Financial statements are the formal records in which companies depict, represent and publish their performance in terms of cash flow, profits, liabilities, assets, and retained earnings.
There are three main financial statements used in accounting and finance, which are:
1. The Balance Sheet (Statement of Financial Position)
2. The Income Statement (Profit and Loss Account)
3. The Cash Flow Statement
The Balance Sheet
The Balance Sheet shows the assets and liabilities, which make up the company’s financial position at a specific date in time. The Balance Sheet is based on the fundamental accounting equation:
Assets = Liabilities + Owners Equity
Capital refers to the total amount fully paid up shares and retained earnings of the company. The Balance Sheet has to balance and the sum of assets must equal the sum of liabilities and capital. If it does not balance, a mistake has occurred.
Assets and liabilities are classified as current and non-current. Current means relatively liquid and can be turned into cash relatively quickly (usually within a year) and are assumed to be what the business utilizes during its routine trading activities. Current assets include inventory, receivables and cash. Non-current is where the monetary value of the asset or liability is not utilized within a year. Non-current assets are therefore assets which are not as liquid in nature they are sometimes referred to as long term assets. They are not used as part of daily trading in cash terms and include machinery, buildings and land. A current liability of a company is a debt that is payable within one year, wages are an example of a current liability. A non-current liability is often referred to as a long term liability (not be repayable in the following 12 months) these include long term borrowing such as a mortgage or a long term lease on an office or warehouse. The capital will include amounts for the share capital and retained earnings, you may also see a share premium or a revaluation reserve in this section.
The Balance Sheet is a snap shot of the company’s financial position at a set date in time and is often used in financial analysis to compare one year with another or one quarter with another. This is often described as a photograph of the company’s financial position. The Balance Sheet is also important to investors for several reasons including the level of current assets that could be utilized to pay back loans etc. and as a performance indicator based on the company’s history and standards within the industry that the company operates. Investors may apply financial ratios the to analyse the Balance Sheet and produce recommendations and information based on mathematical comparisons.
Profit and Loss Account
The Profit and Loss Account presents the results of a company’s trading activities during a period of time (e.g. one financial year). The net income is given from subtracting expenses from revenue (turnover or sales) to give a net profit or loss. The Profit and Loss Account can be divided into two parts, the operating part which provides information about the company’s principle trading activities and non-operating part which can relate to gains and losses not directly generated through normal trading activities. Financial analysts use this to understand what makes a company profitable and where there may be savings to be made that may affect future revenue.
The Cash Flow Statement
The Cash Flow Statement is another mandatory financial statement which compliments the profit and loss account and the balance sheet. It looks at the company’s sources of cash and cash equivalents in relation to movements in the balance sheet and income. The Cash Flow Statement will consider cash from three main areas, operating activities, investment activities and financing activities. These will also form the three sections of the Cash Flow Statement.
It is important to remember that an accounting profit does not necessarily mean that the company has the physical cash to meet its financial obligations. The Cash Flow Statement is very important as it shows quickly whether the company has the ability to remain liquid and survive.
This, using a simple example, can be when a company buys $1 million worth of stock with a thirty-day credit period and then sells $0.5 million (cost) to another company for $0.75 million cash and the remaining $0.5 million (cost) to another company for $0.8 million on a 90 day credit term. The company is in profit i.e. has revenues of $1.55 million (0.75 + 0.8) against expenses of $1.0 million ($0.55m profit), however has a shortfall in the cash balance of $0.25 million for 90 days which may force the company to close if there is insufficient cash already available to cover this period.
The Cash Flow Statement represents all the transactions within a company and shows where cash has been obtained and been spent. Cash is crucial to the day to day running of the majority of businesses so without a positive cash flow they may need to increase borrowing meet running costs.