liabilities and equity.

Example Co. — Balance Sheet — For the Year Ended December 31, 2024

Assets — Current Assets
Cash	$100,000
Accounts Receivable	$50,000
Inventory	$70,000
Total Current Assets	$220,000
Fixed Assets
Certificates of Deposit	$180,000
Vehicles	$195,000
Property	$400,000
Intangible Assets	$5,000
Total Fixed Assets	$780,000
Total Assets	$1,000,000
Liabilities — Current Liabilities
Accounts Payable	$15,000
Wages Payable	$40,000
Taxes Payable	$20,000
Current Portion of Term Debt	$25,000
Total Current Liabilities	$100,000
Non-Current Liabilities
Term Debt	$500,000
Total Liabilities	$600,000
Shareholder’s Equity
Owner’s Capital	$200,000
Common Stock	$150,000
Retained Earnings	$50,000
Total Shareholder’s Equity	$400,000
Total Liabilities and Shareholder’s Equity	$1,000,000

How To Evaluate A Balance Sheet

There are multiple ways to analyze a balance sheet. The table below lists the most common performance indicators and their purpose.

Performance Indicator	Purpose	Formula
Working Capital	Shows the amount of liquid resources available to fund operations, buy inventory, or pay short-term debt.	Current Assets – Current Liabilities
Current Ratio	Measures the company’s ability to fund operations, buy inventory, or pay short-term debt using available liquid resources.	Current Assets / Current Liabilities
Quick Ratio	Measures the company’s capacity to fund operations, buy inventory, or pay short-term debt without liquidating inventory.	(Current Assets – Inventory) / Current Liabilities
Debt-to-Asset Ratio	Measures the percentage of total assets that rely on debt for funding.	Total Liabilities / Total Assets
Debt-to-Equity Ratio	Determines which source of funding a company is more reliant on.	Total Liabilities / Total Equity
Return on Assets	Measures a company’s efficiency in using resources to generate profit.	Net Income / Total Assets

Income Statement

The income statement is a type of financial statement that reports all revenue and expenses incurred within a range of time. It helps companies evaluate profitability, cost management, and revenue-generation capacity.

There are two ways to report income statements. Single-step income statements derive net income from the difference between revenues plus gains and expenses plus losses. Meanwhile, multi-step income statements report income at multiple levels: gross, operating, pre-tax, and after-tax.

Single-step income statements consist of the following components:

• Revenues: All money earned from core business activities.
• Gains: Value increases earned from activities outside business operations, such as the sale of assets for an amount higher than book value.
• Expenses: All money spent on core business activities. Examples include the cost of goods sold, salaries, rent, utilities, and marketing expenses.
• Losses: Money spent outside of core business activities. Examples include settlement fees and the sale of assets for lower than book value.
• Net Income: All money retained after subtracting expenses and losses.

The single-step income statement uses the below formula to calculate net income:

Meanwhile, multi-step income statements consist of the following components:

• Net Sales: The total revenue earned generated by core business activities.
• Cost of Goods Sold: The direct costs of creating a product or service, such as materials, packaging, and direct labor.
• Gross Profit: Net sales minus the cost of goods sold.
• Operating expenses: Expenses incurred in running day-to-day business operations, such rent, utilities, wages, and equipment.
• Operating Income: Income retained after subtracting the cost of goods sold and operating income.
• Non-Operating Revenue and Expenses: All revenues and expenses incurred outside core business operations, such as the sale or purchase of financial instruments, stock-based compensation, and settlement winnings or dues.
• Pre-tax Income: Income retained after subtracting the cost of goods sold, operating income, and non-operating income.
• Income Tax: The amount of tax charged to your earnings.
• Net Income: Also known as after-tax income, net income is the revenue the business retains after subtracting all necessary costs.

In summary, the multi-step income statement calculates net income using the below formula:

Single-Step Income Statement Example

Below is an example of a single-step income statement. It lists all amounts within four components: revenue, expenses, gains, and losses. It calculates net income by plugging the values into the net income formula.

Example Co. — Income Statement — For the Year Ended December 31, 2024

Revenue
Merchandise Revenue	$13,000
Revenue from Services	$20,000
Interest Revenue	$2,000
Net Sales	$35,000
Expenses
Cost of Goods Sold	$10,000
Wage Expense	$12,000
Rent Expense	$3,000
Utilities Expense	$500
Income Tax Expense	$6,000
Total Expenses	$31,500
Gains — Settlement Winnings	$2,000
Losses — Loss from Sale of Equipment	$1,300
Net Income	$4,200

Multi-Step Income Statement Example

Below is an example of a multi-step income statement. It displays income at multiple levels to better illuminate what your revenue pays for.

Example Co. — Income Statement — For the Year Ended December 31, 2024

Net Sales	$35,000
Cost of Goods Sold	($10,000)
Gross Profit	$25,000
Operating Expenses
Salaries	($12,000)
Rent	($3,000)
Utilities	($500)
Total Operating Expense	($15,500)
Total Operating Income	$9,500
Non-Operating Revenues and Expenses
Settlement Winnings	$2,000
Loss on Sale of Equipment	($1,300)
Total Non-Operating Revenues and Expenses	$700
Net Income Before Taxes	$10,200
Income Tax Expense	($6,000)
Net Income	$4,200

How to Evaluate an Income Statement

The income statement is primarily used to measure profitability. Investors also use it to evaluate the possible returns of funding your company. Below, we describe the most common performance metrics generated by the income statement.

Performance Indicator	Purpose	Formula
Gross Margin	Measures the amount of money the business keeps after paying for the overhead costs of manufacturing a product or service.	(Net Sales – Cost of Goods Sold) / Net Sales
Operating Margin	Measures the amount of money the business keeps after paying for the cost of overhead manufacturing and day-to-day business operations.	(Net Sales – Cost of Goods Sold – Operating Expenses) / Net Sales
Net Profit Margin	Measures the amount of money the business keeps after paying for the cost of goods sold, operating expenses, non-operating expenses, and tax.	Net Income / Net Sales
Earnings Per Share	Shows the profit a company generates per available share.	(Net Income – Preferred Dividends) / Weighted Average Number of Shares Outstanding
Price-to-Earnings (P/E) Ratio	Measures the amount of money each investor pays per dollar of profit.	Share Price / Earnings Per Share
Revenue Growth Rate	Measures the rate revenue increases or decreases within a given period of time.	(Current Revenue – Previous Revenue) / Previous Revenue

Cash Flow Statement

The cash flow statement monitors cash flow. Put simply, it records all cash and cash equivalents moving in and out of the business at a given range of time.

The cash flow statement differs from the income statement because it requires cash exchange. It is a necessary document for companies that follow the accrual method of accounting, where revenues and expenses don’t automatically translate to cash payments and receipts. With cash flow statements, companies can measure their effectiveness at generating the cash they need to sustain operations.

Cash flow statements consist of the following components:

• Cash Flow from Operating Activities: The cash receipts and payments incurred through core business activities. Examples include sales, materials and inventory purchases, and operating expense payments.
• Cash Flow from Investing Activities: The cash receipts and payments incurred through investments. An example would be the sale or purchase of a long-term asset.
• Cash Flow from Financing Activities: The cash receipts and payments incurred through creditor and shareholder funding. Examples include dividend payments, the issuance of debt or equity, and the repayment of debt or equity.

There are two ways to report cash flow: the direct method and the indirect method.

• Direct Method: This method works forward by listing all cash receipts and payments in real time and then calculating net cash flow.
• Indirect Method: This method works backward by listing net income from the income statement and then subtracting increases and decreases listed on the balance sheet.

Direct Cash Flow Statement Example

Below is an example of a cash flow statement calculated through the direct method. As shown, the document works forward to calculate net cash flow, starting with operating activities and ending with financing activities.

Example Co. — Statement of Cash Flows — For the Year Ended December 31, 2024

Cash Flow from Operating Activities
Employee wages	($12,000)
Cash paid to vendors	($18,000)
Cash received from customers	$300,000
Dividends paid	($20,000)
Interest paid	($10,000)
Income taxes paid	($20,000)
Net cash flow from operating activities	$220,000
Cash Flow from Investing Activities
Purchase of equipment	($100,000)
Sale of securities	$50,000
Net cash flow from investing activities	($50,000)
Cash Flow from Financing Activities
Proceeds from long-term debt	$200,000
Payments on line of credit	($25,000)
Net cash flow from financing activities	$170,000
Ending Cash Balance	$345,000

Indirect Cash Flow Statement Example

This example shows cash flow reported through the indirect method. It takes net income first, then lists all additions and subtractions to calculate net cash flow.

Example Co. — Statement of Cash Flows — For the Year Ended December 31, 2024

Cash Flow from Operating Activities
Net Income	$1,000,000
Additions to cash — Depreciations	$30,000
Decreases in Accounts Receivable	$500,000
Increases in Accounts Payable	$200,000
Increase in Taxes Payable	$70,000
Subtractions from cash — Increase in Inventory	($300,000)
Decrease in Accounts Payable	($20,000)
Decrease in Wages Payable	($30,000)
Net Cash Flow from Operations	$1,450,000
Cash Flow From Investing
Sale of Equipment	$840,000
Purchase of Securities	($90,000)
Net Cash Flow from Investing	$750,000
Cash Flow From Financing
Proceeds from Long-term Debt	$300,000
Profits from Issuing Stock	$35,000
Repayments of Long-term Debt	($25,000)
Common Stock Dividends	($10,000)
Net Cash Flow from Financing	$300,000
Cash Flow for FY Ended December 31, 2024	$2,500,000

How to Evaluate a Cash Flow Statement

Cash flow is used as a conservative measurement of profitability because it only tracks revenues that are immediately usable as cash or cash equivalents. Investors and lenders use cash-flow-related performance indicators to determine the risk of working with a company.

Performance Indicator	Description	Formula
Free Cash Flow	Show the available cash balance after subtracting operating expenses and capital expenditures.	Operating Cash Flow – Capital Expenditures
Current Liability Coverage Ratio	Measures the company’s ability to cover current liabilities with cash and cash equivalents.	Operating Cash Flow / Average Current Liabilities
Price-to-Cash Flow Ratio	Measures the amount of money investors are willing to pay per dollar of cash flow generated.	Operating Cash Flow Per Share / Price Per Stock
Cash Flow to Net Income Ratio	Measures the amount of cash that moves per dollar of profit generated.	Operating Cash Flow / Net Income

Statement of Retained Earnings

The statement of retained earnings is a short document that reconciles retained earnings at the beginning of a designated period with retained earnings at the end of the period. It shows how much profit the company keeps after adding net income and subtracting dividends paid to shareholders.

To calculate retained earnings, companies use the below formula:

Not all companies report their statement of retained earnings. Some include the changes as part of the income statement or the shareholder’s equity component of the balance sheet.

Statement of Retained Earnings Example

The example below shows how to calculate the ending balance of retained earnings. It lists the starting balance first, then adds all net income earned within the year and subtracts all dividends paid out.

Example Co. — Statement of Retained Earnings — For the Year Ended December 31, 2024

Retained Earnings: Starting Balance	$20,000
Add: Net Income earned in 2024	$40,000
Subtotal	$60,000
Less: Dividends	($25,000)
Retained Earnings: Ending Balance	$45,000

Notes to Financial Statements

The notes to financial statements are optional footnotes that explain the contents of the primary financial statements. It helps readers, such as analysts, auditors, and other professionals, follow the flow of information presented.

Below are a few examples of common footnotes found in notes to financial statements:

• Accounting policies tell readers which accounting standards the company followed.
• Depreciation footnotes tell readers how the company calculated depreciation expenses
• Inventory valuation footnotes illuminate how the company calculated the value of unsold inventory.
• Intangible asset footnotes explain how the company valuated intangible assets, such as licensing agreements, trademarks, and patents.
• Employee benefit footnotes outline the purpose, costs, and risks of all benefits included in the employee compensation package.

Financial statements are useful tools for gauging financial performance, crafting evidence-based business strategies and attracting funding sources. By creating reports at regular intervals, you can document your business’ progress, identify trends, and forecast future possibilities. Accurate financial statements are necessary for effective business management.

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