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If you want a clear understand of how your business is doing financially, and you want to be able to predict and plan for the future, a fairly thorough understanding of your financial statements is essential. A sound understanding of financial statements will help you:

• Identify unfavorable trends and tendencies in your business's operations (for example, the unhealthy buildup of inventory or accounts receivable) before the situation becomes critical.
• Monitor your cash flow requirements on a timely basis, and identify financing needs early.
• Monitor important indicators of financial health (for example, liquidity ratios, efficiency ratios, profitability ratios, and solvency ratios).
• Monitor periodic increases and decreases in wealth (specifically, owners' or stockholders' equity).
• Monitor your performance against your financial plan, if you have developed one.

There are four basic kinds of financial statements that can help you determine the present condition of your business. Here's a brief description of them:

• The income statement, also referred to as a "profit and loss statement," "statement of incomes and losses," or "report of earnings," tells you or your investors:
  • the income the business has earned during the accounting period
  • the costs or expenses that were incurred by the business during the period
  • the difference between the costs and incomes for the period, or net profit (or loss)
• The balance sheet is a statement of a company's relative wealth or financial position at a given point in time. It shows assets, liabilities, and owners' equity.
• The position statement, also known as the "statement of changes in financial position" or "sources and uses of cash," helps to explain how a company acquired its money and how it was spent.
• The statement of changes in owners' equity is used to bridge the gap between the amount of owners' equity at the beginning of the period and the amount of their equity at the end of the period.
• What to do with your financial statements contains a checklist of ways to look at the data to put it in perspective.
• Common size financial statements provides an easy way to spot trends in your balance sheets and income statements over time is to convert the dollar amounts to percentages.

Limitations of financial statements. Keep in mind that your financial statements are only a starting point for analysis. Individual numbers aren't good or bad in themselves — you may have to dig for the reason behind any numbers that seem out of whack. For instance, if your statements shows that your accounts receivable have trended significantly downward over the last few years, it could mean that you're collecting the accounts more aggressively (which is good), or it could mean that you're writing off accounts as uncollectible too soon (which is bad). The key is to use your statements to spot trends and anomalies, and then follow these up with further investigation.