Importance of Financial Statements
Financial Statements are very important as it accurately reflects business performance and financial position of the company. Additionally, it helps all stakeholders including management, investors, financial analyst etc to evaluate and take suitable economic decisions by comparing past and current performance and therefore predict future performance and growth of the company.
In this article, we provide the list of top 10 importance of financial statements –
#1 Importance of the Balance Sheet
The balance sheet shows the financial position of the company and provides detailed investments of the companies asset investments. The balance sheet also contains the companies debt and equity levels. This capital mix helps investors and creditors understand the position and the companies performance
There are differences in which various items are reported in IFRS and US GAAP. For example, long-lived assets, inventory, intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. , leases, impairment of longed lived assets as well as taxes
#2 Importance of Income Statement
The balance sheetBalance SheetA 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. is a snapshot of the companies assets, liabilities, equity, and debt. It does not show what actually happened in the period that caused the company to get to the position where it is now. Therefore, profit figures on the income statement are importantIncome Statement Are ImportantThe 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. to the investors.
Income statement formatIncome Statement FormatThe standard format for preparing a company's income statement starts with the sales revenue figure of the business and then adds other income to it. After deducting all business expenses from the total amount of revenue and other income generated, the net profit/loss of the business organization is determined. contains sales, expenses, losses, and profit. Using these statements can help investors evaluate the companies past performance and determine the future cash flows
IFRS and US GAAP also have a difference in the classification of certain expenses like restructuring chargesRestructuring ChargesRestructuring Cost is the one-time expense incurred by the company in the process of reorganizing its business operations. It is done to improve the long term profitability and working efficiency. This expenditure is treated as the non-operating expenses in the financial statements., shipping costs, and handling costs. The necessary expense of depreciation and discontinues operations are also treated very differently.
#3 Importance of Cash Flow Statement
Cash flow statementCash Flow StatementStatement 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. shows the inflow and the outflow of the cash flow in and out of business during the financial period. This gives the investors an idea if the company has enough funds to pay for its expenses and purchases.
The cash flow statement has all three main headings, i.e Operating, Investing, and Financing. This gives the business an overview of all the entire business
Under the US GAAP interest received and paid will be a part of operating activities while under IFRS interest received will be a part of operating or investing activities. Interest paid will be a part of operating or financing activitiesFinancing ActivitiesThe various transactions that involve the movement of funds between the company and its investors, owners, or creditors in order to achieve long-term growth are referred to as financing activities. Such activities can be analyzed in the financial section of the company's cash flow statement.. Similarly, under US GAAP dividends received will be a part of operating activitiesOperating ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production. while dividends paid will be a part of financing activities and under IFRS, dividends received will be a part of operating activities while dividends paid will be a part of the financing
#4 Importance of the Statement of Equity
This is primarily important to the equity shareholders because it shows the changes in the components like retained earnings during the periodRetained Earnings During The PeriodRetained 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.. The difference between equity and debt shows the companies net worthCompanies Net WorthThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus..
A company with a steady increase in retained earnings is sustainable as opposed to increasing shareholderShareholderA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. base
#5 To the Management
The complexities and the size of the business make it necessary for the management to have up to date, accurate and detailed information of the business and the financial position. The financial position helps the management in understanding the performance of the company in comparison to the other businesses and the sector.
Providing management with accurate information enables them to form proper policies for the companies and take correct decisions
The performance of management is ranked by these statements, the performance of these statements will help management justify their work to all the parties involved in the business
#6 To the Shareholders
Shareholders are the owners of the business but do not take part in making decisions and day to day activities. However, these results are shared with the shareholders at the AGM AGM AGM stands for annual general meeting. It is an official gathering of the stockholders and directors of an incorporated company in every calendar year to ensure that there is 100 percent compliance concerning all the lawful requirements like preparation and presentation of its financial statements.held annually.
These statements enable the shareholders to understand how the company has been performing. It also allows them to judge the present and future performance
Financial statements are the most important source of information for current and prospective customers. They also need it to understand the dividend payout ratioDividend Payout RatioThe dividend payout ratio is the ratio between the total amount of dividends paid (preferred and normal dividend) to the company's net income. Formula = Dividends/Net Income and forecast the future dividends
#7 To the Creditors and the Lenders
Factors like liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses., debt, profitability are all judged by the essential metrics in the financial statements. Creditors and Lenders are most concerned about the companies debt position. If the debt level is higher than the other companies in the same industry, it means that the company is over-leveraged
Analyzing these statements will help them decide if they want to continue and determine the future course of action.
#8 To the Employees
There are companies that present a different financial statement for its employees. Employees need business information for mainly two reasons their current wage and future salary appraisals. They will be interested in knowing the current condition as well as the future earnings
#9 To the Government
This is another importance of the financial statements that the government uses financial statements for taxation purposes. The government uses the business performance of these companies in various sectors to assess the economies performance
#10 To the Company
Debt can cripple the progress of any company no matter which sector the company belongs to. Ratios like debt to equity, interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt., debt service charge, etc. help the management take important decision related to debt
Trend analysis of the future metrics and identify the trend of both past and present. This will help the business understand the current weakness and overall health of the company
By getting accurate and regular information, decisions can be made quickly and swiftly. This helps in avoiding roadblocks and maintaining financial liquidity at the same time
If the company wishes to borrow any money, then it can have a look at the current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc. by using the financial statements. Business loans, credit cards are the types of liabilities that the company must consider before applying for further loans
It is mandatory for all public companies to publish financial statements quarterly or annually. Hence to also be compliant with the government norms it is necessary to publish these statements
There are also differences in the layout of the balance sheet and income statement. There is no specific requirement for balance sheet and income statement; however, public companies must follow the particular guidelines as per the regulation by the SEC. In the case of IFRS, there is not a prescribed layout but has a limitation on the number of line items.
This has been a guide to the Importance of Financial Statements. Here we provide a detailed explanation of the top 10 reasons why financial statements are essential. You can learn more about accounting from the following articles –