Three Basic Accounting Financial Statements Every Businessperson Should Know

Three Basic Accounting Financial Statements Every Businessperson Should Know

Starting and running a business can be a daunting, albeit often rewarding, task. One of the most confusing parts of being a small to mid-sized business owner can be getting your brain around the accounting terms your CPA throws at you. I am going to condense some basic accounting terms for you. This will allow you to comprehend the confusing, and sometimes seemingly gibberish terms that you need to know to maintain a healthy bottom line.

In fact, a survey from the National Small Business Association shows that nearly 70% of small businesses rely on financial statements to make internal decisions. Understanding these statements is crucial for steering your business in the right direction. Let’s break down the three essential financial statements so you can grasp their importance and use them effectively.

Balance Sheet

The Balance Sheet is one of the three most common financial statements that are produced by accountants and CPAs. It is used to reveal the financial status of a business at a specific point in time. The Balance Sheet shows assets (what the business owns) and liabilities (what the business owes). The business also shows equity. Equity is the difference between what you own versus what you owe (assets minus liabilities). 

Why Does the Balance Sheet Need to Balance?

You might wonder why accountants seem obsessed with everything “balancing.” Here’s the deal: your balance sheet works like a financial report card, following a simple formula—Assets = Liabilities + Equity. This little equation underpins the entire double-entry accounting system.

If your assets don’t match the sum of your liabilities and equity, it’s a red flag that something in your books isn’t quite right. Maybe you’ve missed recording an invoice, or a loan payment slipped through the cracks. By making sure everything balances, you can catch errors early, keep your records reliable, and present accurate financial information to banks, investors, or even the IRS (who, as we know, have no sense of humor when it comes to math mistakes).

When you look at a balance sheet you will see two columns. The left side shows assets (what you own) and the right side shows liabilities (what you owe).

One issue that confuses people is the basic accounting terms on the balance sheet. These terms are called Accounts Receivable (AR) and Accounts Payable (AP).

Accounts Receivable

Accounts Receivable (AR) is revenue for the sales and services you have provided even though you may not have collected payment yet. You would record this as an asset (left side) because Accounts Receivable will likely convert to cash in the short term. Even though you may not have the cash in hand, it is still considered an asset. An asset is anything a company owns that has monetary value. Therefore, Accounts Receivable would be seen on the left side of the balance sheet. 

Accounts Payable

Accounts Payable (AP) on the other hand are listed on the right side. These are expenses and debts you owe but have not paid yet. These are liabilities.

On a balance sheet, assets are listed in order of liquidity from cash (the most liquid) to land (the least liquid). Liabilities are usually divided into two major categories – current liabilities and long-term liabilities. They are then listed in order of shortest term to longest term which helps you understand what is due and when. 

Finally, equity shows the value of the company after liabilities have been subtracted from assets. Equity is the portion of the company that is owned by the owners and investors.  While equity may give you some idea of what the value of your company is, it is not a complete picture.  Equity does not account for any goodwill or other intangibles that you may have developed as part of your business.  

Net Working Capital: The Link Between Your Statements

Now, let’s talk about net working capital—another term that often gives business owners pause. Net working capital is basically what’s left after you subtract your current liabilities (what you owe in the short term) from your current assets (what you can quickly convert to cash). Think of it as your business's day-to-day operating cushion—it shows whether you’re able to cover your bills and keep operations running smoothly.

But why does net working capital matter when looking at your financial statements? Here’s where things connect: Changes in your current assets and liabilities (for example, collecting receivables or paying off payables) are reflected not just on the balance sheet, but also play an important role in your statement of cash flows. Any movement—like collecting on an invoice or paying a supplier—directly impacts your cash position. These shifts are then adjusted on your cash flow statement to show the real increase or decrease in cash, beyond just profits on paper.

In short, net working capital helps you bridge the gap between what your business owns and owes right now, and it helps you see how those shifts flow through your actual cash situation and ultimately affect your bottom line.

Income Statement

The second financial statement you will need to become familiar with is the Income Statement. An Income Statement summarizes the revenues, costs, and expenses incurred during a specific period. These are usually prepared quarterly or yearly. 

Revenue earned is shown at the top of the report and expenses are subtracted until all the expenses in a given period are accounted for. This includes:

• the cost of goods sold (expenses directly related to the creation of a product or service such as materials, direct labor, and overhead)
• sales and administrative expenses (also known as SG&A)
• depreciation (accounts for the loss of value of an asset such as equipment and vehicles) and taxes

This results in net income which is another basic accounting term and delineates the dollar amount earned in profits. 

A well-structured income statement will clearly show:

• Revenue: The total amount earned from sales or services before any expenses are taken out.
• Expenses: All costs incurred, often broken down into categories such as cost of goods sold, SG&A, depreciation, and taxes.
• Gains and Losses: Any additional income (like the sale of assets) or losses outside regular operations.
• Net Income: The final “bottom line” after subtracting all expenses and losses from total revenue and gains.

For example, a typical income statement will start with your gross revenue at the top, followed by a detailed list of expenses. Each major category—like cost of goods sold, operating expenses, and taxes—is subtracted one at a time, so you can see exactly where your money is going at each step. The end result is your net income, the clearest indicator of whether your business has operated at a profit or loss during that period.

Reviewing income statements over several periods allows you to spot important financial trends, such as increasing costs, shrinking profits, or areas where your business is growing. This trend analysis is essential for making informed business decisions and planning for the future.

The purpose of the Income Statement is to show how much profit or loss your company generated during a specific reporting period. This is an extremely valuable report when you group several Income Statements from consecutive periods so that you can view trends in the revenue and expense items. 

Cash Flow Statement

A Cash Flow Statement is another basic accounting financial statement. It provides information regarding all cash inflows and outflows that a company receives or uses from its ongoing operations, investment, and financing activities during a given period. This enables investors and creditors to understand how a company’s operations are run, where the money is coming from, and how the money is being spent. It measures how well a company manages its cash, as well as how it generates cash to pay its debt and operating expenses.  While often overlooked, this financial statement can be one of the best tools for running a business.  There are profitable companies that can go out of business because they are not paying attention to their cash flow!   

There are three sections in this financial statement. They are cash flow from:

1. Operating activities; cash earned or spent during regular business activity. In other words, this shows the main way your business makes money either by selling products or services.
2. Investing activities; cash earned or spent from investments such as purchasing equipment or investing in other companies.
3. Financing activities; cash earned or spent through financing your company with loans, lines of credit, and/or the owner’s equity.

These are essential as they show your liquidity, show changes in assets, liabilities, and equity, and help you predict future cash flows. All of these are important for making long-term business plans. 

Understanding How Financial Statements Interconnect

The three fundamental financial statements are intricately linked to provide a holistic view of a company's finances. 

The income statement, balance sheet, and cash flow statement are interconnected to provide a comprehensive view of your company’s finances. Net income from the income statement starts the cash flow statement and flows into the balance sheet as retained earnings. Depreciation, listed as an expense on the income statement, also reduces asset values on the balance sheet. The cash flow statement’s ending cash balance appears as an asset on the balance sheet, reflecting your company’s financial position for the next period. This integrated approach helps you understand how your business is performing and where improvements are needed.

Cash Balance: Bringing It All Together

After adding the cash from operations, investing, and financing activities to your prior period’s closing cash balance, you arrive at the current period’s closing cash balance. This figure is reported as the cash asset on your balance sheet. It’s a pivotal moment—this is where you confirm whether your balance sheet truly “balances,” ensuring every dollar is accounted for and your financial records are accurate.

Understanding these connections not only provides clarity but also empowers you to make informed decisions, plan more effectively, and spot potential issues before they become problems.

Putting It All Together: The Role of Financial Statements in Financial Modeling

Once you understand how the income statement, balance sheet, and cash flow statement connect, you can take your analysis a step further with financial modeling. But what does that actually look like in practice?

Financial modeling uses all three statements as its backbone to forecast a business’s future performance. By linking these statements within a spreadsheet—think Microsoft Excel, Google Sheets, or software like QuickBooks—you can project important metrics such as revenue growth, expenses, profit margins, capital requirements, and cash flow. This lets you simulate different scenarios and see the potential impact on your business.

For example, increasing revenue on your income statement will affect your net income, which then flows through to retained earnings on your balance sheet and impacts your available cash. Adjusting capital expenditures or taking on new loans will ripple through all three reports, giving you a clearer sense of how big decisions affect the bigger financial picture.

Building a three-statement model doesn’t have to be daunting. Today, many business owners use financial modeling tools to simplify the process and eliminate the guesswork. These tools allow you to input your assumptions and quickly generate projections, so you can plan for growth, anticipate cash needs, and set goals with confidence.

By leveraging these interconnected statements in a comprehensive financial model, you’ll have a powerful decision-making tool at your fingertips—one that helps you chart your company’s course, prepare for the unexpected, and set yourself up for lasting success.

What Is a Three-Statement Model (Three-Way Forecast)?

A three-statement model, sometimes called a three-way forecast, is a method of bringing together your income statement, balance sheet, and cash flow statement into a single, integrated financial picture. This forecasting tool uses various assumptions—such as projected sales, expenses, or capital purchases—to create a cohesive, future-looking report for your entire business.

The real strength of a three-statement model lies in how changes in one area flow through to the others. For example, an increase in sales on your income statement will impact your cash flows and end up on your balance sheet as higher retained earnings. Similarly, buying new equipment—seen in your cash flow statement under investing activities—affects both your asset balances and your depreciation expenses moving forward.

This interconnected model is invaluable for business owners who want to see the full ripple effect of their decisions, plan ahead with confidence, and ensure every dollar is accounted for across all aspects of the business.

Accessing Practical Templates for the Three-Statement Model

If you’re ready to see how all three financial statements work together in practice, there are several excellent resources available online. For hands-on learning, you can download free Excel templates from reputable sites such as Corporate Finance Institute (CFI), Wall Street Prep, or even Templatelab. These templates typically include pre-built income statements, balance sheets, and cash flow statements that are already linked, allowing you to input your own numbers and see how changes flow through the entire model.

Here are a few places to find quality, user-friendly three-statement model templates:

• Corporate Finance Institute (CFI): Offers a free three-statement model template that is widely used by finance professionals.
• Wall Street Prep: Provides downloadable templates with integrated financial statements for Excel.
• TemplateLab: Features a range of basic financial statement templates, ideal for small businesses or first-time users.

Using one of these templates allows you to experiment with your business's finances—adjusting figures to instantly see how your income statement, balance sheet, and cash flow statement are affected. This practical approach helps reinforce your understanding and supports smarter, data-driven decisions.

Achieve Financial Clarity with Accounovation

At Accounovation, we specialize in more than just basic accounting. We provide clear, actionable insights tailored to your business. Our team simplifies complex financial statements, helping you make informed decisions that drive growth. Ready to take control of your finances? Contact us today to discover how our unique approach can empower your business.

Frequently Asked Questions:

How can previous balance sheets be used to assess a company's financial standing?

Previous balance sheets provide a historical view of a company’s financial position. By comparing balance sheets over time, you can assess trends in assets, liabilities, and equity. This helps identify growth patterns, financial stability, and potential areas of concern, such as increasing debt or declining assets. Analyzing these trends allows you to evaluate the company’s overall financial health and make informed decisions.

What is cash flow from investing, and why might negative cash flow from investing not be a bad thing?

Cash flow from investing reflects the cash spent or earned from activities like purchasing or selling assets. Negative cash flow from investing often indicates that a company is investing in its future growth, such as buying new equipment or expanding operations. While it might reduce cash reserves in the short term, it can lead to increased profitability and business expansion in the long run.

What role does depreciation play across the three financial statements?

Depreciation is an expense that spreads the cost of a tangible asset over its useful life. On the income statement, it reduces taxable income, lowering overall expenses. On the balance sheet, depreciation decreases the value of fixed assets, reflecting their declining usefulness over time. In the cash flow statement, depreciation is added back to net income because it’s a non-cash expense, ensuring an accurate representation of cash flow from operations.