Why Are Financial Statements Important?

written financial statement

Financial statements are important because they provide stakeholders with information about its activities, results and financial position. Additionally, each financial statement serves a different purpose. In this article, we are going to discuss in detail why financial statements are important. We’ll start by shortly mentioning the major financial statements.

Table of Contents

What Are Financial Statements? 

Financial statements are written reports that include financial information about the activities, results and performance of a company. 

There are three common financial statements: 

  • Balance Sheet: a financial statement that includes financial information about an organization’s assets, equity and liabilities on a certain specific point in time. 
  • Income Statement: this financial statement shows an overview of a firm’s income and expenses over a certain period. The income statement is also called Profit and Loss Statement. 
  • Cash Flow Statement: this third major financial statement includes an overview of all cash that has come into the company or left the company over a certain period of time. Also known as Statement of Cash Flows. 

Each of these three financial reports serves different purposes. I will create a series of articles in which we dive into the details of each of these statements. But first, let’s investigate why businesses create financial statements. 

The Purpose of Financial Statements 

The main reason why businesses create financial statements, is to provide stakeholders with information about its activities, results and financial position. Below are several stakeholders that are all interested in financial statements for their own reasons: 

  • Shareholders: they are the owners of the business. Management of a company creates financial reports to account for the decisions that are taken. Additionally, they provide shareholders with information about the performance of the company. Shareholders give their money to a company in return for a percentage of ownership. A shareholder wants a positive return in its investment. That’s why they want to know about how the company is doing financially. 
  • Management: The management of a business are the ones who take the important operational decisions at a company. Financial statements help them to assess how the company has done and where it should improve. They use the information from financial statements to make strategic decisions about the direction of a company. 
  • Potential investors: investors are interested in the future of a company. If the financial outlook of a business is positive, they might decide to invest in that company. Potential investors get their information firstly from financial statements. Potential investors could be large, institutional investors as well as individuals buying just a couple of stocks. 
  • Financial institutions: a bank wants to be sure that if they grant a loan, the debt will be repaid. When a company applies for credit at a bank, the bank will use information from financial statements to assess the creditworthiness of that company. 
  • Government / tax authorities: businesses have to pay taxes over their profits. Governmental institutions use information from financial statements to determine the amount of taxes a firm has to pay. Governmental institutions may use information from financial statements to analyze how an economy is doing. 
  • Buyers: customers may be interested in financial information from a company. This is especially true if they rely on this company to supply a certain product. For example, this may be the case when there is no alternative company that offers the same product.
  • Suppliers: a supplier wants to be sure that their buyer is financially stable. This helps them to reduce the risk of not being repaid because they buyer goes bankrupt. 
  • Employees: as an employee you want to have job security. It helps to know whether a company has a stable financial position. While I doubt that all employees will analyze the financial statements of their employer in detail, transparency is still valuable. 

All three major financial statements provide stakeholders with financial information. That said, each financial statement has its own focus and its own purposes. Let’s look at the purpose of each of the three financial statements. 

Why Is the Balance Sheet Important? 

A balance sheet provides a snap shot of a company’s financial position in a certain point in time. This makes the balance sheet different from the income statement and the cash flow statement. Those two statements provide financial information over a period of time.  

Moreover, the balance sheet is important because the information in the balance sheet can be used to analyze the financial performance of a company. Several financial ratios are calculated by using information from the balance sheet. Without going into a lot of detail , financial ratios take information from financial statements and draw conclusions about the firm’s financial performance. For example, the ratio of the amount of debt to the amount of equity can be distilled from the balance sheet. I will write a separate article about financial ratios soon.

The Purpose of the Income Statement

The objective of companies is to generate business value. The created value should lead to profits. The income statement shows whether a company succeeds in reaching this objective.  Because the income statement shows the results over a period of time, it answers the question how an organization has performed during that period. 

The income statement also classifies a company’s revenues and expenses into several subgroups. This helps to analyze where a company is performing well and where it should improve. Additionally, the income statement over period 2 (say 2020) can be compared to the income statement in period 1 (2019), to analyze the performance over time. 

Why is the Cash Flow Statement Important? 

The cash flow statement is important to get insights into the cash inflows and cash outflows over a certain period. This is essential. It helps to have a good understanding of a company’s solvency in the long term.  

It is important to point out that recorded revenues do not equal cash inflow. Revenues are recorded in the income statement at the moment of the sale, but that does not mean that cash is received instantly. Cash is needed to oblige to short term and long-term payment obligations, such as debt, taxes, & accounts payable. Revenues could lead to profits, but additionally a company must assure there are enough cash resources to stay solvent. The cash flow statement gives insight into the cash position of a company. 

The cash flow statement makes a distinction between cash in/outflow from operating, investing and finance activities. Again, this division leads to more understanding of where cash is coming from, and where the company is leaking cash.

Are Financial Statements Important for Small Businesses?

Yes, financial statements are also important and valuable to small businesses. Financial statements matter for small businesses for the same reasons as for large public companies: to provide stakeholders in the company with information regarding the businesses and its performance. Admittedly, you may not have any shareholders that require financial information. Your suppliers and customers also won’t be asking about it. But potential investors, financial institutions and government / tax authorities may still require financial information for a variety of reasons.

But perhaps even more importantly, as a small business owner, financial information matter to you personally. Because they give you as the owner valuable information on how your own business is doing. It helps you gain insights into where your operation is doing well and in which areas there is room for improvement.

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