The Importance and Purpose of Financial Statements

A small business’ financial statements include its balance sheet, income statement, and cash flow statement. Why are financial statements important? Together, these three documents help a small business understand its financial health and how to continue sustaining and growing the company. Understand how to use your financial statements to benefit your business today and in the future.

Common uses of financial statements.

When used correctly, financial statements are woven into nearly everything a company does, every conversation it holds, and every decision it makes, but the following uses are the most common ways business owners use them.

Analyze sales and cash flow

Much of a financial statement’s importance comes from the insights it provides into the financial health of your company. It’s easy to track your sales, but there are a lot of other factors to look at more closely—factors that, when understood properly, provide a much fuller picture of your company’s performance. The following are good places to start to better understand your sales and cash flow.

• Monitor profit margins – Whether your company sells products or services, it’s crucial to keep a constant eye on your profit margins. It’s easy to keep tabs on this in your balance sheet, where you can easily subtract expenses from your sales. Track over different periods of time to account for seasonal differences, as well as infrequent expenses like taxes.  
• Look at expenses – If your profit margins aren’t as high as you’d like (or even nonexistent), examine what your business is spending on expenses. You may need to cut back in areas that aren’t producing results or ramp up in areas that have been successful areas, such as marketing channels that have the potential to scale your sales. 
• Analyze customer behavior – Another purpose of financial statements is to analyze purchasing habits. Do you have repeat customers? How long does it take them to pay their invoices? If you notice an increase in your accounts receivable, for instance, then you know it’s time to ramp up your invoice collection process. In this case, you could switch from net-30 to net-15 days to shorten the payment period, or charge a late fee to encourage people to pay faster. In this way, your financial information helps you identify problems so you can come up with workable solutions.

Track liquidity ratio

Checking your business’ liquidity ratio is another strategic use of its financial statements. It’s a major indicator of health and is an important component in assessing your future financial needs. 

To determine your liquidity, divide your current assets by your current liabilities. In formula form, it looks like this:

Liquidity Ratio = Current Assets / Current Liabilities 

Experts recommend a minimum ratio of 1.5. For example, if your assets totalled $200,000 and your liabilities totalled $75,000, your liquidity ratio would be 2.7—well within a healthy range. In this case, you could feel confident in embarking on a new initiative or launch because you were not over-leveraged.

On the other hand, let’s say your assets and liabilities were flipped: your assets totalled just $75,000 and your debt was at $200,000. Your liquidity ratio would be just 0.375, dangerously lower than the recommended 1.5. In this case, you would want to prioritize paying down debt, increasing profit margins, and/or lowering expenses to get to a healthier ratio. 

Make informed decisions

Keeping a constant eye on your financial statements helps you make informed business decisions. In a very real way, these documents illuminate what you should prioritize now and what to save for later.

• Budgets and staffing – As you grow your business and establish different departments or teams, your financial statements help you create budgets for each area. For instance, you may decide to increase your marketing efforts or cut back on certain areas that can help reduce expenses and boost profit margins. Alternatively, you may decide that it’s time for your next hire.
• Inventory management – Looking at your sales for different seasons also helps you plan for future cycles. When selling physical products, you can develop more accurate lead times with manufacturers and order the right amount for a specific time of year. If you provide services, you can see what areas of expertise are growing and need extra support. A marketing agency, for instance, may realize that requests for video editing services are on the rise and invest in the people and technology to grow that area.

• Staff communication – Don’t overlook the importance of financial statements and managing your team. As you develop into a company with multiple full-time and part-time employees, be sure to celebrate wins together. Communicate successes to instill confidence and show appreciation—it’s a great way to retain quality team members when they know they’re contributing to something successful.

And if something isn’t working, figure out the problem areas based on your financial statements. Then you can use the data to help inform your team members of what’s working and what isn’t. That way it doesn’t feel like you’re blaming anyone, but simply looking for solutions together to fix the issue, whether it’s a lack of sales or low customer retention rates.

Increase your financing opportunities

Another way to utilize your financial statements is to prepare for financing opportunities. By analyzing your liquidity, accounts receivable, cash flow, and other metrics, you’ll know how prepared you are to handle both financial emergencies and opportunities. 

And if you ever want to apply for business financing in the form of a loan or line of credit, having your financial statements ready can help you sail through the application process. Lenders want to have an in-depth understanding of your financials to make sure your company can handle the payments. By having your documents organized and up-to-date, you’ll be more likely to get approved for a business loan.

Stay compliant with taxes

The final use of financial statements is an easy tax preparation season. Whether you do your company’s taxes on your own or hire a professional, your balance sheet is a must-have in determining how much taxable income your business has earned. This information also demonstrates relevant tax compliance for payroll and product sales.

And in case your small business is ever audited, your financial statements give you all the documentation you need to answer any questions from the IRS.

_{Information provided on this blog is for educational purposes only, and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strives to keep its content up-to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.}