Financial statements describe either the past or the future financial condition and performance of a business. The term financial statement can refer to one of several types of schedules and summaries of economic information. Typically, however, the term describes a set of documents that include an income statement (also called a statement of operations), a balance sheet (also called a statement of financial condition), and a cash flow statement.
An income statement details the profits and losses of a business for a specific period. For example, you might want to know the profits or losses of your business over the past month. Therefore, you would prepare an income statement that lists your revenues and expenses and calculates the profits or losses for the month.
A balance sheet identifies and lists the assets and liabilities of a business as of a specific time. It paints a clear picture of what the business owns, what the business owes, and the difference between the two (often called the net worth or owner equity). Typically, you prepare a balance sheet as of the end of the period for which an income statement is prepared. For example, if you prepare an income statement for a month, you might also want to prepare a balance sheet as of the last day of the month.
A cash flow statement outlines the cash inflows and outflows of a business for a specific period. Generally, you prepare a cash flow statement for the same period for which you prepare an income statement.
Financial ratios express relationships among the amounts reported in the financial state- ments. The ratios can offer insights into the economic health of a business. The ratios can also indicate the reasonableness of the assumptions implicit in a forecast. For example, by comparing the ratios of your business with the ratios of similar businesses, you can com- pare the financial characteristics of your business with those of other businesses. By com- paring the ratios in your pro forma model with industry averages and standards, you also test your modeling assumptions for reasonableness.
Two general categories of financial ratios exist: common size ratios and intrastatement or interstatement ratios. Common size ratios convert a financial statement—usually a balance sheet or an income statement—from dollars to percentages. Common size ratios allow for comparisons of the assets, liabilities, revenues, owner equity, and expenses of businesses of various sizes. The comparison can be either at a point in time or as a trend over time. Intrastatement or interstatement ratios quantify relationships among amounts from different financial statements or from different parts of the same financial statement. Intrastatement and interstatement ratios are an attempt to account for the fact that amounts usually cannot be interpreted alone, but must be viewed in the context of other key financial factors and events. In general, both categories of ratios are most valuable when compared with indus- try averages and trends.