What are financial statements?

In simple terms, financial statements are documents that capture the financial health of your business during a specific period of time, whether that’s a year, a quarter or a month. They’re crucial in helping you make sound financial decisions, map out your business’s future and seize any opportunities that arise.

You can rely on four fundamental financial statements to gauge the financial position and performance of your business:

A snapshot of what your business owns and what it owes, a balance sheet shows you how money was used during a particular statement period. The featured elements are assets (bank balances, stocks, accounts receivable, investments), liabilities (accounts payable and debt) and shareholders’ equity. This data allows you and others to assess the financial strength of your business and its ability to absorb potential losses.

It includes revenue from selling products or services, expenses to manage your business and profits and losses. In short, it indicates how profitable your business was during a fixed period of time. By breaking down expenses and showing growth, or lack thereof, it allows business owners to create budgets for the years ahead.

This statement documents the movement of cash and its equivalents (namely, short-term investments) through your business during a determined period of time. It provides information on the various activities of your company, the financing it receives from lenders and its investments. It does not, however, contain new information beyond what’s provided by the balance sheet and income statement.

This document shows the cumulative earnings of the business – or what the owners retain in the business – after shareholders have been paid dividends. It also indicates the change in retained earnings between the beginning and ending of a specific earning period.

However, if you’re looking to secure a business loan, attract investors or buyers, or present a year-end report to shareholders, you’ll typically need external financial statements. Also called engagements or assurances, these are prepared by a professional such as an accountant or bookkeeper. They include:

Most commonly used by smaller companies, this is the simplest type of statement. To put one together, an accountant will compile information provided by the business but will not formally validate or audit the figures

Most suitable for mid-size or more complex businesses, this type of statement digs further into a company’s financial status. It requires more involvement on the part of an accountant, who will provide services that may include assessing the company’s practices, policies and procedures. Ultimately, the review engagement broadly determines the plausibility of a business’s financial information.

Generally reserved for large or publicly traded companies, an audited financial statement offers the greatest degree of assurance regarding the accuracy of a business’s financials. It involves a series of tests – including a physical count of inventory, an analysis of internal controls and a review of supporting documents – that audits a sampling of transactions.

Reading the numbers on a statement is one thing – deciphering what they’re telling you is something else altogether. Looking at ratios and noticing how they change will help you identify areas of concern or opportunities to exploit. Tracking trends month to month and year to year will help you identify what’s going on with your business and indicate the best time to make changes.

Basic ratios include :

• Current ratio: This is calculated by dividing your current assets by your current liabilities and will speak to the long-term viability of your business. A current ratio of 1.25 or higher is generally considered to be good.
  
  
• Debt to tangible net worth ratio: This is calculated by dividing your total debt by shareholder equity. Put another way, it compares a company’s level of debt to how much owners have invested in it. A ratio of 2.5x or lower is generally considered to be good.
  
  
• Cash flow coverage ratio: This is calculated by dividing earnings before interest, taxes, depreciation and amortization (EBITDA) by the total principal and interest payments made during a certain period. It measures your business’s ability to meet its debt obligations with the cash that it generates. A ratio of 1.5x or higher is generally considered to be good.

When preparing financial statements, for-profit companies in Canada can use two possible accounting frameworks, both of which outline the rules and procedures that should be followed. Having these standards means financial statements remain consistent and transparent across companies and can be more easily compared when the time comes to audit, invest or prepare taxes. Structured accounting frameworks provide businesses with more accurate financial information, helping to mitigate potential financial or legal risks.

• International Financial Reporting Standards (IFRS): Publicly traded companies must follow the rules set out by the IFRS, which are used in more than 140 countries worldwide and allow existing or potential investors to compare companies globally.
  
  
• Accounting Standards for Private Enterprises (ASPE): Although they can choose to use IFRS, private companies tend to prepare financial statements following ASPE’s rules, which are set out by the Accounting Standards Board. While still comprehensive, the ASPE framework is simpler and less cost-intensive to implement.

Preparing financial statements requires a careful and detailed approach. To proceed error-free, watch out for the following:

• Mixing personal and business accounts, which will complicate both your financial reporting and tax filing.
  
  
• Failing to reconcile bank and credit card statements regularly, which can lead to avoidable discrepancies and mistakes.
  
  
• Misclassifying assets and liabilities, which can skew how well your business is doing financially.
  
  
• Misclassifying cash flows across operating, investing and financing categories, which makes it difficult to properly determine your business’s liquidity.
  
  
• Misclassifying expenses, which can misrepresent your business’s activities and how your resources are being used.
  
  
• Reporting revenue inaccurately, whether that means recording the wrong amount or attributing it to the wrong accounting period.
  
  
• Applying accounting policies inconsistently, making it impossible to accurately compare financial statements from different periods

Almost anyone looking to better understand a business’s financial health and future potential will be interested in financial statements. This includes:
 

• Business owners, who want to make informed financial decisions.
  
  
• Employees, who want to grasp how the company they work for is performing and what impact that might have on job security, compensation and advancement.

• Customers and suppliers, who want to gauge the long-term viability of a business.
  
  
• Financial institutions and other lenders, who want to assess a business’s ability to repay a loan.
  
  
• Existing and possible investors, who want to get a snapshot of a business’s financial situation.
  
  
• Government authorities, who want to calculate the amount of taxes to be paid.
  
  
• Potential buyers, who want to evaluate what a business is worth.
  
  

Understanding your business’s financial statements is the same as understanding your business. A financial advisor can offer guidance on how best to approach them and see the story behind the numbers.

Reach out today.