Various Financial Statements Explained

July 27, 2023
10 MIN READ
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Financial statements are written documents that communicate an entity's business activity and financial performance. The balance sheet summarizes assets, liabilities, and shareholders' equity as a brief time overview. The income statement primarily concerns a company's revenues and costs for a certain period. After subtracting costs from sales, the statement yields a company's profit amount, known as net income. The cash flow statement (CFS) evaluates a company's ability to generate cash to meet debt commitments, cover operational expenditures, and fund investments. The statement of changes in equity documents how earnings are kept inside a business for future growth or given to outside parties.

What are financial statements?

Financial statements are written documents that describe a company's commercial activity and financial performance. Government authorities, accountants, and corporations, among others, frequently audit financial accounts to verify accuracy and for tax, financing, or investment purposes. The income, cash flow, balance sheet statements, and statements of changes in equity are fundamental financial statements for for-profit businesses. Nonprofit organizations have a similar but distinct set of financial statements.

The concept of financial statements

Traders and financial analysts use financial data to examine the efficacy of a business and forecast the future direction of its stock price. The annual report covers the firm's financial statements and is one of the most essential sources of reliable and audited financial data.

Market analysts, creditors, and investors use financial statements to assess the financial stability of a business and its profit potential. The three primary financial statement reports are income, cash flows, and balance sheet statements.

Financial statements are not all made equal. The regulations followed by US corporations are known as Generally Accepted Accounting Principles (GAAP), whereas the rules followed by foreign companies are known as International Financial Reporting Standards (IFRS). Furthermore, US government agencies follow a distinct set of financial reporting guidelines.

The balance sheet

As an overview in time, the balance sheet summarizes a company's assets, liabilities, and shareholders' equity. The date on the balance sheet indicates when the snapshot was taken, usually after the reporting period. A balance sheet's elements are broken down as listed below.

1. Assets

·       Cash and cash equivalents, consisting of Treasury bills and certificates of deposit, are examples of liquid assets.

·       Accounts receivable are the funds due to the firm by its clients for the purchase of its goods and services.

·       Inventory refers to the things a firm has on hand that are meant to be sold during the transaction. Inventory includes finished products, unfinished work in progress, or raw materials that have yet to be worked on.

·       Prepaid expenses.

·       Investments are not used in operations but are held for capital appreciation.

·       Trademarks, patents, goodwill, and other intangible assets cannot be physically touched yet provide the firm with future economic (and often long-term) advantages.

2. Liabilities

·       Accounts payable are bills that are due as part of a business's usual course of operations. This comprises utility expenses, rent invoices, and raw material purchase responsibilities.

·       Wages payable are compensation owed to employees for hours performed.

·       Notes payable are documented debt instruments that document formal debt arrangements, such as payment schedules and amounts.

·       Dividends payable are dividends that have been authorized but not yet paid to shareholders.

·       Long-term debt can refer to commitments such as mortgages, sinking bond funds, or other loans due in full in more than a year. It is worth noting that the short-term element of this debt is classified as a current obligation.

3. Equity of Shareholders

·       Shareholders' equity is defined as the total assets of a business less total liabilities. Shareholders' equity (sometimes known as stockholders' equity) is the amount of money returned to investors if the organization's assets were dissolved and its debt was paid off.

·       Retained earnings are a component of shareholders' equity and represent the net earnings not distributed to shareholders as dividends.

The income statements

The income statement covers a period, which is a quarter for quarterly financial statements and a year for yearly financial statements. The income statement summarizes sales/revenue, costs, net income, and earnings per share.

1. Revenue

The money generated by selling the goods or services offered by a business is known as operating revenue. Manufacturing and selling automobiles would provide operational revenue for an automobile manufacturer. Operating revenue is earned by a company's fundamental business operations.

Non-operating revenue is revenue generated by non-core company activity. These revenues are unrelated to the principal purpose of the company. Examples of non-operating revenue include:

·       Interest on funds held in a bank

·       Rental revenue generated by a property

·       Royalty payment receipts from strategic alliances

·       Profits from an advertisement display on the firm's property

Other income is revenue generated by other activities. Profits from the sale of long-term assets such as land, automobiles, or a subsidiary are examples of other revenue.

2. Expenses

Principal costs are incurred while the principal activity of the firm generates money. Cost of goods sold (COGS), selling, general and administrative expenditures (SG&A), depreciation or amortization, and research and development (R&D) are all examples of expenses.

Employee salary, sales commissions, and utilities like power and transportation are all typical expenditures. Interest on loans or debt is an example of a secondary activity expense. Losses from asset sales are also documented as costs.

The income statement's principal function is to express information on profitability and the financial consequences of corporate activities. Still, compared across numerous periods, it may help reveal if sales or revenue is rising. Investors may also assess how well the management of an organization controls spending to judge whether a company's attempts to reduce the cost of sales will result in higher profits in the long run.

The cash flow statement

The cash flow statement (CFS) evaluates a company's ability to generate cash to meet debt commitments, cover operational expenditures, and fund investments. The cash flow statement is used with the balance sheet and income statement. The CFS enables shareholders to comprehend how an organization's operations work, where its money comes from, and how it is spent. The CFS also indicates whether or not a firm is financially stable.

A cash flow statement cannot be calculated using a formula. Instead, it has three parts that report cash flow for every task for a firm to utilize its funds. These three CFS elements are given below.

a. Operating activities

The CFS operating activities comprise all sources and uses of cash derived from the operation of the business and the sale of its products or services. Any changes in cash accounts receivable, depreciation, inventory, and accounts payable are included in cash from operations. These interactions include wages, income tax payments, interest payments, rent, and cash revenues from selling a product or service.

b.  Investing actions

Investing operations encompass all sources and uses of cash generated by an organization's investments in the company's future. This sector includes the purchase or sale of an asset, loans paid to suppliers or received from consumers, and payments associated with a merger or acquisition.

This component also includes purchases of permanent assets such as property, plant, and equipment (PPE). In a nutshell, changes in equipment, assets, or investments are related to cash from investments.

c.  Financing initiatives

Funds from financing operations comprise cash received from traders or financial institutions and cash paid to stockholders. Debt issuance, equity issuance, stock repurchases, loans, dividend payments, and debt repayments are all examples of financing operations.

The cash flow statement addresses the income statement and balance sheets in three critical company operations.

Changes in equity

The equity statement of changes measures total equity over time. This data relates to a balance sheet for the same period; the closing balance on the change of equity statement equals the total equity recorded on the balance sheet.

The procedure for changes in shareholder equity varies by firm. Generally, there are several components:

·       Beginning equity is the equity at the end of the previous period that rolls over to the beginning of the current period.

·       (+) Net income: the firm's money in a certain period. The proceeds from operations are immediately recorded as equity in the firm and are rolled into retained profits after the fiscal year.

·       (-) Dividends: the amount of money distributed to shareholders from earnings. Instead of maintaining all the profits a business makes, it may distribute some gains to investors.

·       (+/-) Other substantial income: the change in additional total income from one period to the next. Depending on the transaction, this amount may be an increase or deduction from equity.

A corporation's statement of changes in equity includes activity for acquisitions, dispositions, stock-based award amortization, and other financial activities. This data is valuable for determining how much money the firm keeps for future growth rather than dispersed outside.

Comprehensive income statement

A statement of comprehensive income presents expected net income while adding adjustments to other comprehensive income (OCI). All unaccounted profits and losses that are not reflected on the income statement are included in other comprehensive income. This financial statement displays a company's overall income change, including gains and losses that have yet to be reported in compliance with accounting regulations.

The following are some examples of transactions recorded on the statement of comprehensive income:

·       Net income (as shown on the income statement).

·       Gains or losses on debt securities that have not yet been recognized

·       Unaccounted profits and losses from derivatives

·       Unrealized translation changes owing to currency fluctuations

·       Retirement program unrealized gains or losses

Financial statements for nonprofit organizations

Nonprofit organizations keep financial records in the form of financial statements. Nevertheless, the financial statements used differ because of the variations between for-profit and purely philanthropic entities. A nonprofit entity's standard set of financial statements comprises the following:

·       Functional expenses statement

This is unique to nonprofit organizations. The statement of functional costs categorizes spending by entity function (often administrative, program, or fundraising costs). This information is made available to the public to demonstrate the percentage of company-wide costs directly tied to the objective.

·       Statement of cash flow

This is the same as a for-profit entity's cash flow statement. Even though the accounts presented may differ owing to the unique structure of a nonprofit corporation, the statement is still separated into operating, investing, and financing operations.

·       Statement of activities

This is the corresponding degree of a profit and loss statement for a for-profit corporation. This report charts the evolution of operations through time, covering the reporting of contributions, grants, event income, and costs incurred to make things happen.

·       Statement of financial position

This is the for-profit counterpart of a balance sheet. The most significant distinction is that nonprofit organizations do not have equity holdings; any remaining balances after all investments have been dissolved and liabilities have been met are referred to as "net assets."

Drawbacks of financial statements

Even though financial statements contain an array of details on an enterprise, they are not without limitations. Because the statements are open to analysis, investors frequently reach distinct conclusions about a business's financial health.

When assessing financial statements, it is critical to compare various time frames to ascertain any common patterns and compare the business's outcomes to those of its acquaintances in the same sector.

Finally, financial statements are just as accurate as the information fed into them. Oftenly, illegal financial activity or insufficient corporate supervision has resulted in misstated financial statements meant to deceive users.

Conclusion

Financial statements are the key to evaluating a company's financial success from the outside. The balance sheet indicates the financial stability of a business by displaying its liquidity and solvency, whereas the income statement shows its profitability. A cash flow statement connects the two by recording the sources and uses of cash. Financial statements show how a firm performs over time compared to its rivals.