Financial statements are the formal records of financial activities of a company. The overview of the profitability and financial conditions of a company for both long & short term is reflected from its financial statements. Financial statements are of the following four categories.
- Balance Sheet
- Income Statement
- Statement of Retained Earnings
- Statement of Cash Flows
Financial Statements Analysis and Purpose
The purpose of financial statements is to give information about the performance, financial strength and alteration in the financial position of a company which is beneficial for many users in their economic decision making. The financial statements must be comprehendible, reliable, relevant and comparable. The financial position of a company is directly associated with the reported assets, liabilities and equity. Similarly the financial performance of a company is directly related with the reported income and expenses.
- Balance Sheet
The balance sheet in accounting is also referred as statement of financial position, which is the summary of the value of all liabilities, owner’s equity and assets for a company or an individual on a particular date. Balance sheet is one of the most important categories of financial statements and is considered as the snapshot of financial condition of a company on a particular date. The balance sheet is the only single statement among all the four financial statements of the company, which applies to single point in time instead of a period of a time.
There are three parts of a balance sheet of a company which are assets, liabilities and shareholder’s equity. The liabilities are generally followed by the listing of the main categories of assets. The difference between assets and liabilities is referred as the net worth or net assets of the company. According to accounting equation, assets minus liabilities must be equal to net worth.
Assets are further subdivided into following two categories
- Current Assets
- Long term Assets
The current asset is referred to that asset in accounting which is used up or expected to be sold within one year or one business cycle. Common current assets include accounts receivables, inventory, cash, cash equivalents, short term investments and the part of prepaid accounts which will be used within one year.
The balance sheet mainly classifies all assets as current assets and long term assets. The current ratio is obtained by dividing total current assets by total current liabilities. The liquidity of a company is measured by this ratio which reflects the ability of company to fulfill its short term obligations.
Inventories includes list of goods and materials which are used in the manufacturing process. The inventories are maintained and properly managed by the company so that desired products are manufactured in proper time that matches with the delivery date of these products to the customers. Moreover effectively management of the inventories reduces the problems of the production process like lowering of the productivity due to the idleness of the production unit as a result of lack of materials.
- Accounts Receivables
Accounts receivables refer to the amount of money owed by the customers for receiving of goods or services on credit basis from a company. In many companies, invoices are generated and mailed to the customers for the delivery of goods on credit or bills are delivered electronically to the customers which are required to be paid within certain time period called payment terms.
The amount that customers of a company owe to it is the mentioned in the head of accounts receivables on balance sheet. In case of recording of credit sale transaction, receivable is debited and sales account is credited. When owed amount is paid by the customer, cash is debited and receivable is credited in the journal entry. The accounts receivables balance is always debited on the ending trial balance.
- Cash and Cash Equivalents
In the asset portion of the balance sheet of the company, cash and cash equivalents are most liquid assets mentioned there. Assets that are readily convertible into cash are considered as cash equivalents like short term government bonds, money market holdings, marketable securities and commercial paper etc. The cash equivalents are different from other investments on the basis of their short term range of existence. Cash equivalents are matured within the period of three months whereas short term investments mature within 12 months and long term matures more than period of 12 months.
Long Term Assets
Those assets which serve the company for more than one year period are considered as long term assets. These long terms assets include plants & equipment, land & buildings and long term investments etc. Mostly these long term assets are treated favorably in terms of taxation as compared to current assets. Tangible long term assets are generally called as fixed assets.
- Property, Plant & Equipment
Non-current assets are also called Property, Plant & Equipment (P, P&E) because these assets cannot be easily converted into cash form. On the other cash and bank accounts are current assets and considered as liquid assets. Mostly, tangible assets are considered as fixed assets.
Fixed assets generally include items such as land & building, furniture, motor vehicles, computers, fixtures, office equipment and plant & machinery. Tax favors are provided to these assets mostly which are not given to short term assets.
Liabilities include accounts payable and long term liabilities. Liabilities refer to the portion of amount that is acquired externally for financing the assets of the company.
- Accounts payable
Accounts payable include the amount of money that is owed by the company for receiving materials & supplies from other suppliers on credit basis. When invoice is received from the supplier, it is added to the accounts payable account and when this amount is reduced from the account at later time when it is paid to the relevant supplier. Generally goods are shipped by the supplier following with the issuance and delivery of invoice to the purchasing company. The invoice amount is later paid by the company.
Equity mentioned on the balance sheet shows the net assets amount. The shareholder’s equity is the amount owing to the shareholders of the company which is paid after payment of the other liabilities in case of insolvency of the company. The equity shown on the balance sheet must equal the difference between assets and liabilities. In other words
Equity = Assets – Liabilities
Equity is composed of a large number of equally valued shares which are authorized, issued and paid up. Each share has fix par value which is paid by the investor to company in order to become its part owner. The collective amount of these shares is considered as equity.
- Income Statement
The second important category of financial statements “Income statement” that is also referred as profit & loss statement which shows the profits earned by the company through its operations. It reflects the conversion process of revenue into the net income. Income statement is prepared for a specified period of time which is generally one year time. It shows that either the company makes money or lost it during the reported period.
Income statement is not produced by the charitable organizations that are required to publish their financial statements. Rather, these charitable organizations generate similar statement that shows the point that charity is not operating to make profit.
Income statement contains the following component parts.
- Cost of Goods Sold
- Gross Profit
- Operating Revenue
- Non-Operating Section
Cost of Goods Sold
Cost of goods sold includes all those costs that are directly incurred in the production of the product of a company. These directly incurred costs include material costs and labor costs to manufacture a finished product. The overhead costs are also included in this category. Other indirect expenses are excluded from this category like sales force costs, distribution costs etc.
Gross profit is the profit obtained from the difference of the sales and cost of goods sold. It does not include the deduction of taxation, indirect costs and interest payments etc. Gross profit is an important measure of the profitability of a company but many small companies fail because they ignore the regular demand to fulfill the fixed costs of the business.
It includes Revenue, Expenses, General & Administrative Expenses (G&A), Selling Expenses, Research & Development Expenses, Depreciation.
It includes all the cash inflows or other increase in assets of a company during a specified period of time from the manufacturing or delivering of good, offering of services or even other activities too. It is generally given by sales minus sales discounts, allowances and returns.
These include the cash outflows or incurrence of liabilities or utilization of assets by a company during a period from manufacturing or delivery goods, offerings services, or even other activities too.
- General & Administrative Expenses
It indicates the expenses that are incurred to manage the business like legal & professional fees, utilities, insurance, office salaries etc.
- Selling Expenses
The expenses required to sell products are included in this head like advertising, sales salaries & commission, shipping, freight etc).
- R&D Expenses
The expenses included in the research and development purpose are categorized in this head.
It includes the charge against the reduction in the useful working life of fixed asset.
It includes Other Revenues or Gains and Other expenses of Losses items.
- Other Revenues or Gains
It includes incomes and gains from activities that not regarded primary business activities. These gains are unusual in nature.
- Other Expenses or Losses
It includes the expenses and losses that are not associated with the primary business activities.
- Earnings before Interest & Taxes (EBIT)
EBIT reflects the profitability of a company and is generally considered as operating profit or operating income. It is evaluated as revenue minus expenses (excluding interest & tax expense). It is given by
EBIT = Revenue – Operating Expenses
- Net Earnings
Net earnings shows the actual earnings of a company after deducting all the expenses from gross sales like interest, depreciation and taxes etc. net earnings are considered as the one of most important evaluator of performance of a company.
Statements of Retained Earnings
The next and third important thing which is recorded in the financial statements is the record of retained earnings or losses. In accounting terms retained earnings include that part of income which is not being distributed to the shareholders and retained inside the company for future reinvestment purpose. Besides income, loss can also be retained by the company if it incurred. Retained earnings accumulate from one year to another.
Retained earnings can be seen in the equity portion of the balance sheet. But for the complete information about the retained earnings or retained losses, there is always create separate statements for both retained earnings and losses.
Statements of Cash Flows
The form of financial statements that records the cash generated and used within a specific period of time is known as cash flow statements. The time period may vary from 3 months to 12 months depends on the company management decisions. There are probably 4 categories, which are recorded in the cash flow statement.
- Operating Activities
- Investing Activities
- Financing Activities
- Supplemental Information
Operating activities are all about the day to day to activities and expenses of business, like manufacturing, selling and marketing expenses, etc which occurred on daily basis.
Investing activities probably relate to the investing in selling and purchasing of products and services, properties, plants and equipment, etc.
Financing activities belongs to selling and purchasing of bonds and stock, etc in the financial market and is also recorded in the financial statements and in cash flow statement.
Supplemental information that is also recorded in the cash flow statement, is the information or items that did not involves in cash, like taxes paid or interest paid, etc are known as supplemental information for business.