Why is it important to understand financial statements?

A company’s financial statements provide financial information that investors, creditors and analysts use to evaluate a company’s financial performance. A good deal of the information presented in a financial report is required by law or by accounting standards. Your company's financial statements are important tools for senior managers to communicate past successes as well as future expectations. By publishing financial statements, management can communicate with interested outside parties, such as investors, the news media and industry analysts about its accomplishments running the company.

Financial Conditions of a Company

A company’s financial conditions are of a major concern to investors and creditors. As sources of finance for your company operations, investors and creditors rely on financial reports to gauge conditions for both the safety and profitability of their investments. More specifically, investors and creditors need to know where their money went and where it is now.

Your financial balance sheet addresses such issues by providing detailed information about the company’s asset investments. The balance sheet also lists a company’s outstanding debt and equity components, and so debt and equity investors can better understand their relative positions in a company’s capital mix.

Reporting on Operating Results

Financial conditions shown on the balance sheet are snapshots of a company’s assets, liabilities and equity at the end of a financial reporting period; they don’t reveal what happened during the period from operations that may have caused changes to financial conditions. Therefore, operating results during the period also concerns investors. The financial statement of income statement reports operating results such as sales, expenses and profits or losses. Using the income statement, investors can both evaluate a company’s past income performance and assess the uncertainty of future cash flows.

Importance of the Cash Flow Statement

The importance of the cash flow statement is that it shows the exchange of cash between a company and the outside world during a period, and so investors can know if the company has enough cash to pay for expenses and asset purchases. The company profits reported in the income statement can be difficult to interpret and most likely contain certain non-cash elements, providing no direct information on a company’s cash exchange during the period.

Moreover, a company also incurs cash inflows and outflows during a period from other non-operating activities, namely investing and financing. To investors, cash from all sources, not just accounting income from operations, is what pays back their investments.

Statement of Shareholders’ Equity

The statement of shareholders’ equity is especially important to equity investors because it shows the changes in various equity components, including retained earnings, during a period. The amount of shareholders’ equity is a company’s total assets minus its total liabilities, representing the company’s net worth. A steady growth in a company’s shareholders’ equity by way of increasing retained earnings, as opposed to expanding shareholder base, means the accumulation of investment returns for current equity shareholders.

Becoming an effective manager requires continuously honing and improving your management skills. This could mean exchanging resources with others in your network, reading books or publications, or taking online courses.

Not to be overlooked are the management tools you have at your immediate disposal: your business’s financial statements. Financial statements can be used by managers to track performance, budgets, and other metrics, and as tools to make decisions, motivate teams, and maintain a big-picture mindset.

3 Financial Statements Used by Managers

There are three key financial statements managers should know how to read and analyze: the balance sheet, income statement, and cash flow statement.

The balance sheet provides a snapshot of a company’s financial health for a given period. It lists the assets, liabilities, and equity line by line for the period so that stakeholders can understand the breakdown.

The income statement, also known as the profit and loss statement, or P&L, gives an overview of the income and expenses during a set period. Typically presented annually or quarterly, the income statement allows businesses to compare trends in income and expenses over time.

Finally, the cash flow statement details the inflows and outflows of cash for a specific period. Broken into operating activities, investing activities, and financing activities, the cash flow statement demonstrates the business’s ability to operate in both the short and long term.

When analyzed together, these statements provide a holistic view of the financial health of your organization. They can be used to learn from previous pitfalls and successes as you strategize for the future. Here are six ways you can leverage your company’s financial statements to excel as a manager.

Related: How to Prepare a Balance Sheet: 5 Steps for Beginners

6 Ways Managers Can Use Financial Statements

1. Measure Impact

As a manager, it’s important to have a method for tracking the impact your efforts have on your company’s bottom line. Take a look at your company’s income statement, and note the direct expenses related to the revenue for that period.

Perhaps you purchased a piece of software, requested more ad spend, or hired a specialist for a big project. Did those expenses result in the net income you were targeting? Moving forward, you can learn from your mistakes and double down on investments that paid off.

2. Determine Budgets

Financial statements are also useful when managing and planning budgets. Because the financial landscape is ever-changing, John Wong, HBS Online’s Senior Associate Director of Financial Planning and Analysis, cautions against using previous financial statements as a starting place for future budgets.

“Historical data is essential to building a budget, but should be used as a reference point and not necessarily a starting point,” he writes in a previous blog post.

An understanding of your company’s financial health and history is necessary when budgeting, and should be paired with a forward-thinking mindset.

3. Cut Unnecessary Costs

Being able to see your company’s expenses line by line on both the income and cash flow statements can highlight areas where it’s possible to cut costs. Maybe you’ve been paying a monthly subscription for a service you no longer need, or your team outings could be scaled back in favor of more inexpensive activities. Seeing a list of every expense and how it impacts your company’s net income can be an eye-opening chance to save money and reallocate spend where it’s needed most.

4. Think Big-Picture

Keeping the broader health of your organization in mind is vital when managing your team. Analyzing the balance sheet, income statement, and cash flow statement can allow you to understand the ins and outs of your company’s finances and give you bigger-picture clarity to guide your goal-setting and decision-making processes.

Related: 5 Ways Managers Can Use Finance to Make Better Decisions

5. Align Across Departments

Your company’s financial statements can be used to ensure multiple departments are on the same page. When managers from each department have analyzed the statements, discussions about goals and budgeting can center on a shared understanding of the organization’s current financial health, and offer perspective into other managers’ goals and motivations.

6. Drive Team Motivation

Consider using your company’s financial statements as tools to motivate and engage your team. The income statement can show how your employees’ projects positively impacted the company’s revenue, which could boost their performance and drive.

When setting team goals, leverage financial statements to provide context for why specific benchmarks were targeted and the thought process behind your plans for reaching them. Instill in employees your same big-picture mindset and the knowledge that their efforts make a tangible difference to the company.

Become a Finance-Driven Manager

Your organization’s financial statements are valuable assets you can use to make strategic decisions and manage your team. If you’re unsure of where to begin, brushing up on your financial literacy, networking with finance professionals, or taking a finance course are great places to start. Bolstering your financial knowledge can enable you to make the best use of the resources available to you and become a finance-driven manager.

Are you interested in using finance to become a better manager? Explore our six-week online course Leading with Finance and other finance and accounting courses and discover how you can gain the skills and confidence to use the fundamentals of finance in your career.