The Purpose of Financial Statements
Financial statements are a written record of the financial performance and business activities of a given company. Financial statements are usually audited by accountants, government agencies, independent firms, etc. This is done to ensure transparency and accuracy when reporting the financial position, performance and changes in financial position of an enterprise for taxes, financing or investment purposes. Once accounted for, these financial statements are then used by a variety of stakeholders to make the most informed decision about the allocation of resources.
One of the most important tools for presenting reliable and well-audited financial data is an annual report that always contains the company’s financial statements. They are then used by investors, creditors and market analysts to evaluate the company’s earning potential, financial health and the future direction of their stock price. Financial statements include three main pieces of information: the balance sheet, income statement and statement of cash flow.
No one statement is able to provide sufficient information for a company’s financial analysis. However, when you put all three financial statements together, an analyst is able to determine the financial position and profitability as well as the financing, operating and investing activities of the company.
The balance sheet (also known as the statement of financial position) of a company provides an opportunity to determine the book value of that company. The balance sheet is split into three different categories: assets, liabilities and shareholders’ equity. This offers a summation of these financial activities on a specific date.
An income statement (or, a statement of financial performance) is where you will find all the necessary details on the revenue that the company earns and the expenses that are involved in how they operate. More generally, this statement should expose the direct, indirect and capital expenses a company has incurred. Overall, the income statement provides a detail-oriented perspective on the whole operating activities of an enterprise.
Statement of Cash Flow
The statement of cash flow provides insight into the overall liquidity of a business by showing its cash transaction activities. The cash flow statement primarily measures how well a company is able to generate cash to fund its operating expenses, pay its debt obligations and fund investments. This statement reports all the cash inflows and outflows that occur over the course of an accounting period with a sum total of cash available.
A company’s financial statements – and how the three relate to each other – relay important, contextualised and accurate information vital to a successful company financial analysis. The balance sheet will provide a necessary overview of the company’s assets, liabilities and stockholders’ equity as a snapshot in time. There is a date at the top of the balance sheet that will inform you when it was taken – normally around the end of the fiscal year.
The income statement is primarily focused on an enterprise’s revenues and expenses over the course of a particular period. Then by subtracting their expenses from their revenues; this statement becomes the enterprise’s profit figure referred to as net income. The income statement primarily focuses on a company’s revenues and expenses during a particular period. Once expenses are subtracted from revenues, the statement produces a company’s profit figure called net income. The cash flow statement complements the balance sheet and income statement.
The three financial statements are inevitably connected. Profits and losses found in the income statement will also be reflected in the assets and liabilities of the balance sheet. Additionally, changes in cash flow will show up in both the income statement and the balance sheet and vice versa.
Financial statements can go even further than that and be required for other purposes:
- Investment decisions – Investors use the information gleaned from the statements to decide whether or not to invest in a company and at what price per share they are willing to invest at.
- Credit decisions – Banks and other lenders will use the full financial statement to determine whether they should offer, extend or restrict the amount of credit provided to that business.
- Taxation decisions – In order to determine what a business might owe in taxes; government entities will look at that business’s assets or income derived from their financial statements.
- Union bargaining decisions – A union’s ability to bargain from different positions on behalf of its union members can be greatly impacted by the business’s perceived ability to pay; which can be argued using information found in their financial statements.
The Importance of Financial Statements
All three of these accounting statements are important for understanding and analysing the wholistic financial performance of a company. The income statement looks into the core operating activities of the company and offers insight into what generates earnings. While the balance sheet and statement of cash flow are more focused on the capital management of the company’s assets and structure.
A business that is performing at the top of their game will be successful in three areas: their asset management, operating efficiency and capital structuring. Management is then responsible for navigating these three components in such a way that is most beneficial to stakeholders and the interconnected reporting between these three areas is what makes the financial statement so important.