A financial statement is a compilation of financial data, arranged and organized according to the accounting principles. It presents the financial data of an entity in a concise form.
Financial statements play a very important role in reporting the financial strength and weakness of any business organization.
Financial statements can be used in the analysis of the firm for the following purposes:
- To assess the liquidity position of the firm.
- To assess the operating efficiency of the firm.
- To assess the profitability of the business.
- To determine the importance of different components of the financial position of the firm.
- To identify the reasons for the change in the financial position of the business.
There are three basic financial statements.
- Balance Sheet
- Income Statement
- Statement of Cash Flows
These are often called general-purpose financial statements because they provide general information for use by all external users.
What is the Balance Sheet?
The balance sheet is one of the basic financial statements. It is more formally referred to as the statement of financial position. The balance sheet reports the financial position of an entity at a specific point in time. The financial position is reflected by the assets of the entity, its liabilities or debts, and the equity of the owner.
A balance sheet has two sides:
- Liabilities & Owners’ Equity
Note that the two sides of the balance sheet are always equal.
The asset side of the balance sheet is the list of assets, which the business entity owns.
The liabilities side of the balance sheet is the list of owner’s claims and outsider’s claims, i.e., what the business entity owes.
The equality of the assets side and the liabilities side of the balance sheet is an undeniable fact and this justifies the name of the accounting equation as balance sheet equation also.
The basic accounting equation for the balance sheet is as follows.
Assets = Liabilities + Equity
Format of Balance Sheet
A balance sheet can be presented in the following layout mode.
- Account or Horizontal Format
- Narrative or Vertical Format
Heading of Balance Sheet
The heading of the balance sheet indicates:
- the name of the entity
- the name of the statement
- the date of Balance sheet
A balance sheet is prepared at the close of business on the last day of the income statement period.
For example, if the income statement is for the year ending March 31, 2019, the balance sheet is prepared at midnight March 31, 2019.
Main Sections of Balance Sheet
The balance sheet is divided into three main sections:
- Owner’s equity
Assets are the resources a company owns. Assets are used by the company in its operations to generate sales and profits.
Some examples of assets are;
1. cash and cash equivalent
2. inventories (goods held for sale),
3. land, buildings, and equipment
4. patents, trademarks, and copyrights
Liabilities are obligations or debts that the company has to pay at some time in the future.
Some examples of liabilities are;
1. amounts owed to suppliers for goods or services bought on credit,
2. borrowed money (e.g., money owed on bank loans),
3. salaries and wages owed to employees,
4. taxes owed to the government, and services to be performed
Owner’s equity represents the claims by the owner of a business to the assets of the business.
Theoretically, the owner’s equity is what would be left if all liabilities were paid, and it is sometimes said to equal net assets.
What is the income statement?
The income statement is referred to by various names, such as the statement of profit and loss, the statement of income, statement of operations, statement of earnings, or others.
Whatever name is used, its purpose is the same:
To provide users of the financial statements with a measurement of a reporting entity’s results of operations over a period of time.
This allows users to make important investing, lending, and other decisions by understanding trends of key measures such as sales and profitability.
The reporting period covered by the income statement can be a month, quarter, half-year or year.
But generally, the reporting period of the income statement is of one year.
Proft for the period is the excess of income over expenses for that time. If expenses for the period exceed income, a loss is incurred.
Format of Income Statement
The income statement can be presented in two formats:
- one-step format
- two-step format.
In a “one-step” format, revenues and gains are grouped together, and expenses and losses are grouped together. These amounts are then totaled to show net income or loss.
This is simple and easy to prepare but it doesn’t give the external users of the financial statements much information about the company operations.
Here is an example of a one-step format of income statement;
In a “two-step” format, subtotals are used to show decision-useful line items such as gross margin and operating income separately from nonoperating income and net income or loss.
Many commercial and industrial reporting entities use a “two-step” format.
Here is an example of a two-step format of income statement;
Heading of Income Statement
The heading of the income statement indicates:
- the name of the entity
- the name of the statement
- the time period covered by the statement.
What is the Statement of Cash Flows?
The statement of cash flows is a primary financial statement. The statement of cash flows acts as a bridge between the income statement and balance sheet by showing how money moved in and out of the business.
Generally, It is prepared for each period for which an income statement is presented.
A cash flow statement serves the following purposes:
- It provides information for planning the short term financial needs of the firm.
- It helps the management to assess whether it will have enough cash to meet day to day expenses.
- It is helpful in preparing the cash budget as it informs about and the deficit period of cash.
- It helps in the comparison with the cash budget which in tum helps in ascertaining the extent to which the financial resources of the firm have been generated and used as per the plan.
- It studies the trend of cash receipts and payments and enable management to assess the true position of cash in the future.
- It is helpful in ascertaining the flow of cash from the various activities separately.
Format of the statement of cash flows
There are two methods of preparation and presentation of the statement of cash flows.
- Direct method
- Indirect method
Here is a sample Statement of cash flows under the Direct Method. You can download this sample in Excel Format.
Main Sections of Statement of Cash Flows
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
Cash flows related to operating activities may be presented in one of two ways — the direct method or the indirect method.
The presentation of investing and financing activities are identical under the direct and indirect methods.
Although the presentation of operating cash flows differ between the two methods, both methods result in the same amount of net cash flows
The large majority of reporting entities elect to use the indirect method for preparation and presentation of the statement of cash flows.
Qualitative characteristics of financial statements
The qualitative characteristics that make the information provided in financial statements useful to users. The four principal qualitative characteristics are:
It is essential that the information provided in financial statements is readily understandable by users. Users are assumed to have a reasonable knowledge of business and economic activities and accounting, and a willingness to study the information with reasonable diligence.
Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations.
The information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully what it either purports to represent or could reasonably be expected to represent.
Comparability means that users must be able to compare the financial statements of an enterprise over time to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different enterprises to evaluate their relative financial position, performance, and changes in financial