Financial statements are the record sheet of a business. Whether you are a new investor, a small business owner, an administrator, or just trying to maintain track of your finances. You require to understand how to understand, analyze, and build financial statements. So you can prepare a full and detailed understanding of your finances. Financial statements will show you how much money the operation has stashed continuously, how much debt is owed, the income coming in every month, and the expenses going out the door.
Meaning of Financial Statements
Financial statements are records that depict financial and accounting information linking to businesses. A company’s management practices it to interact with outside stakeholders. These involve shareholders, tax authorities, regulatory bodies, investors, creditors, etc.
Financial statements involve the following reports:
- Balance sheet
- Profit and Loss statement
- Cash flow statement
Nature of Financial Statements
Financial statements are made using facts linking to events, which are recorded chronologically. We have to initial record all these facts in monetary terms. Then, we have to treat them using all applicable rules and procedures. Lastly, we can now practice all this data to create financial statements.
Based on this understanding, the nature of financial statements depends on the following points:
- Recorded facts: We require to first record facts in monetary form to create financial statements. For this, we require to account for figures of accounts like fixed assets, cash, trade receivables, etc.
- Accounting conventions: Accounting Method and standards guide some conventions applicable in the process of accounting. We have to implement these conventions while developing financial statements. For instance, the valuation of inventory at cost price or market price, depending on whichever is more economical.
- Postulates: Apart from conventions, even postulates represent a big role in the development of financial statements. Postulates are primarily assumptions that we must make in accounting. For example, the going interest postulate assumes a company will exist for a long time. Therefore, we have to treat assets on a historical cost base.
- Personal judgments: Even personal views and judgments play a big role in the preparation of financial statements. So, we have to rely on our own views while determining things like depreciation.
Now that we know the meaning and nature of financial statements, a glimpse at their objectives would be significant.
Objectives of Financial Statements
Stakeholders of a company increasingly rely on financial statements to explain its functioning. They describe the true state of affairs of the company. Here are some views of financial statements:
- Financial statements show an actual state of a company’s economic assets and liabilities. Outside stakeholders like investors and professionals usually do not possess this information otherwise.
- They assist in foretelling the amount of a company’s capacity to earn profits. Shareholders and investors can utilize this data to make their financial judgments.
- Financial statements of a company describe the effectiveness of its management. How well a business is performing depends on its profitability, which these records show.
- They even assist readers in these statements to know the accounting methods used in them. This helps in knowing statements more comprehensively.
- These statements also give information describing the company’s cash flows. Investors and creditors can practice this data to foretell the company’s liquidity and cash requirements.
- Finally, financial statements demonstrate the social influence of businesses. This is because it explains how the company’s outer factors affect its functioning.
Elements of Financial Statements
The Financial Accounting Standards Board (FASB) has established the following details of financial statements of business enterprises:
- Assets are likely future economic gains received or managed by a particular entity as a result of past transactions or events.
- General income is the difference in equity (net assets) of an entity during a period from transactions and other events and things from nonowner sources. It covers all changes in equity during a period except those emanating from investments by owners and distributions to owners.
- Distributions to owners are reductions in net assets of a special enterprise resulting from transferring assets, rendering services, or acquiring liabilities to owners. Distributions to owners lower ownership interest or equity in an enterprise.
- Equity is the continuing interest in the assets of an entity that continues after subtracting its liabilities. In a business or company, equity is the ownership stake.
- Expenses are currents or other methods of assets or incurring of liabilities during a period from delivering or delivering goods or rendering services.
- Gains are gains in equity (net assets) from peripheral or incidental activities of an entity.
- Investments by owners are developments in net assets of a particular company resulting from shifts to it from other entities of something of value to get or build ownership interest.
- Liabilities are likely future sacrifices of economic gains arising from existing obligations of a particular entity to transfer assets.
- Losses are drops in equity (net assets) from external or incidental transactions of an entity and all other transactions.
- Revenues are inflows or other enrichment of assets of an entity. Also, settlement of its liabilities during a period from giving. Or producing goods, rendering services, or other activities that compose the entity’s ongoing primary or central operations.
Three Important Financial Statements
The three important statements are the balance sheet, profit& loss statements, and cash-flow statements:
The balance sheet is so-called because it constantly balances according to this relationship: Assets = Liabilities + Owners’ equity.
A balance sheet that doesn’t balance is simply incorrect. The balance sheet presents the assets that a company owns, the liabilities that it owes, and the funds provided by its shareholders.
Assets hold land, equipment, inventory, goodwill, patents, brand value, etc. Liabilities cover debt (long-term and short-term) and any other payables that a business has. Shareholder funds are in the application of equity and reserves.
A vulnerable balance sheet is one that is saddled with debt. When a company has a strong balance sheet, it has added assets and equity to liabilities. To understand the balance-sheet strength, you need not see the balance sheet; you can just see at the debt-equity ratio.
The following method compiles what a balance sheet shows:
ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY
A company’s assets have to match, or “balance,” the sum of its liabilities and shareholders’ equity.
As its name implies, the P&L statement informs you about the profitability of a company. The easy formula to calculate profits is Profit (loss) = Revenue – Expenses.
The title ‘revenue’ usually has 2 entries: revenue from sales and other income. Other income is the result of sources other than the center area of the company’s operations. For example, it could be income from investments, dividends, royalties, etc.
The head ‘expenses’ establish the levels of expenditure such as cost of raw materials, employee costs, etc. On deducting the total costs from the total revenues, we see the ‘operating profit’, which is nothing but a company’s profit from its core services. To arrive at the final profit number, any different income or loss is to be added to or subtracted from the running profit. Finally, net profit is earned after deducting the tax applicable.
The cash-flow statement explains the movement of cash in a company. While companies can deceive their profits by accounting jugglery, they can’t fudge the flow of hard cash. So, a cash-flow statement gives a true picture of a company’s financial health. But, for banks and finance companies, the cash-flow statement is of restricted use as they develop a diverse business model than different kinds of businesses.
The cash-flow statement has 3 components: cash flows from operating projects, from financing activities, and from investing activities. The statement further mentions the prevailing cash holding of the business.
What you require to reduce in the data is whether flows from operating activities are actual or not. If they are positive, it indicates that the company can create cash from its operations. If they are negative, it indicates that the company is losing money. While it may register profits in its P&L statement, negative flows from orders should ring an alarm.
Cash flows from financing activities show the money allocated for the company’s services or the money paid towards debt repayment. The former will be a positive number on the statement, while the end will be a negative number. Cash flows from investing activities take the cash used in investments. For example, a business that has made surplus cash may park it in a bank fixed deposit. Next year it may withdraw cash from that Fixed Deposit. The above will be a negative number on the statement, while the end will be a positive number.
A company’s financial statements are a glass into its financial health. No wonder reading them is an integral part of structural analysis. While examiners dig more difficult into financial statements and try to find the not-so-obvious features of a company’s financials. Understanding basic financial statements must answer for an investor in most cases.
There are 3 major financial statements: the balance sheet, profit-and-loss statement, and cash-flow statement.
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