Financial Statements

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.

• 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 revenues and expenses.
• Cash flows, 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 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.

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:

• Assets
• Liabilities
• Net assets (equity)
• Revenues
• Expenses

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 statement 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 flow 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 Equity 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 works.

• Under the current assets, you can consider cash, accounts receivable, rent prepaid, etc. Under the non-current assets, 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 payable, accounts payable, income tax payable, outstanding salaries, etc. As a long-term/non-current liability, you can consider long-term debt.

The balance sheet sometimes gets quite complex. The accountants need to make sure that every record is properly reported so that the total assets 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 sales 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 analysis.
• We deduct the costs of goods sold from net sales, and we get the gross profit.
• We deduct the operating expenses from gross profit, like the expenses required for daily administrative expenses. We get the EBIT, meaning the earnings before interest and taxes, 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 taxes.
• From EBT, we deduct the income taxes for the period, and we get the Net Income meaning profit after tax.

Example 3 - Cash Flow Statement

source: Colgate SEC Filings

• Cash Flow from Operations is the cash generated from the business's core operations.
• Cash Flow from Investing Activities 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 Activities 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 shares, etc.

Example 4 - Shareholders' Equity Statement

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 earnings 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/losses 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 –

• Cash Flow Statements Purpose
• Examples of SG&A Expenses
• List of Operating Expenses
• Definition of Financing Activities