A financial statement is a formal record of the financial activities of a business. Financial statements are usually prepared at the end of a quarter (quarterly report) and also at the end of the year (annual report).
The purpose of a financial statement is to provide people with information about the business so that the right decisions can be taken at the right time. These people include investors, creditors, debtors as well as the management. Unlike popular perception, it is not just the stakeholders who do a financial analysis using the statements; the management also indulges in such an exercise. This is done so that important business decisions can be taken for better growth and operations. Also, companies seeking to be listed on the stock exchange are required to share financial statements that are based on the accounting principles adopted by the country (for instance, NASDAQ requires financial statements that are compliant with US GAAP).
There are five basic financial statements:
Table of Contents
- Income Statement
- Balance Sheet
- Statement of Stockholders’ Equity
- Cash Flow Statement
- Statement of Comprehensive Income
The value of these important financial statements and why a business of any size requires them is explained below:
1. Income Statement:
This is the primary statement used to measure the performance of a business. This statement shows both the growth in ‘top line’ as well as the ‘bottom line’: the former being the sales or revenue and the latter is the net income or net earnings of the firm. Net income is generally used as a measure to see how successfully the company made money during the period for which the statement was prepared. Another important element that is part of the statement is the expenses made by the firm to generate the income.
On the income statement, the management should compare sales and expenses from one period to the previous period and should check if there are any big changes. For instance, if administrative costs have gone up significantly without any improvement in sales, the income statement will reveal the same and the management can look at ways to reduce expenses.
Other notable expenses that are part of the income statement are those of research and development and the interest paid on borrowed funds. If the latter is high, the company could look at other cheaper sources for funds. In this manner, the income statement can reveal trends in both sales and expenses so that the business can make decisions for better operation and growth.
2. Balance Sheet:
This statement is also known as the Statement of Financial Position as it supplies information about the assets, liabilities, and owners’ equity of the organization. While the income statement is generated for a particular period, the balance sheet is prepared as on a particular date (usually at the end of an accounting year). Hence, the balance sheet is like a financial snapshot of the firm at a particular point in time.
The elements in the statement – assets, liabilities, and equities – reveal the resources the company owns and how those resources are financed. The management should compare the statement with the previous periods and check for major ups and downs in the elements. For instance, on the assets side, if inventories are growing faster than sales, the management could look for ways in which inventories can be converted into sales more quickly. In this way, the balance sheet can reveal aspects that can help better the financial position of the firm.
3. Cash Flow Statement:
This statement is also known as the Statement of Cash Flows. It provides information about the cash inflows and outflows of an organization during a period.
Cash flow could be of three different types:
- Operating cash flows indicate the cash flows related to revenues and expenses of the firm.
- Investing cash flows are the investments made in long-term assets
- Financing cash flows are related to stockholders’ equity-like payment of dividends.
Cash flows are helpful in determining money available to pay creditors. Usually, an increasing cash flow from operating activities would indicate a healthy cash flow situation for the company.
4. Statement of Stockholders’ Equity:
This statement provides information about stockholders’ equity balances as listed on the balance sheet, with explanations on why these items changed. Changes in the statement usually happen due to the distribution of dividends, new issuances of stock, and repurchases of treasury stock. The management should keep reviewing dividend payments and retained earnings. If retained earnings are decreasing, the management should check whether it has sufficient funds for paying off its liabilities.
5. Statement of Comprehensive Income:
This statement provides information about comprehensive income which cannot be included in the income statement. Items such as unrealized gains/losses, pension, investments, and foreign currency transactions are part of this statement. This statement would help the management determine possible sources of cash in the future.
As is evident from the above article, accurate financial statements and financial reporting can give management a number of insights for improving operations, increasing income, reducing expenses, and ensuring compliance. Management should make an effort to note trends in sales, expenses, and other important aspects in order to improve operations and set the business on the path to profitability.