Understanding Financial Statements

Understanding Financial Statements - Beginner’s Guide

May 15, 2025

Financial statements are the backbone of every successful business. They offer a clear snapshot of a company’s financial health while uncovering inefficiencies and gaps that may hinder growth.

At Mugo and Co, we recognize how vital these reports are to informed decision-making and day-to-day operations.

That’s why we’ve created this comprehensive guide: to walk you through the essentials of financial statements, explore the different types, and provide practical examples to enhance your understanding.

Let’s get started.

Introduction

Just as every meal needs a plate, an organization’s financial information requires a structured format for clear communication.

Financial statements serve as these structured reports, making it easier for stakeholders to understand a company’s financial position.

Financial statements are written records that provide insights into a company’s financial health, facilitating audits and ensuring compliance with tax, financing, and investment requirements.

These reports help business owners make informed decisions, assist investors in assessing profitability, and ensure regulatory bodies can monitor compliance effectively.

Types of Financial Statements

There are three primary financial statements required by Generally Accepted Accounting Principles (GAAP):

Balance Sheet – Displays what a company owns (assets), owes (liabilities), and the difference (equity).
Income Statement – Summarizes a company’s revenues, expenses, and profits over a specified period.
Cash Flow Statement – Tracks the flow of cash in and out of the business.

Each Financial statement offers a different perspective on a company’s financial health. Together, they provide a comprehensive view of the organization’s financial standing, ensuring transparency and full disclosure in line with the Full Disclosure Principle under GAAP.

This principle mandates that all material facts related to financial performance must be disclosed, ensuring stakeholders have all the relevant information to make informed decisions.

1. Balance Sheet (Statement of Financial Position)

A balance sheet shows a company’s financial position at a specific point in time, detailing its assets, liabilities, and equity.

Key Components:

Assets: What the company owns. Can be divided into:
- Current Assets: Cash, accounts receivable, inventory, prepaid expenses.
- Fixed (Long-Term) Assets: Property, machinery, buildings, vehicles.
- Intangible Assets: Patents, goodwill, copyrights.
Liabilities: What the company owes. Can be divided into:
- Current Liabilities: Accounts payable, short-term loans, accrued expenses.
- Long-Term Liabilities: Bonds payable, deferred tax liabilities, long-term loans.
Shareholder’s Equity: The ownership value remaining after liabilities are deducted from assets, including common shares, preferred shares, and retained earnings.

EXAMPLE OF BALANCE SHEET

STARFIRST LTD. STATEMENT OF FINANCIAL POSITION AS OF DECEMBER 31, 2017
ASSETS	AMOUNT(KSH)	LIABILITIES & EQUITY	AMOUNT(KSH)
CURRENT ASSETS		CURRENT LIABILITIES
CASH	10,000	ACCRUED EXPENSES	25,000
INVENTORY	20,000	SHORT-TERM LOANS	15,000
ACCOUNTS RECEIVABLE	15,000	ACCOUNTS PAYABLE	10,000
PREPAID EXPENSES	20,000	PAYROLL LIABILITIES	25,000
TOTAL CURRENT ASSETS	65,000	TOTAL CURRENT LIABILITIES	75,000
NON-CURRENT ASSETS		NON-CURRENT LIABILITIES
LAND	500,000	LONG-TERM LOANS	400,000
MACHINERY	200,000	TOTAL NON-CURRENT LIABILITIES	400,000
INTANGIBLE ASSETS	40,000	EQUITY	80,000
TOTAL NON-CURRENT ASSETS	740,000	SHARE CAPITAL	100,000
TOTAL ASSETS	805,000	RETAINED EARNINGS	150,000
		TOTAL EQUITY	330,000
		TOTAL LIABILITIES & EQUITY	805,000

2. Income Statement (Profit & Loss Statement)

The income statement summarizes a company’s revenues, expenses, and profits over a period of time, showing whether the company is profitable.

Key Components:

Revenue: Total income from business operations (e.g., sales revenue, service fees).
Cost of Goods Sold (COGS): Direct costs of producing goods or services sold.
Operating Expenses: Indirect costs such as rent, utilities, salaries, and marketing.
Net Income (Profit): The final profit after all expenses, taxes, and interest have been deducted.

EXAMPLE OF AN INCOME STATEMENT

STARFIRST LTD. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2024
AMOUNT (KSH)
REVENUE
SALES REVENUE	250,000
OTHER INCOME	120,000
TOTAL REVENUE	370,000
COST OF GOODS SOLD(COGS)
RAW MATERIALS	50,000
DIRECT LABOR	10,000
FACTORY OVERHEADS	10,000
TOTAL COGS	(70,000)
GROSS PROFIT(Total Revenue Less COGS)	300,000
OPERATING EXPENSES
SALARIES & WAGES	20,000
RENT & UTILITIES	5,000
MARKETING & ADVERTISING	10,000
DEPRECIATION	3,000
OTHER OPERATING EXPENSES	2,000
TOTAL OPERATING EXPENSES	(40,000)
OPERATING PROFIT (Gross Profit Less Operating Expenses)	260,000
INTEREST EXPENSE	(20,000)
EARNINGS BEFORE TAX (EBT) (Operating Profit Less Interest Expense)	240,000
TAXES	(40,000)
NET PROFIT (EBT Less Taxes)	200,000

3. Cash Flow Statement

This financial statement tracks the movement of cash in and out of the business, highlighting the company’s liquidity.

Key Components:

Operating Activities: Cash generated from or used in the company’s core business operations.
Investing Activities: Cash spent on or received from purchasing or selling assets, investments, etc.
Financing Activities: Cash from borrowing, loan repayments, issuing stock, or paying dividends.

EXAMPLE OF CASH-FLOW STATEMENT

STARFIRST LTD. CASH FLOW STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2024
	AMOUNT(KSH)
CASH FLOWS FROM OPERATING ACTIVITIES
Net Income	120,000
Adjustments for Non-Cash Items
Depreciation	10,000
Changes in Working Capital:
Increase in Inventory	(5,000)
Increase in Accounts Receivable	(8,000)
Increase in Accounts Payable	7,000
Net Cash from Operating Activities	124,000
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of Equipment	(20,000)
Sale of Old Equipment	5,000
Net Cash Used in Investing Activities	(15,000)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from Loan	30,000
Loan Repayment	(10,000)
Dividends Paid	(15,000)
Net Cash from Financing Activities	5,000
NET INCREASE IN CASH	114,000
OPENING CASH BALANCE	50,000
CLOSING CASH BALANCE	164,000

Additional Financial Statements

Beyond the main three, other financial statements might be required, depending on the business type:

Statement of Changes in Equity – Tracks changes in ownership and shareholders’ investments.
Statement of Comprehensive Income – Includes unrealized gains/losses from foreign exchange, investments, etc.
Non-Profit Financial Statements – Used by NGOs and charitable organizations to track donations and expenses.

Final Thoughts

Understanding financial statements is crucial for business owners, investors, and stakeholders. They provide essential insights into a company’s financial stability, profitability, and cash flow, guiding key business decisions.

By mastering these financial reports, you’ll be equipped to make informed choices, identify potential risks, and ensure compliance with industry regulations.

Need Help with Your Financial Statements?

At Mugo, we do more than just audits, we prepare clear, reliable, and GAAP-compliant financial statements tailored to your business or organization.

Whether you’re a startup, SME, or nonprofit, we ensure your reports are accurate, compliant, and ready for investors, regulators, or board reviews.

Reach out today to simplify your numbers and strengthen your financial reporting.