What are financial statements?
Financial statements are a record of a business’s finances over a period of time. Financial statements contain essential financial information such as details of assets, liabilities, income, expenses, etc. Financial statements in essence are a formal, historical record of the business’ finances that can be used to evaluate business health and performance. For evaluation, financial data is presented in four fundamental sets collectively known as financial statements. In most reporting jurisdictions, financial statements comprise at least the following:
- The balance sheet or statement of the financial position
- The profit & loss account or an income statement
- The cash flow statement or formerly the flow of funds statement
- The statement of retained earnings or the statement of changes in comprehensive income
The Balance Sheet
The balance sheet contains data on the assets, liabilities, and the shareholder’s equity of the business at the time of recording or in other words at any particular point of time, which usually is the year-end for business reporting purposes. Assets refer to any valuable possessions owned by the business. This can include anything that can be sold for money or used to earn money. Things like raw materials, machinery, real estate, etc. count as assets, and so does cash. Conceptual or intellectual property which does not have a physical form such as a trademark or patent also counts as an asset. Liabilities are the debts a business owes, which may include rent, salaries, or loans payable by the company. The shareholder’s equity is also known as net worth and refers to the amount of money that would be left if the business sold all its assets and paid off all its liabilities. The residual of all the assets and liabilities belong to the shareholders of the business, which is referred generally to as equity or the shareholders’ equity. This includes the capital of the company, i.e., the funds injected by the owners, whether individuals, partners, or shareholders.
In a nutshell, the balance sheet shows data on assets, liabilities, and shareholder’s equity in the form of the accounting equation:
ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY
To sum up, the total assets of the business should be equal to the sum of its liabilities and shareholder’s equity. If the balance sheet shows otherwise, there is a discrepancy that must be addressed. The balance sheet is primarily used to gauge the financial health of the business as it displays the business’ ability to pay off its liabilities. A healthy business is generally perceived to be one that has more assets than its liabilities.
The Income Statement
The income statement contains data on the revenue and income earned and the cost and expenses incurred by the business over a specific period of time. As defined, revenue is “the money generated from normal business operations, calculated as the average sales price times the number of units sold.” The revenue is also called the “top line” of the income statement.
The expenses associated with the manufacture of the sold products as well as the operations cost of the business are then subtracted from the revenue and these two, i.e., the cost of goods sold, and expenses are presented as line items on the face of the income statement. Any interest the business earned or paid over the specific time period is also subtracted and lastly, the tax expense is deducted. Once all deductions have been accounted for, we arrive at the end of the business statement which shows the “bottom line” or the net income or loss of the business.
The income statement is also used to evaluate the financial performance of the business. It differs from the balance sheet in that it shows the profitability of the business, which can be used by investors and financial analysts to judge the investing and future viability of the business.
The cash flow statement
The cash flow statement tracks and records the movement of cash through the business over a specific period of time. All incoming and outgoing cash over the time period is presented on the face of the cash flow statement. While the income statement represents the net profit earned by the business, the cash flow statement shows how much cash was generated from investing, operating, and financing activities. The purpose of the cash flow statement is not to provide a concrete dollar number for the cash available at a specific reporting time, although that can also be seen on the face of it, but rather to show the change in cash flow over a time period. The cash flow statement is made using data from both the income statement and the balance sheet.
The statement of retained earnings
Out of the four basic financial statements, the statement of retained earnings is usually the least used and is often combined with the income statement. Regardless, it is still valuable as it shows the changes in the retained earnings of the business. Retained earnings is a cumulative figure that represents the portion of the net income which has been retained so far by the business after paying off dividends to the shareholders. Companies focusing on growth may not pay any dividends and instead plough back the money for expansion purposes. The main purpose of this financial statement is to show the financial stability of the business through a record of the saved net income over time.
Making use of the four basic financial statements
The next step after learning about the four basic financial statements is figuring out how to turn the data inside them into useful information. A simple way to achieve this is by using financial ratios. Financial ratios are essentially mathematical formulae that can refine raw financial data into meaningful information. Expertise Accelerated publication “7 Financial Ratios Every Small Business Owner Should Know“ provides a quick guide to using ratios for analyzing the financial performance of a company.
Other than utilizing financial ratios, business owners can also hire a dedicated accountant or a financial analyst as in-house resources or consultants to evaluate their financial statements and provide insights into financial performance, flagging areas in which the business performed well and the areas in which it needs to improve. A growing business must focus on leveraging its financial data to measure performance and make projections for the future. While this is an expensive move for small businesses, it is one of the most effective ways to spur business growth. Luckily, the rising popularity and success of outsourcing in the accounting sector means that small businesses can make full use of these four financial statements too.
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