This article is part of a series of articles that will explain the key components of the financial and operational planning process for small businesses. This is the sixth article in the series and will explain the next element of the financial plan: the relationships among financial statements.
Relationships among Financial Statements
The statement of financial position (balance sheet), the income statement, and the statement of cash flows are all based on the same transactions, but they present different “views” of your business. They should not be thought of as alternatives to each other; rather, all are important in terms of presenting key financial information about your business.
The following diagram explains how the three financial statements relate to the period of time they cover. The horizontal line represents time (for example, a month or a year). At the beginning and ending points in time, your business prepares a statement of financial position (balance sheet) that gives a static look in financial terms of where your business stands. The other two financial statements—the income statement and the statement of cash flows—cover the intervening period of time between the two balance sheets and helps explain important changes that occurred during the period.
Date at beginning of period Date at end of period
|-----------------------------------[Income statement and Statement of cash flows] ---------------------------------------|
Balance Sheet (beginning of period) Balance Sheet (end of period)
If you understand where you business stands financially at two point in time, and if you understand the changes that occurred during the intervening period in terms of your business’ profit-seeking activities (income statement) and its cash activities (statement of cash flows), you know a great deal about your business that is valuable in assessing its future cash flows—information that is useful to you, investors, and creditors.
Because the balance sheet, income statement and statement of cash flows are derived from the same underlying financial information, they are related closely to each other.
The balance sheet represents an expansion of the accounting equation (total assets = total liabilities minus owner’s equity) and explains the various categories of assets, liabilities and owners’ equity. The income statement explains changes in financial position that result from profit-generating transactions in terms of revenue and expense transactions. The resulting number, net income, represents an addition to the your (owners’) equity in the business. The statement of cash flows explains the ways cash increased and decreased during the period in terms of your business’ operating, investing and financing activities.
While these three key financial statements present important information, they do not include all possible information that might be presented about your company. There is also important nonfinancial information that underlies the statement of financial position, the income statement, and the statement of cash flows that could be presented and that would benefit users of the statements.
Financial reporting, and financial statements in particular, can be thought of as a lens through which you can view your business. A lens allows you to see things at a distance that you would not otherwise be able to see; it also allows you to focus in greater detail on certain aspects of what you are looking at. Financial information, and particularly financial statements, allows you to do just that—focus in on certain financial aspects of your business that are of particular interest to you in making important investing and credit decisions. Financial reporting encompasses financial statements, but it is not limited to financial statements.
Your financial plan might feel overwhelming when you get started, but the truth is that it is absolutely essential to understand.
Even if you end up outsourcing your bookkeeping and regular financial analysis to an accounting firm, you—the business owner—should be able to read and understand these documents and make decisions based on what you learn from them. Using a business dashboard tool can help, so you’re not wading through spreadsheets to put your figures on the important details.
If you create and present financial statements that all work together to tell the story of your business, and if you can answer questions about where your numbers are coming from, your chances of running a successful, profitable business are much higher.
If you’d like help creating your comprehensive financial plan and understanding the related financial statements … we can help. We specialize in helping businesses create comprehensive financial plans, monitor their financial activity and understand their financial statements. So, if you don’t have the expertise or resources, click here to contact us!
For more on small business financial plans, check out the other articles in the series on the Key components of the financial and operational planning process for small businesses: