How to Prepare a Financial Statement

Financial statements provide an overview of a business’s financial activities and position. These documents show how a company generates revenue, manages expenses, and utilizes its assets and liabilities. They are a tool for business owners to understand their financial health and performance over specific periods.

Understanding these statements is also important for external parties, including potential investors, lenders, and government agencies. For instance, the Internal Revenue Service (IRS) often requires businesses to submit financial information for tax compliance. Preparing accurate financial statements is a foundational aspect of sound business management, enabling informed decision-making and compliance with regulatory requirements.

Gathering Necessary Information

The first step in preparing financial statements involves collecting all relevant financial records. This ensures every transaction is accounted for, providing the raw data needed for accurate reports. Organized collection streamlines the process, reducing omissions or errors.

Begin by compiling all bank and credit card statements for the period under review, as these provide a record of cash inflows and outflows. Gather all sales records, including invoices, point-of-sale data, or revenue logs, which detail income from goods sold or services rendered. Collect all purchase invoices and receipts for expenses, inventory acquisitions, and purchases of long-term assets like equipment.

Payroll records are another component, detailing wage payments, employee benefit costs, and payroll tax liabilities. Businesses maintain records of federal payroll taxes remitted, such as those reported on Form 941, and state unemployment taxes. Compile any loan agreements, which outline debt obligations, interest rates, and repayment schedules, providing information for liabilities.

A list of assets, including details such as purchase dates, original costs, and depreciation information for items like vehicles or machinery, is also needed. Compile records of accounts receivable, detailing money owed to the business by customers, and accounts payable, which tracks amounts the business owes to its suppliers or creditors. Information regarding owner contributions or withdrawals should also be available to account for equity.

Preparing the Income Statement

The Income Statement, also known as the Profit and Loss (P&L) Statement, provides an overview of a business’s financial performance over a specific period, such as a quarter or a fiscal year. This statement details how revenues are transformed into net income or loss by subtracting all costs and expenses. Its preparation begins by summarizing the financial data gathered from various source documents.

Start by calculating total revenue, which represents the total amount earned from sales of goods or services during the period. This figure is derived from sales records and invoices, reflecting gross earnings before any deductions. Next, determine the cost of goods sold (COGS), which includes the direct costs attributable to the production of goods sold. For businesses selling physical products, this involves the cost of raw materials, direct labor, and manufacturing overhead tied to the sold items.

Once COGS is determined, subtract it from revenue to arrive at the gross profit, which indicates the profitability of sales before considering operating expenses. Identify and sum all operating expenses, which are costs incurred in normal business operations. These expenses include rent, utilities, marketing, administrative salaries, and insurance premiums, all sourced from purchase invoices, bank statements, and payroll records.

Depreciation, a non-cash operating expense, systematically allocates the cost of a tangible asset over its useful life. This expense is calculated based on the asset list and chosen depreciation method, and does not involve an actual cash outflow in the current period. Account for any other income, such as interest earned on bank deposits, and other expenses, like interest paid on loans, before subtracting all expenses from revenues to arrive at the net income or loss for the period.

Preparing the Balance Sheet

The Balance Sheet offers a snapshot of a business’s financial position at a specific moment in time, presenting what the company owns, what it owes, and the owner’s stake. It operates on the accounting equation: Assets equal Liabilities plus Equity. This equation must always balance, providing a check on the statement’s accuracy.

Begin by listing all assets, which are resources owned by the business expected to provide future economic benefit. Current assets are those expected to be converted into cash, sold, or consumed within one year, including cash balances, accounts receivable, and inventory. Non-current assets, such as property, plant, and equipment, are those with a useful life extending beyond one year, and these are listed at their cost less accumulated depreciation.

Next, list all liabilities, which represent the company’s obligations to external parties. Current liabilities are debts due within one year, such as accounts payable, short-term loans, and accrued expenses like payroll taxes payable or estimated income tax obligations. Non-current liabilities are long-term debts due beyond one year, like mortgages or long-term notes payable.

Calculate the equity section, which represents the owner’s residual claim on the assets after liabilities are satisfied. This includes owner’s capital or contributions, reflecting direct investments made into the business. Retained earnings, which accumulate the business’s net income less any owner withdrawals or distributions over time, also form part of equity. The net income figure from the Income Statement flows into the retained earnings calculation on the Balance Sheet. After compiling all assets, liabilities, and equity components, verify that total assets equal the sum of total liabilities and total equity to ensure accuracy.

Preparing the Cash Flow Statement

The Cash Flow Statement details the cash inflows and outflows of a business over a specific period, explaining how cash is generated and used, which often differs from net income. This statement is categorized into three primary activities: operating, investing, and financing. The indirect method is commonly used, starting with net income and adjusting for non-cash items and changes in working capital accounts.

Begin the operating activities section with the net income figure from the Income Statement, as this represents the starting point for reconciliation. Add back any non-cash expenses that were deducted in calculating net income, such as depreciation and amortization, since these do not involve actual cash outlays. Adjust for changes in current asset and liability accounts from the Balance Sheet; for instance, an increase in accounts receivable suggests cash was not yet collected, so it is subtracted, while a decrease indicates cash collection and is added. An increase in accounts payable means expenses were incurred but not yet paid in cash, so it is added back, while a decrease implies cash was used to settle obligations and is subtracted.

The investing activities section details cash flows from the purchase or sale of long-term assets. This includes cash spent on acquiring new equipment, vehicles, or property, which would be a cash outflow, or cash received from selling such assets, which would be an inflow. These activities reflect the business’s investment decisions.

The financing activities section details cash flows from debt and equity transactions. This includes cash received from new loans, which is a cash inflow, or cash paid to repay loan principal, which is an outflow. Cash contributions from owners are inflows, while owner withdrawals or distributions are outflows. Sum the net cash flows from operating, investing, and financing activities to arrive at the net increase or decrease in cash for the period, which should reconcile with the change in the cash balance on the Balance Sheet.

Reviewing and Presenting the Statements

Once the Income Statement, Balance Sheet, and Cash Flow Statement have been drafted, a review process is necessary to ensure their accuracy and consistency. This step helps identify and correct any errors before the statements are finalized. Begin by cross-referencing all amounts with original source documents, such as bank statements, invoices, and payroll records, to confirm no transactions were omitted or incorrectly recorded.

A primary consistency check involves ensuring the net income reported on the Income Statement flows into the retained earnings section of the Balance Sheet. The ending cash balance calculated on the Cash Flow Statement must match the cash balance reported as a current asset on the Balance Sheet for the same period. Changes in current asset and liability accounts from the Balance Sheet, such as accounts receivable or accounts payable, should also align with the adjustments made within the operating activities section of the Cash Flow Statement.

When presenting the statements, clarity and appropriate formatting are important for readability. Each statement should have a clear title, specifying the business name and the period covered (e.g., “For the Year Ended December 31, 2024” for the Income Statement and Cash Flow Statement, or “As of December 31, 2024” for the Balance Sheet). Using consistent currency denominations and proper line item descriptions enhances comprehension.

Maintaining organized and detailed financial records is important for current statement preparation, future periods, and potential audits. The IRS advises businesses to keep records that support income, deductions, and credits shown on a tax return for at least three years from the date the tax return was filed or the tax was due, whichever is later. Some records, particularly those related to property, should be kept for longer durations, potentially indefinitely, to substantiate cost basis for future sales or depreciation calculations.