Banks and investors use financial statements to determine whether your company is a sound loan prospect or a solid investment. Their interest in a financial overview of your business is understandable: Nobody wants to lend money to a business that is unlikely to pay it back. Financial statement documents should look clean and professionally presented to reinforce the impression that your plans and your company are mature and sound.
The components of financial statements are the profit and loss statement, the balance sheet, the cash flow statement and, less commonly, a statement of retained earnings.
A profit and loss statement summarizes your company's business activities and earnings over a period of time such as a month or a year. The upper section shows your earnings, breaking them down into categories such as wholesale and retail sales. The lower section presents your expenditures during the same period. The bottom line of your profit and loss statement shows your net earnings or losses during that time frame, which is calculated by subtracting your total expenditures from your total income.
The expenditure section of a profit and loss statement is further broken down into cost of goods sold and other operating expenses. COGS reflects your variable costs such as materials and production labor, which fluctuate relative to how much business you transact. Other operating expenses, or fixed costs, include expenditures such as rent and business licenses, which don't directly increase in relation to your sales volume. Net profit is calculated by subtracting only COGS expenses from your gross sales.
A balance sheet is a quick summary of your financial situation at a particular moment in time. The left side of the statement lists and categorizes everything you own, breaking it down into line items such as cash on hand, leasehold improvements and real estate. The right side captures your current liabilities including balances on loans, mortgages and credit cards and accounts payable to vendors and suppliers.
The right column also includes a line for owner's equity, which reflects your investment in the business and balances the balance sheet equation so the sum of the assets column equals the total of the liabilities column.
A lender or investor will evaluate your balance sheet to determine how your profits and losses are playing out and making their way into the form of assets with real value. Your balance sheet will also reflect whether you have cash available to field unforeseen circumstances or whether all of your tangible worth is tied up in long-term investments, such as business property, where it can't be easily withdrawn.
Your cash flow statement focuses on your liquid cash, showing its various sources as well as the total you'll have available in surplus and to finance debt. These sources include cash from operating activities or net income adjusted for deductible expenses such as depreciation, which lower your bottom line on paper but don't represent any real cash outflow in the present. Your cash flow statement also includes incoming cash from investments and from financing activities such as principal repaid on loans you've made.
These essential features of your financial statement create a well-rounded picture of how well your company is doing financially and whether your track record makes you a worthy prospect for a loan. Not only should your statements show some profitability and the ability to manage revenue successfully, but they should also show your company's financial patterns over time.
A full set of financial statements should also provide some clues to the overall soundness of your bookkeeping. If your profit and loss statements show that you consistently make a profit, yet your balance sheet shows that you're chronically short on cash, a savvy lender will rightfully have some questions to ask. Similarly, if your income statement shows you losing money year after year, yet you have incurred no debt, lenders and investors will want to know how you've covered your losses.