Financial Statements Definition
Financial statements are written reports created by a company’s management to summarize the business’s financial condition over a certain 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 by specified and standardized accounting standards to ensure that reporting is consistent.
Financial statements are credentials that ensure investors and other stakeholders have the opportunity to learn about the current financial status of a company before they make investments or other strategic decisions. They can compare every statement prepared to check the actual status of the entities they want to associate with.
Table of contents
- Financial Statements provide a representation of a company’s financial performance over time.
- The balance sheet provides the details of the company’s sources and uses of funds.
- An income statement provides an understanding of the revenuesThe RevenuesRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions. and expenses.
- 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 summarizes shareholders’ accounts for a given period.
Financial Statements Explained
Financial statements are records that reflect how a company has performed financially in a fiscal year. These are prepared monthly, quarterly, and annually based on the purposes they are used for. Though companies can have one statement to showcase their financial inflow and outflows, it is difficult for the stakeholders to depend on one record for making major decisions. Thus, they have to develop more than one statement to ensure the readers get a clear picture of their financial status and their performance.
If the financial statements of a company depict improvement in performance, it signifies growth. As a result, investors know that investing in the entity would be a good idea. On the other hand, if the expenses, debt, and costs recorded in the statements are more than the revenue, income, and profits, the company’s performance is doubtful. This, in turn, refrains investors from investing in those entities.
Financial Statements Video Explanation
The preparation of financial statements includes specifications regarding the transactions made, be it revenue generated or expenses incurred. These details are listed under different categories, which constitute the elements or components of the financial statements. Some of them are:
- Net assets (equity)
Now, let us look at the types of financial statements below:
#1 – Balance Sheet
The balance sheet is a financial statement that provides a snapshot of the assets, liabilities, and shareholders’ 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
#2 – Income Statement
The income statementThe Income StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. is the next financial statement everyone should look at. It looks quite different from the balance sheet.
#3 – Cash Flow Statement
The 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 FlowA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business. statement. These statements are cash flow from the operating activities, cash flow from investing activities, and cash flow from finance activities.
#4 – Statement of Changes in Shareholders Equity
Statement of Changes in Shareholders EquityShareholders EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period. is a financial statement that summarizes changes in the shareholder’s equity in a given period.
Let us consider the following examples to see how the transactions are recorded and how to read them:
Example 1 – Balance Sheet
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 worksHow The Balance Sheet WorksA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company..
- 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. 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.
Example 2 – Income Statement
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..
- We deduct the costs of goods sold from net sales, 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..
- We deduct the operating expenses from gross profit, like the expenses required for daily administrative expensesAdministrative ExpensesAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts.. 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., by deducting the operating expenses.
- 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..
Example 3 – Cash Flow Statement
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 business’s core operations.
- 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 investments in the company like buying property, plants, and equipment or other investments.
- Cash Flow from Financing ActivitiesCash Flow From Financing ActivitiesCash flow from financing activities refers to inflow and the outflow of cash from the financing activities like change in capital from securities like equity or preference shares, issuing debt, debentures or repayment of a debt, payment of dividend or interest on securities. relates to the cash inflows or outflows related to the debt or equity of the company. It includes raising debt or equity, loan repayments, buyback of sharesBuyback Of SharesShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company., etc.
Example 4 – Shareholders’ Equity Statement
source: Colgate SEC Filings
- Common Stock is the first and most important component of shareholders’ equityShareholders' EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period.. Common stockholders are the owners of the company.
- Additional Paid in CapitalAdditional Paid In CapitalAdditional paid-in capital or capital surplus is the company's excess amount received over and above the par value of shares from the investors during an IPO. It is the profit a company gets when it issues the stock for the first time in the open market. 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 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.
Consolidated financial statements are of great importance. Below are some of the ways in which these statements can be used:
- No matter which type of financial statement it is, each of them helps assess the financial status and performance of a company based on the elements they individually take into account.
- Whether these statements are separately considered or taken into account as a consolidated credential, they are used as the major source of information for stakeholders, especially investors, helping them make wise and well-informed decisions.
- The detailing in the records helps stock traders to decide whether they should invest in the assets of a particular company.
- The companies use these statements for policy-making, thereby deciding on the company’s taxation and other aspects.
The analysis of financial statements serves to be helpful for both the management and investors. As stated above, the investors go through the records to understand how the companies are growing and decide whether they should invest in the assets offered for trade in the market.
On the other hand, the management uses the analysis report to make strategic decisions, keeping in mind the growth of the business and its expansion.
Though these credentials are a must for record-keeping and further decision-making, there are a few limitations that one must know of:
- The transaction records in the financial statements are based on a specific period, which may or may not reflect the present financial status of the companies.
- There are chances of miscalculation, tampering, or fraud in the record-keeping, which makes it difficult for the readers to rely on the details completely.
- Referring to only one financial statement is never a good idea. Hence, one must analyze the financial statement individually as well as have a look at the consolidated detail to ensure the derivations are better, clearer, and more reliable.
This has been a guide to what are Financial Statements. Here we explain these with examples, their types, elements, uses, importance, and limitations. You may learn more about basic accounting from the following articles –