What Are Financial Statements and Why Are They Important?

What Are Financial Statements and Why Are They Important?

These periodic reports can offer you a glimpse into where and how companies make and lose money, as well as their performance and vitality.

Whether you’re a new business owner, looking to invest in securities, or just trying to hone your skills, financial statements are a solid starting point. Understanding financial statements is also important if you’d like to keep your finger on the pulse of companies’ financial health—or even make big-picture business decisions at your own job. 

The Basics

What are financial statements?

Financial statements are written or digital records that disclose a company’s business activities and performance at a certain point in time. These records are essential, generally prepared annually or quarterly, and used by a number of stakeholders and parties to examine the company’s financial health and earning potential. 

Under the Generally Accepted Accounting Principles (GAAP), the Financial Accounting Standards Board requires regular and consistent financial reporting for public companies. There are three key components in a basic financial statement:

  1. A balance sheet
  2. An income statement
  3. A cash flow statement. 

Balance sheet

A balance sheet shows the company’s total assets, and how they’re financed—through debt or equity. Balance sheets are based on a fundamental formula: 

Assets = Liabilities + Equity

In this equation: 

Balance sheet example 

Consider Apple’s balance sheet for the third quarter of 2020. As is specified on the sheet, the numbers presented are in millions, except for the number of shares, which are reflected in thousands and par value.

Apple’s 2020 balance sheet.

Income statement 

An income statement reports revenues and expenses, and net income of a company for a certain period of time. Accounting periods can vary. For annual reports, that period of time would cover a year; for quarterly statements, it would cover a three-month quarter. 

The income statement culminates in the “bottom line”—physically, the bottom line—of the report, which shows you a company’s profitability after all costs are accounted for. Income statements are based on another fundamental equation: 

Net income = Revenue – Expenses

In this equation: 

Income statement example

Find Apple’s income statement for the third quarter of 2020 below. As is specified on the sheet, the numbers presented are in millions, except for the number of shares, which are reflected in thousands and par value.

Apple’s 2020 Income statement.

Cash flow statement

A cash flow statement—or statement of cash flows—is a measure of how much cash is entering and exiting the business over a period of time. 

Unlike the balance sheet, a cash flow statement is not centered on a formula. However, there are three sections on the statement that show cash flows for different parts of the business. 

Cash flow statement example

Find Apple’s cash flow statement for the third quarter of 2020 below. As is specified on the sheet, the numbers presented are in millions.

Apple’s 2020 cash flow statement.

How are financial statements used?

Financial statements are used by a number of parties to analyze a company’s profitability, financial health, and stock projections. Some individuals or groups who use companies’ financial statements include: 

Notable financial statement ratios

“Once you know how to select and calculate financial ratios, you can start looking at them over time to spot trends or warning signs. And you can also compare your company ratios to competitors or to industry averages to see how your company stacks up.” —Nic Barnhart, cofounder of Pareto Labs

At a glance, balance sheets, income statements, and cash flow statements seem to be a bunch of numbers labeled assets, liabilities, equity, revenue, and expenses. However, there are several financial ratios that you can apply to these reports to glean meaning from all that financial information.

Four types of financial ratios laid out in a graphic

There are four different types of financial ratios. 

Within these four types of financial ratios, there are specific formulas that companies commonly use.

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