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What is Meaning of Financial Statement
Financial statements are written documents that convey a company's business activities as well as its financial performance during a given period of time. Audits of financial statements are frequently conducted by government agencies, accounting firms, and other organisations for the purposes of verifying their accuracy and meeting the requirements for taxation, financing, or investing. The balance sheet, income statement, statement of cash flow, and statement of changes in equity are the primary financial statements used for businesses that are operated for profit. Organizations that are not-for-profit make use of a set of financial statements that are comparable but distinct.
Purpose for financial statements
Assessing profitability: Financial statements, such as the income statement, provide information about a company's revenues, expenses, gains, and losses. This helps stakeholders assess the profitability and earning capacity of the business.
Evaluating liquidity: The balance sheet reveals a company's current assets and liabilities, allowing stakeholders to evaluate its liquidity and ability to meet short-term obligations. It helps determine if the company has enough cash and liquid assets to cover its debts.
Analyzing solvency: Financial statements assist in evaluating a company's long-term solvency by disclosing its long-term liabilities, equity, and asset composition. It helps stakeholders determine if the business has a healthy financial structure and can meet its long-term obligations.
Assessing efficiency and effectiveness: Financial statements provide insights into a company's efficiency and effectiveness in managing its resources. For example, metrics such as return on assets (ROA) and return on equity (ROE) indicate how effectively the company is utilizing its assets and generating returns for shareholders.
Supporting investment decisions: Investors rely on financial statements to evaluate investment opportunities. By analyzing financial data, investors can assess a company's financial health, growth potential, and future prospects, enabling them to make informed investment decisions.
Assisting credit decisions: Financial statements are crucial for lenders and creditors when assessing creditworthiness and determining the risk associated with lending money. They provide insights into a company's ability to repay loans, interest coverage ratios, and overall financial stability.
Facilitating benchmarking and industry analysis: Financial statements are valuable for comparing a company's financial performance against industry peers. By analyzing key financial ratios and metrics, stakeholders can assess the company's relative performance and identify areas for improvement.
Supporting tax compliance: Financial statements provide the necessary information for tax reporting and compliance. They assist in calculating taxable income, determining tax liabilities, and supporting tax audits.
Enhancing transparency and trust: Financial statements promote transparency by disclosing financial information to stakeholders. Transparent reporting helps build trust and credibility among investors, shareholders, and the public, demonstrating the company's commitment to openness and ethical practices.
Guiding strategic decision-making: Financial statements provide vital insights for strategic decision-making within a company. By analyzing financial data, management can identify strengths, weaknesses, and areas of improvement, helping them formulate effective strategies for growth, expansion, and risk management.
Let’s look at each of the financial statements in more detail.
A) Income Statement
A report known as an income statement details the amount of revenue that a business generated over the course of a particular time period (usually for a year or some portion of a year). A revenue statement will also detail the costs and expenditures that were incurred in order to generate that revenue. The net earnings or losses of the company are typically displayed in what is referred to as the "bottom line" of the statement. This will tell you how much money the company made or lost during the specified time period.
Earnings per share, abbreviated as "EPS," are also reported on income statements. Using this calculation, you can determine how much money would be distributed to shareholders if the company decided to distribute all of the net earnings for the period. (Companies almost never give out all of their profits to their shareholders. In most cases, they put the money back into the company.)
Imagine the components of an income statement as a flight of stairs in order to better comprehend how they are organised. The total amount of sales that were made during the accounting period is where you begin, as it is at the very top of the list. After that, you make your way down the ladder one step at a time. At each stage, a deduction is made for particular costs as well as any other operating expenses that are connected to the generation of the revenue. After deducting all of the company's expenses, you will find out how much money the business actually made or lost during the accounting period at the bottom of the stairs. This is what many people refer to as "the bottom line."
B) Balance Sheet
A balance sheet gives specific details about the assets, liabilities, and shareholders' equity of a company.
i) Assets
Assets are valuable possessions that a business owns. This typically means that they can be used by the business to create goods or render services that can be sold, or they can be sold themselves. Physical assets include things like buildings, vehicles, machinery, and stock. It also includes things like patents and trademarks that are immovable but still exist and have value. Cash is also a form of asset. Investments a company makes are also.
ii) Liabilities
A company's liabilities are the sums of money it owes to other parties. This can refer to a variety of debts, such as loans taken out by a company to launch a new product, building rent, payments owed to suppliers for materials, employee payroll, costs associated with environmental cleanup, and taxes owed to the government. Providing future customers with goods or services is another example of a liability.
iii) Shareholder Equity
Equity held by shareholders is also referred to as capital or net worth. It is the amount that would remain after a business sold all of its assets and settled all of its debts. The shareholders, or business owners, are the rightful owners of this surplus cash.
C) Cash Flow Statements
Statements of cash flow are used to report both cash coming into and going out of a business. This is significant because a company must have sufficient cash on hand in order to be able to pay its operating expenses and buy assets. A cash flow statement can tell you whether or not a company generated cash, in contrast to an income statement, which can only tell you whether or not a company made a profit.
The changes in cash flow over a period of time are shown on a cash flow statement, rather than the absolute dollar amounts at any given point in time. It takes the information from a company's income statement and balance sheet and rearranges it in a different order.
The net increase or decrease in cash over the course of the period is revealed in the very last line of the cash flow statement. In most cases, cash flow statements will be broken down into three primary sections. Each section analyses the cash flow resulting from one of the following three categories of activities: operating activities, investing activities, and financing activities.
i) Operating Activities
The first section of a cash flow statement is dedicated to the investigation of a company's ability to generate cash from its net income or losses. This part of the cash flow statement reconciles the net income (which is shown on the income statement) to the actual cash that the company received from or used in its operating activities. This part of the cash flow statement is included for most companies. In order to accomplish this, an adjustment is made to the net income to account for any non-cash items (such as adding back expenses related to depreciation) and to account for any cash that was used or provided by other operating assets and liabilities.
ii) Investing Activities
The cash flow from all investing activities is shown in the second section of a cash flow statement. These investing activities typically include the buying and selling of long-term assets like real estate, machinery, and other equipment, as well as investment securities. Because the transaction required the use of cash, the cash flow statement will show that the company has experienced a cash outflow from investing activities as a result of the acquisition of the piece of machinery. If the company made the decision to sell off some investments from an investment portfolio, the proceeds from the sales would show up as a cash inflow from investing activities because it provided cash. This would be the case regardless of whether or not the company actually sold any investments.
iii) Financing Activities
The cash flow from all financing activities is shown in the third part of a cash flow statement. The most common ways to get cash flow are to sell stocks and bonds or borrow from banks. In the same way, paying back a bank loan would be a use of cash flow.
D) Statement Of Comprehensive Income
The term "comprehensive income" refers to the combination of "net income" and "unrealized income," which can include things like unrealized gains or losses on hedge or derivative financial instruments as well as unrealized gains or losses on currency transactions. It gives a more complete picture of the income of a company than the income statement does, which only shows part of the picture.
The "accumulated other comprehensive income" section of the shareholders' equity section is where you should report any income that wasn't included in the income statement. The purpose of comprehensive income is to include a total of all operating and financial events that affect non-owners' interests in a business. This is accomplished by including a total of all of the components that make up comprehensive income.
Unrealized gains and losses on investments that are available for sale are accounted for as part of a company's comprehensive income. It also includes cash flow hedges, the value of which can shift depending on the market value of the underlying securities, as well as debt securities that have been moved from the "available for sale" category to the "held to maturity" category, which can also result in unrealized gains or losses. Adjustments made to account for fluctuations in the value of foreign currencies, as well as those made to pension and/or post-retirement benefit plans, can also result in gains or losses.
E) Statement Of Shareholder Equity
As a component of its balance sheet, a company is required to issue a financial document known as the statement of shareholders' equity. It highlights the changes in value that have occurred to a company's stockholders' or shareholders' equity, also known as ownership interest, from the beginning of a given accounting period to the end of that period. Typically, the statement of shareholders' equity will measure different things at the beginning of the year compared to what it measures at the end of the year.
A company's shareholders' equity can be calculated by finding the difference between the total assets and total liabilities of the business. This is the most basic definition of shareholder equity. The shareholders' equity statement highlights the activities of the business that contribute to the growth or decline in the value of the shareholders' equity.
F) Supplementary Notes
When financial statements are distributed to third parties, supplementary notes should also be included in the package. These notes provide explanations of a variety of activities, additional detail on some accounts, and other items that are required by the accounting framework that applies, such as GAAP or IFRS. The nature of the issuing entity's business as well as the kinds of transactions that it participated in will determine the level of detail that is provided as well as the types of details that are provided. Because it can be quite time-consuming to produce the disclosures, a reporting entity will typically only include the minimum amount required by law in the supplementary notes, even though these notes can still be quite extensive.
G) Management Discussion and Analysis (MD&A)
The MD&A, which stands for management discussion and analysis, is an integral component of the annual financial statements of a company. The management discussion and analysis (MD&A) report's objective is to offer a narrative explanation, as seen through the eyes of management, of how an entity has performed in the past, its current financial condition, and its potential for the future. In doing so, the MD&A makes an effort to supply investors with information that is comprehensive, impartial, and well-balanced in order to assist them in deciding whether or not to invest in an entity or to continue investing in it.
In this section, you'll find a summary of the past year, as well as some of the most significant factors that had an impact on the company's financial performance during that time period. Additionally, you'll find an objective and balanced analysis of the company's history, as well as its present and future.
The MD&A typically describes the corporation's liquidity position, capital resources, results of its operations, underlying causes of material changes in financial statement items (such as asset impairment and restructuring charges), events of an unusual or infrequent nature (such as mergers and acquisitions or share buybacks), positive and negative trends, effects of inflation, domestic and international market risks, and significant uncertainties. MD&As are required by generally accepted accounting principles (GAAP).
Who Use Financial Statement
1) Investors & Shareholders
The investors and shareholders are the owners of the company, and as such, they have a need for the financial statements in order to check the profitability of the business as well as the overall financial position of the company. This enables them to evaluate the return that they are getting on their investment in the company. They decide whether to increase their investment in the company if the company is giving good returns or to divest their funds from the company if they feel that the company lacks the ability to earn adequate profits. This decision is made possible by the presence of financial statements.
2) Lenders
Companies, such as financial institutions, such as banks and NBFCs, are the ones who receive money from lenders, who are also known as "lenders." Before extending financial assistance to a business, these creditors examine its current financial standing to determine whether or not it will be able to pay back the loan along with the associated interest and fees in a timely manner. Before extending a loan to any company, the vendors require that the company provide both its current and projected financial statements. This enables the vendors to determine whether or not their debts are adequately secured and whether or not the likelihood of their debts becoming delinquent is very low or even nonexistent.
3) Vendors
The term "vendor" refers to the suppliers who provide something to the company, such as raw materials or other goods, that the company requires in order to carry out its day-to-day operations. Even though the vendors do not have the same interest in analysing the long-term repaying capacity of the company as the lenders do because their lending period is in the months, they still need to check the capacity of the company to whom they are selling their goods to ensure that they will be repaid for the purchase.
4) Rating agencies
The credit rating agencies that assign credit ratings to companies based on their respective financial positions are required to examine the companies' financial statements before assigning ratings to those companies. These agencies assign ratings to companies on the basis of the information contained in the financial statements.
Why Financial Statement Important
The way a company runs its operations is reflected in its financial statements. It sheds light on how much revenue a company generates and how it does so, the costs associated with running the business, how effectively the company manages its cash flow, as well as the company's assets and liabilities. The complete picture of how well or poorly a company manages itself can be seen in the company's financial statements.
FAQ on Financial Statement
What is a financial statement?
A financial statement is a formal record that summarizes the financial activities, position, and performance of a business or individual. It provides crucial information about the financial health, profitability, and liquidity of an entity.
What are the main types of financial statements?
The main types of financial statements are:
Income Statement (also known as Profit and Loss Statement): It shows the revenue, expenses, and net income or loss of a company over a specific period.
Balance Sheet: It presents the assets, liabilities, and shareholders' equity of a company at a specific point in time, providing a snapshot of its financial position.
Cash Flow Statement: It provides details about the cash inflows and outflows of a company during a specific period, categorizing them into operating, investing, and financing activities.
Statement of Changes in Equity: It outlines the changes in shareholders' equity, including net income, dividends, and additional capital contributions, over a specific period.
Why are financial statements important?
Financial statements are important because they provide valuable information for decision-making by various stakeholders, including investors, lenders, shareholders, and management. They help assess the financial performance, stability, and viability of a business, enabling informed decisions about investments, loans, acquisitions, and overall financial strategies.
What information can be found in an income statement?
An income statement provides information on a company's revenues, expenses, gains, and losses during a specific period. It includes details such as sales or revenue from operations, cost of goods sold, operating expenses (e.g., salaries, rent, marketing), non-operating income or expenses, taxes, and net income or loss.
What does a balance sheet indicate?
A balance sheet indicates the financial position of a company at a specific point in time. It presents the company's assets (such as cash, inventory, property, and investments), liabilities (such as loans, accounts payable), and shareholders' equity (including retained earnings and capital contributions). The balance sheet follows the fundamental equation: Assets = Liabilities + Shareholders' Equity.
What is the purpose of a cash flow statement?
The purpose of a cash flow statement is to provide insights into the cash inflows and outflows of a company during a specific period. It categorizes cash flows into operating activities (e.g., revenue, expenses), investing activities (e.g., purchase/sale of assets), and financing activities (e.g., loans, equity transactions). It helps assess the company's ability to generate cash, meet financial obligations, and identify trends in cash flow management.
How does the statement of changes in equity differ from other financial statements?
Unlike the income statement, balance sheet, and cash flow statement that focus on specific periods, the statement of changes in equity summarizes the changes in shareholders' equity over a period of time. It includes items such as net income, dividends paid, additional capital contributions, share repurchases, and adjustments for changes in accounting policies. It helps stakeholders understand the factors influencing the equity position of a company.
What are some key ratios derived from financial statements?
Financial ratios are derived from financial statements and help analyze a company's performance and financial health. Some key ratios include:
Profitability ratios (e.g., gross profit margin, net profit margin)
Liquidity ratios (e.g., current ratio, quick ratio)
Solvency ratios (e.g., debt-to-equity ratio, interest coverage ratio)
Efficiency ratios (e.g., inventory turnover ratio, accounts receivable turnover ratio)
Return on investment ratios (e.g., return on assets, return on equity)
Who uses financial statements?
Financial statements are used by various stakeholders, including:
Investors: They analyze financial statements to evaluate the profitability and financial health of a company before making investment decisions.
Lenders and Creditors: Financial statements help lenders and creditors assess the creditworthiness and repayment capacity of a company when considering loan applications or credit extensions.
Shareholders: Shareholders use financial statements to monitor the performance of the company and determine the value of their investments.
Management: Financial statements assist management in making informed decisions about resource allocation, financial planning, and strategy formulation.
Government and Regulatory Authorities: Financial statements are used by tax authorities and regulatory bodies to ensure compliance with financial reporting standards and regulations.
Analysts and Researchers: Financial analysts and researchers analyze financial statements to provide insights, forecasts, and recommendations about companies and industries.
General Public: Financial statements, especially those of publicly traded companies, are often made available to the public, allowing individuals to understand the financial health and performance of companies they are interested in or invested in.
How often are financial statements prepared?
Financial statements are typically prepared at the end of each accounting period. For most companies, this is done on an annual basis, following the fiscal year-end. However, interim financial statements may also be prepared quarterly or semi-annually to provide periodic updates on the company's financial performance.
Are financial statements audited?
Financial statements can be audited by external auditors. Auditing involves an independent examination of the financial statements to ensure they are prepared in accordance with accounting principles, accurately represent the financial position and performance of the entity, and comply with applicable regulations. Audited financial statements provide an additional level of assurance to stakeholders regarding the reliability of the financial information presented.
What is the difference between financial statements and financial reports?
The terms "financial statements" and "financial reports" are often used interchangeably, but there is a subtle difference. Financial statements refer to the formal documents that present financial information in a structured format, such as the income statement, balance sheet, cash flow statement, and statement of changes in equity. On the other hand, financial reports encompass a broader range of financial information, including narrative explanations, management discussions, footnotes, and supplementary schedules that provide additional context and insights alongside the financial statements.
Can financial statements be prepared for non-profit organizations?
Yes, financial statements can be prepared for non-profit organizations. While the format and terminology may differ slightly, non-profit organizations also produce financial statements to report their financial activities and demonstrate accountability. Non-profit financial statements typically include a statement of activities (similar to an income statement), a statement of financial position (similar to a balance sheet), a statement of cash flows, and notes to the financial statements that provide additional information about the organization's activities and financial condition.