Financial statements are important sources of financial information that can be used to make sound business decisions. This means that every component of financial statements is important. Components of a financial statement can be described as the building blocks used for constructing the financial statement and these items represent, in words and numbers, various resources, claims to those resources, and any transactions that create changes in those resources and claims.
Below is a list of components of the most important financial statements – balance sheet, profit and loss (P&L) statement, and cash flow statement - and their importance.
A Balance Sheet is a statement of the assets, liabilities, and capital of an organization at one particular point in time. This statement gives an idea as to what the company owns and owes and also the amount of shareholding. The critical components of this statement are as below.
An asset can be tangible or intangible and is often owned or controlled with the belief that it would provide some future benefit and can be tangible or intangible. While the former includes current assets and fixed assets, the latter refers to rights and other non-physical resources that provide value to the business. Current assets consist of inventory, accounts receivables, and other short-term investments. Fixed assets could be buildings, equipment, and other physical resources. Intangible assets usually include goodwill, copyright, trademarks, and patents.
Liabilities are a company's legal debts or obligations that might arise during the course of business operations. These are usually settled over time through the transfer of economic benefits like cash, goods, or services. Liabilities include accounts payable, salaries or wages payable, interest due, customer deposits, and other such obligations to third parties. Liabilities might be of two types - current or long-term. While the former could be liquidated within a year, the latter can be repaid only in the long term (more than a year). Long-term liabilities include long-term bonds issued by the firm, notes payables, leases, pension obligations, and long-term product warranties.
It is the residual assets of an entity that remain after deducting liabilities. Theoretically, this is the capital available for distribution to shareholders. Hence, from a company’s liquidation perspective, equity would be considered the residual claim on the assets of a business, available to shareholders, after liabilities have been paid. For instance, if Company X has $3,000,000 as assets and $800,000 as liabilities, then equity would be $2,200,000 (= $3,000,000 - $800,000). Equity usually comprises funds contributed by shareholders, reserves, and retained earnings. Therefore, the only way to increase the amount of owners' equity is by either getting more funds from investors or by increasing profits.
This statement is a summary of the financial performance of a business over time. This is usually prepared after every quarter or year. The components in this statement include:
The amount of cash that a company actually receives during a specific period, through the sale of goods or services, is referred to as the company’s revenue. This would include discounts and deductions for returned merchandise. Revenues would also include the amount received as a result of using the capital or assets of the business as part of the operations of the business. Revenue is the "top line" or "gross income" of the business.
The outflow of money or incurring of liabilities (or a combination of both) through the production of goods, rendering services, or carrying out any activity that would form a part of the business’s operations, are the expenses of the company. Typical business expenses include wages or salaries, utilities such as rent, depreciation of capital assets, and interest paid on loans. The purchase of an asset such as a building or equipment is not an expense. Expenses also include the Cost of Goods Sold (COGS), which is the cost incurred for selling goods during the period and includes import duties, freight, handling, and other costs for converting inventory to finished goods.
A company’s gain is an increase in equity through peripheral or incidental transactions by a firm, other than those from revenue or investments by owners (shareholders). It refers to any economic benefit that is outside the normal operations of a business. Typically, gains refer to unusual and nonrecurring transactions, such as gain on sale of land, change in a stock’s market price or a gift. It is often shown in the P&L statement as non-operating income.
A company’s losses are decreases in equity through peripheral or incidental transactions carried out by the firm, other than those from expenses or distributions to owners. This could be lost on the sale of an asset, writing down of assets, or a loss from lawsuits. It could also include costs that give no benefit. It is often shown in the P&L statement as a non-operating expense.
This statement is a summary of the actual or anticipated inflows and outflows of cash in a firm over an accounting period. This could be prepared at the end of a month, quarter or year. The cash flow statement would reflect the liquidity position of the business. This is used as the basis for budgeting and business planning. The components in this statement include:
Operating activities of a business refer to the production, sales, and delivery of the finished product and collection of payments from customers. Cash outflows here could include purchasing raw materials, advertising, and the cost of shipping the product. They might not include payment to suppliers, employees, and interest payments. Depreciation and amortization are also included in the cash flow statement. Cash inflows here consist of receipts from the sale of goods and services and interest received.
These are cash flows related to investments and include the purchase of assets, gains or losses through investments in the financial market or in subsidiaries, and other related items.
This would account for activities that aid a firm in raising capital and repaying investors. The cash flow might include cash dividends, adding or changing loans, or issues of stock. Cash flow from financing activities reveals the company’s financial strength. Financing activities that produce positive cash flow include cash from issued stocks and bonds. Financing activities that produce negative cash flow include cash for repurchasing stock, paying off debt or interest, or payment of dividends to shareholders.
Every item in financial statements is important and provides insights into the workings and performance of the firm. These components are useful to all stakeholders including the management, employees, suppliers, and shareholders, for putting in place sound business plans and following a financially viable strategy.