Having accurate, up-to-date financial statements is important for any small business owner. But what, exactly, are your financial statements telling you?
A business's financial statements serve many purposes. While the specific purpose will differ based on the specific user, having a set of the basic financial statements—balance sheet, income statement, cash flow statement, and statement of equity—will:
- Provide most users with the information they need for their decision-making processes
- Give financial statement analysts the data required to calculate financial ratios that provide reliable measures of a business's financial performance
Purpose of financial statements
Financial statements provide users with a report on the financial health of a business. Because of this, they can serve more than one purpose.
1. Tax liability and compliance
If your business is required to file financial statements to comply with tax regulations, the statements might be used by government entities to assess your business's tax liability.
2. Business strategies and decision-making
Both individually and read as a whole, financial statements provide business owners with a numbers-based look at the financial health of their business. The data provided by your business's financial statements can help you determine whether you are meeting your current goals, the effectiveness of your business strategies, and the kinds of goals you may want to set for the future.
Financial statements can also provide management with the information necessary to make business decisions and day-to-day operating decisions. Whether you're assessing the need to expand your business's production capacity or determining the effectiveness of hiring more employees, financial statements can help you make better decisions based on concrete and accurate numbers.
3. Creditors' decisions
Many businesses will find themselves in need of an infusion of funds at some point in their history. When your business applies for credit, potential creditors will want to see accurate and current financial statements.
The information provided by the statements will help creditors to assess things like the financial health of your business, and whether your business will be able to make payments on any credit they may decide to extend to you. And, if you already have debt obligations owing to a creditor, financial statements will help the creditor determine whether to extend more credit, or if they should restrict the amount of credit extended.
4. Investors' decisions
Another way for businesses to raise funds is through investors. Whether you're offering investors preferred shares or common shares, potential investors will want to see your business's financial statements in order to decide whether they should make an investment, and how much of an investment they should make.
As with creditors, financial statements enable investors to gauge the financial health of your business. Potential investors also will want to use the data provided in your financial reports to assess your current financial performance and predict future financial performance.
5. Other Users of Financial Statements
Other users of financial statements include shareholders or LLC members, suppliers, customers, and employees. Different elements of the financial statements will be important, depending on the user. For example, a member of an LLC might want to use financial statements to assess how well their capital investment in the LLC is doing, while a business's supplier will want to gauge a business's ability to pay its invoices in a timely manner.
Calculating critical financial ratios
In using financial statements to assist in their decision-making, many users also depend on the data in the statements to calculate financial ratios that serve as performance measures. The primary source of the data required for the calculation of most financial ratios comes from a business's income statement and balance sheet, but certain ratios also rely on numbers found in some of the other basic financial statements.
By taking the time to prepare and use the four financial statements—balance sheet, income statement, cash flow statement, and statement of equity—you and your team will gain additional insight into both the performance and the growth of your small business.
Find out more about Business Accounting