Every organization is established with a certain purpose. Every organization has its own purpose and the objectives of the firm differ from one another. Regardless of this difference in the objective and purpose of the existence of the business organization, they all have a common in them. All of the organizations involve themselves in some money related transaction. They purchase some goods, sell some other things, pay salary, performs some investments and does several other financial related tasks. The business must analyze its financial position at a certain period so that it can make certain decisions. To simplify this task, every business organization summarizes its financial activities in some form of statements called the financial statements. Financial Statements are the formal representations of the financial activities of the company carried over a certain period. Generally, financial reports are presented in the written form to quantify the performance, financial strength, and the company’s liquidity position. These statements represent and reflect the various effects of the financial activities on the firm that are carried overtime.
There can be several types of financial statements based on the type of transactions that are recorded on it. Some kind of financial statement records the income and expenses of the business while some other form of financial statement records the entire cash inflows and outflows occurring from the company. However, it is very important to understand the financial statements for various purpose. Different financial statements must be understood in a different way, and a logical understanding must be derived from the financial statements. Understanding of the financial statement is necessary for the purpose of decision making, for the investment purpose, investment research, company’s survival and for several other purposes.
As discussed earlier, there are several types of financial statements depending upon the nature of the financial information contained in it. The three of the most common type of financial statements are a statement of income and expenses, also known as income statement, statement of cash flow and the balance sheet statement.
Different Financial Statements and Their Major Elements
In the course of business, every business decision is based on the financial health and the performance of the company, and this information is provided by the financial statements. As potential investors of the business, we seek to obtain information about how well did the company perform in the past financially, how it is performing now and how likely it is going to perform in the future. The financial statements of the company also serve for the purpose of evaluating the company’s performance with that of others in the industry to make the appropriate financial decision such as making an investment decision, valuating the stock or buying the capital equipment.
In this paper, we will discuss the three kinds of financial statements that are most importantly used by the investors.
Income Statement
The income statements summarize all the incomes and the expenses of the company over the period. The various revenues are reported in the statement which is then followed by the expenses incurred concluding with the net profit or loss during the period. The income statement is based on the primary equation as:
Net Income (Loss) = Revenues – Expenses
Generally, the income statement is prepared for a year or the period of analysis can vary depending upon the need.
The income statement is important for a different purpose for different financial information user. Investment analyst makes the use of income statement to know about the company’s incomes, expenses, and the profit trends while the banks and lenders use income statement to know about the top income source and its sustainability and quality. The direction of the profits can be monitored using the income statement. By comparing the elements of the income statement over the number of years, one can understand if the incomes, expenses, and profits are increasing or decreasing and the rate of growth or fall in these elements. This kind of information is very vital in the financial decision making.
The income statement also presents the information about the earnings per share. For the potential investor, the information about the earnings per share is very crucial because the investor is very likely to invest in those companies whose earnings per share is high. This information is also used in other ratio analysis like price-earnings ratio to make the decisions regarding the investment.
In addition to this, the income statement clearly presents the sources of incomes at the top of the statement followed by the expenses sources and the net profit at the end. By presenting the information in such a classified way, one can know which source of income is crucial to the business and which source is generating highest revenue so that the company can focus more on such sources. Similarly, the company can know about the source that is the major source of expense. The company can take appropriate measure to control the expenses if it shows unusual growth. In this way, the company can take an appropriate decision regarding income and expenses.
Balance Sheet
Even though many users of the financial information find income statement to be handy, but it cannot provide the complete information about the company’s financial position. The proper financial position is reflected by the balance sheet which shows the position of assets, liabilities, and the capital at a point of time. While the income statement provides information about the expenses and incomes over the period, balance sheet provides the value of assets, liabilities and stockholder’s ownership position at a specific date. Balance sheet is based on the following equation
Total Assets = Liabilities + Equity
The financial analysts utilize the balance sheets in order to understand the present scenario of assets and liabilities and to determine the financial situation of the firm. For example, while analyzing the trend in the inventory which is an asset as well as the invoices of suppliers or accounts payable which is a liability, it can give information about the actual demand for the product in the market and the basis on which the firm orders from its suppliers. The change in figures in the inventory such as an increase might suggest an expectation for the increase in demand in the market. Although carrying large inventory might mean an increase in demand, but the analyst must be aware that it might not be beneficial to hold a large amount of inventory.
Additionally, the balance sheet also suggests the changes in the debt of the firm and helps to understand better if it is highly levered. The equity of the firm shows the actual valuation of the firm through its book value that is used to calculate the price to book ratio. It will also show the amount that will remain after liquidation to the shareholders.
Cash Flow Statement
Lastly, the cash flow statement is another important financial statement prepared by the companies. This report provides the detail about the amount of cash that comes in and goes out of the firm. The financial statements help us understand the difference between cash and profit. It is usually the case that a firm has more profit but lack sufficient cash or vice versa.
A statement of cash flow is divided into three sections which are:
cash flow from operating activities,
cash flow from investing activities and
cash flow from financing activities.
The cash flow from operating activities section includes the cash received from daily operations of the company. In the case of selling a product in cash, this would mean a cash inflow that is an increase in the section. However, the outflow would be manufacturing products, paying the suppliers, providing employees with their salaries, and this would reduce the cash from operating activities.
The analysis of cash flow from operations is important as it helps to understand the exact amount of cash generated from the regular business operations. It would not be a good sign to escalate profit while the cash flow through operations is decreasing.
In terms of cash flow from investing activities, it refers to the buying and selling of investments. It can include property, plant, and equipment, along with other long-term assets. It can also be long and short term equity and debt through other company. Moreover, when the firm witnesses and expects the demand and growth in the market, there will be a drastic increase in outflow from this section to enhance the production to meet the demand.
In the case of financing activities, it includes getting or repaying capital. The inflows of cash include sales of stock as well as the issue of debt. Similarly, the outflows include purchasing back the stock, providing dividends, paying back the debts, etc.
The analysis of the cash flow from financing section shows the effect of an increase in debt financing leads to higher value for the shareholders. This can only be achieved if there are profits gained from the borrowed sum. The analyst must also be careful when there is an increase in debt in a greater proportion. Moreover, the company buying back its shares can also mean providing cash to the shareholders or stating the belief of management that their shares are currently undervalued.
Thus, the cash flow statement summarizes the cash flow from operation, investing and financial activities. The cash flow model is used to determine the target price level for the stock.
How the Statements Are Linked?
In order to best explain the link between the three financial statements, the example of an operating activity of the firm can be taken. Let's take an example of widget manufacturer and the process of manufacturing and selling a widget.
The widget must be manufactured before they are sold. So, an initial capital is needed to develop a manufacturing plant, to buy raw material, and to produce widgets. This will have an impact on the balance sheet and cash flow statement. There will be an increase in cash, fixed assets and inventory on the balance sheet. Similarly, there will be an effect in all three section of the cash flow statement. In the initial phase, there will be cash outflow from operating activities to produce the widgets. The company builds a manufacturing unit which reduces cash flow from investing activities. The cash flow increases when there is the issuance of debt in the financing activities.
Secondly, the widgets are sold to the consumers on the account. This means the customer does not pay cash immediately. It has an impact on the income statement and balance sheet. There is a rise in both revenues and expenses of the income statement. The balance sheet decreases as inventory reduces after the sales, but the account receivable rises due to the sales on account of the widgets.
After the collection of cash, the debts are paid or given back to the shareholders through dividends. There is an effect on the balance sheet and cash flow statement. Getting the cash from sales, there is an increase in cash and decrease in receivable in the balance sheet. The cash flow from operating activities increases.
When the dividends are paid out, and cash is used to clear the debt, the cash decreases in the balance sheet. In cash flow statement, there will be a reduction in the cash after paying debt and distributing dividends in the financing activities. This will not have an impact on the income statement.
Thus, the three financial statements are interlinked with each other when recording a transaction in the firm. It is vital to look into different statements for understanding the financial aspects of the firm. Sometimes, all the inventories are sold on the account, but the cash is not received. There will be a healthy income statement due to revenues and expenses. But, the balance sheet will showcase the increasing amount in the accounts receivable. The problem can also be discovered from the operating activities section of cash flow statement when the outflows increase in manufacturing and raw materials, but the collection of cash is zero.
Conclusion
Thus, each statement has its own significance and rule to record the transaction. Each plays a vital role in understanding the financial scenario of the firm. Moreover, the components in one statement are connected to that of another. So, if there is a fault in recording one transaction, the overall result might not be efficient and accurate. These statements are used to determine the firm's position in the industry, to understand problems arising in the firm, and to provide the value for their investment in the firm to the shareholders. This will also enable in making a comparison with a similar firm in the industry.
