Financial Statements Definition
Financial statements are written reports created by a company’s management to summarize the financial condition of the business over a certain time period (quarter, six monthly or yearly). These statements, which comprise the balance sheet, income statement, cash flow statement, and statement of shareholders equity, must be prepared in accordance with specified and standardized accounting standards to ensure that reporting is consistent at all levels.
- Financial Statements provide a representation of a company’s financial performance over time.
- Balance Sheet provides the details of the company’s sources and uses of funds.
- Income Statement provides an understanding of the revenues and the expenses of the business.
- Cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. , on the other hand, tracks the movement of cash in the business.
- Statement of Changes in Shareholders’ equity provides a summary of shareholders’ accounts for a given period.
Basics of Financial Statement
Now, let’s look at the basics of financial statements along with a practical example.
#1 – Balance Sheet
The balance sheet is a financial statement that provides a snapshot of the assets, the liabilities, and the shareholder’s equity. Many companies use the shareholders’ equity as a separate financial statement. But usually, it comes with the balance sheet.
The equation that you need to remember when you prepare a balance sheet is this –
Assets = Liabilities + Shareholders Equity
Let’s look at a balance sheet so that we can understand how it works –
source: Colgate SEC Filings
The above is just a snapshot of how the balance sheet works.
- Under the current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc., you can consider cash, accounts receivable, rent prepaid, etc. Under the non-current assetsNon-current AssetsNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company's investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark., we can put equipment, plant, building, etc.
- The idea is to follow a sequence from more liquid to less liquid.
- At the same time, on the other hand, you can consider notes payableNotes PayableNotes Payable is a promissory note that records the borrower's written promise to the lender for paying up a certain amount, with interest, by a specified date. , accounts payableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period., income tax payable, outstanding salaries, etc. As a long-term/non-current liability, you can consider long-term debtLong-term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability..
The balance sheet sometimes gets quite complex, and the accountants need to make sure that every record is properly reported so that the total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity always equal total liabilities plus shareholders’ equity.
#2 – Income Statement
The income statement is the next financial statement everyone should look at. It looks quite different than the balance sheet. In the income statement, it’s about the revenue and the expenses.
source: Colgate SEC Filings
- Well, it starts with the gross salesGross SalesGross Sales, also called Top-Line Sales of a Company, refers to the total sales amount earned over a given period, excluding returns, allowances, rebates, & any other discount. or revenue. Then we deduct any sales return or sales discount from the gross sales to get the net sales. This net sale is what we use for ratio analysisRatio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements..
- From net sales, we deduct the costs of goods sold, and we get the gross profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services..
- From gross profit, we deduct the operating expenses like the expenses required for daily administrative expenses. By deducting the operating expenses, we get the EBIT, meaning the earnings before interest and taxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital..
- From EBIT, we deduct the interest charges paid or add interest received (if any), and we get EBT, meaning earnings before taxesEarnings Before TaxesPretax income is a company's net earnings calculated after deducting all the expenses, including cash expenses like salary expense, interest expense, and non-cash expenses like depreciation and other charges from the total revenue generated before deducting the income tax expense..
- From EBT, we deduct the income taxes for the period, and we get the Net Income, meaning profit after taxMeaning Profit After TaxProfit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business..
#3 – Cash Flow Statement
Cash Flow Statement is the third most important statement every investor should look at.
There are three separate statements of a cash flowStatements Of A Cash FlowStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities. statement. These statements are cash flow from the operating activities, cash flow from investing activities, and cash flow from finance activities.
source: Colgate SEC Filings
- Cash Flow from OperationsCash Flow From OperationsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital. is the cash generated from the core operations of the business.
- Cash Flow from Investing ActivitiesCash Flow From Investing ActivitiesCash flow from investing activities refer to the money acquired or spent on the purchase or disposal of the fixed assets (both tangible and intangible) for the business purpose. For instance, the purchase of land and joint venture investment is cash outflow, while equipment sale is a cash inflow. relates to the cash inflows and outflows related to investment in the company like buying of property, plant, and equipment or other investments.
- Cash Flow from Financing Activities relates to the cash inflows or outflows related to debt or equity of the company. It includes raising of debt or equity, loan repayments, buyback of shares, and more.
#4 – Statement of Changes in Shareholders Equity
Statement of Changes in Shareholders Equity is a financial statement that provides a summary of changes in the shareholder’s equity in a given period.
source: Colgate SEC Filings
- Common Stock is the first and most important component of shareholders’ equity. Common stockholders are the owners of the company.
- Additional Paid in Capital means when the company receives a premium on the shares.
- Retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company. or losses are accumulated from the previous period. In simple terms, retained earnings are the amount the company keeps after paying the dividend from net income.
- Treasury shares are the sum total of all the common shares that have been purchased back by the company.
- Accumulated Other comprehensive income contains unrealized gains/lossesUnrealized Gains/lossesUnrealized Gains or Losses refer to the increase or decrease respectively in the paper value of the company's different assets, even when these assets are not yet sold. Once the assets are sold, the company realizes the gains or losses resulting from such disposal. that do not flow through the income statement.
Financial Statements Video
This has been a guide to what are financial statements and its definition. Here we discuss the basic overview of financial statements – balance sheet, income statement, cash flows, and statement of changes in shareholders equity. You may learn more about basic accounting from the following articles –