What Are the Three Major Financial Statements?

Last Updated August 21, 2024

Every business owner needs to know the three major financial statements to gain a comprehensive and holistic overview of your company’s financial condition. Together, these documents provide valuable information for business accounting and strategic decision-making regarding investments, expansions, and cost-cutting.

If you’re looking for investors, they’re going to want to see and review these statements before making a decision on your business.

By periodically creating and updating these essential statements, you can easily identify which areas of your business are most profitable and where inefficiencies lie—empowering you to evaluate resource allocation and operational adjustments.

In this article, we’ll walk you through each major financial statement: the balance sheet, the profit & loss statement, and the cash flow statement.

1. Balance Sheet

A balance sheet provides a snapshot of a company’s financial state at a specific moment. This is a tool for businesses to understand their current financial health, informing them on decisions they can make in the future. Let’s break down the details.

What Is Included in a Balance Sheet?

Key elements of a business balance sheet include cash and cash equivalents, accounts receivable, inventory, property, plant and equipment, accounts payable, and accrued expenses. Also, shareholders’ equity encompasses retained earnings and issued capital.

What Does a Balance Sheet Show?

A business balance sheet shows a company’s financial health, indicating liquidity, leverage, and the overall balance of income and expenditure over time. By analyzing these components, stakeholders can assess the firm’s operations and financial stability.

How to Create a Balance Sheet

Start by listing your assets, organized from most to least liquid. Next, detail your liabilities, from short to long-term obligations. Finish by calculating shareholders’ equity by subtracting total liabilities from total assets.

For step-by-step guidance, have a look at our comprehensive tutorial on how to make a business balance sheet.

How to Analyze a Balance Sheet

Analyzing a balance sheet means calculating ratios like the current ratio, debt-to-equity ratio, and return on equity. This analysis offers insights into liquidity, indebtedness, and profitability. Understanding these ratios provides a clearer picture of financial health and guides strategic decision-making for your business.

2. Profit and Loss Statement

Next, a profit and loss statement—also known as an income statement—measures a company’s financial performance over a specific period. It details revenue, costs, and expenses to show the net income or profit earned. This statement is vital for assessing a company’s profitability, operations, and cost management.

What Is Included in a Profit and Loss Statement?

The components of a profit and loss statement include sales revenue, cost of goods sold (COGS), gross profit, operating expenses, and net profit. Sales revenue is the income from business activities, COGS represents the direct costs of producing goods, and operating expenses cover the costs of running the business. The difference between revenue and total costs and expenses is the net profit.

What Does a Profit and Loss Statement Show?

It shows whether a company can generate profit by increasing revenue, reducing costs, or both. This statement is vital for investors and creditors to assess the firm’s financial health and operational success.

How to Create a Profit and Loss Statement

To create a profit and loss statement, begin with total revenue, subtract COGS to find gross profit, deduct operating expenses to arrive at operating profit, and then adjust for taxes and interest to determine net profit.

How to Analyze a Profit and Loss Statement

Analyzing a profit and loss statement involves looking at trends in key figures such as gross profit margin, operating margin, and net profit margin over time. Comparing these margins helps understand a company’s profitability and efficiency.

3. Cash Flow Statement

Finally, a cash flow statement shows the inflow and outflow of cash within a business. It highlights how well a business manages its liquidity or cash on hand. This document is very important to understand a company’s operations, investment opportunities and activities, and financing decisions over a period of time.

What Is Included in a Cash Flow Statement?

The statement categorizes cash activities into three areas: operating activities, investing activities, and financing activities. Operating activities refer to the core business operations. Investing activities detail transactions related to assets such as purchasing equipment. Financing activities include actions like issuing stock or borrowing funds. Additionally, you can use this information to build a cash flow model.

What Does a Cash Flow Statement Show?

A cash flow statement shows a detailed look at where a company’s money comes from and how it’s spent. This clarity is vital for assessing a firm’s ability to generate positive cash flow, fund operations, and grow without external financing.

How to Create a Cash Flow Statement

To create a cash flow statement, start with your net income, and adjust for non-cash transactions and changes in working capital in the operating activities section. Then, list cash spent on or received from investments and financing.

How to Analyze a Cash Flow Statement

To analyze your cash flow statement, examine cash flow from operations in relation to net income, identifying trends in cash flow from investing and financing. Positive cash flow from operations indicates healthy operations, whereas reliance on financing signals issues.

How Are the Three Major Financial Statements Linked?

It’s important to understand that each statement feeds into the next, creating a loop that comprehensively illustrates a company’s financial dynamics.

The balance sheet presents a company’s assets, liabilities, and shareholders’ equity at a specific point in time. It sets the stage for the other two statements by providing the context of a company’s financial position. The profit and loss statement then details the company’s operational performance over a period, showing how revenues translate into net income or loss. This net income from the profit and loss statement is a direct link to the balance sheet, as it contributes to the equity portion, reflecting the company’s retained earnings or accumulated losses.

The cash flow statement bridges the balance sheet and profit and loss statement by showing the actual cash generated or used by the company in a given period. It adjusts the net income from the profit and loss statement for non-cash items and changes in balance sheet accounts to reveal the net cash flow from operating, investing, and financing activities. This statement highlights how changes in the balance sheet and operations affect cash and cash equivalents, which are reported on the balance sheet.

The profit and loss statement explains changes in the equity section of the balance sheet over time, while the cash flow statement details cash movements that underpin the balance sheet’s asset and liability changes.

Linking the three financial statements is critical. In order to get the clearest scope into your business’s performance, you must analyze them together rather than individually.

In-Summary: What Are the Three Essential Financial Statements?

A properly prepared balance sheet, profit & loss statement, and cash flow statement should in conjunction provide a glimpse into a business’s financial status and overall health.

But the work doesn’t stop there. There’s more to financial planning than documenting what’s happened in the past and what’s ongoing in the present. It’s equally, if not more important to plan ahead. That’s where a pro forma analysis comes in, which involves projecting future statements and target goals. To do this, you can use current and past data as a barometer, along with identifying market and economic trends and your current sales trajectory.

Running a business takes a lot of work, and all of these calculations and analyses are put of that. But by putting your best foot forward when it comes to examining your business affairs, you can sleep well knowing you’re doing everything in your power to give yourself the best chance to earn maximum profits.

Three Major Financial Statements FAQs

What are the three major financial statements?

The three major financial statements are the following:

• Balance Sheet: This shows a company’s assets, liabilities, and shareholders’ equity at a specific point in time.
• Profit and Loss Statement: This outlines revenues, expenses, and net income over a period of time.
• Cash Flow Statement: This details the inflows and outflows of cash through operating, investing, and financing activities.

What is the most important financial statement?

The importance of each financial statement varies based on the user’s needs. Investors might prioritize the profit and loss statement for profitability insights while creditors may focus on the balance sheet to assess liquidity and financial health. Managers, on the other hand, often rely on the cash flow statement to ensure the business can cover its expenses. Collectively, they provide a full picture of financial health.

How do you measure a company’s strength and financial performance?

A company’s strength and financial performance are measured through various financial ratios derived from the major financial statements. Key ratios include the debt-to-equity ratio, current ratio, return on equity, and net profit margin. These metrics evaluate a company’s solvency, liquidity, efficiency, and profitability. They provide a comprehensive view of its financial stability.

Which of the financial statements is typically prepared last?

The cash flow statement is typically prepared last. It uses information from the balance sheet and the profit and loss statement to show the actual cash inflows and outflows. Since it reconciles net income with the cash generated or used by the company, it depends on the final figures from the other two statements.

What is a pro forma financial statement?

A pro forma financial statement is a projection of a company’s financial performance based on hypothetical scenarios or future events. These statements are used for planning and decision-making purposes, allowing companies to forecast the effects of significant changes, such as acquisitions, divestitures, or new financing. Pro forma statements are essential for strategic planning and investment analysis.

How does depreciation flow through the financial statements?

Accounting for depreciation is critical when composing your financial statements. Depreciation starts on your balance sheet as Property, Plants & Equipment (PP&E), before flowing onto your income statement where it’s listed as an expense. It then is added back in the cash flow statement, listed as a cash inflow.