Monitoring one's personal income and expenditure is always a great practice. It acts as a stepping stone for excellent financial planning. But this is not limited to just individuals. This also applies to companies and other forms of business organizations.
A business has innumerable transactions throughout its existence, and finance being a limited resource, it becomes extremely crucial to utilize it judiciously. To ensure judicious utilization, the financial transactions must be accounted for. Besides, it is also important for the management to keep the owners, i.e., shareholders informed about the performance and financial position of the company.
And for this very reason, financial statements are prepared.
What are Financial Statements?
The financial statements comprise the Income Statement, the Balance Sheet, Cash Flow Statement, Statement of changes in equity, if applicable, and the notes. For a company having a single line of business, standalone financial statements are prepared. However, for a company like a conglomerate, both standalone and consolidated statements are to be prepared.
In today’s article, we will understand the basic features of these financial statements and what they consist of.
Previously known as the Profit and Loss statement, this statement represents the company's profitability. Profit is nothing but an excess of revenue over the expenses of an organization. The income statement projects the income and expenditures of a company for a specific period. For example, the period could be yearly, half-yearly, or quarterly.
The statement states the revenue earned from the primary business activity and income and gains from any other source. From this, various revenue expenditures incurred are deducted. Finally, tax and other items are adjusted to arrive at the net profit for the year.
The Balance Sheet is another important financial statement of a company. This statement lists all the assets, liabilities, and capital of the enterprise. In simpler terms, assets are all those expenditures a company incurs that yield a return for a period of time. Liabilities are the amounts owed to outsiders. Finally, capital refers to the funds borrowed from either the owners or outside parties.
The balance sheet has 2 major parts: assets, liabilities, and capital. The total of assets must be equal to the total of liabilities and capital. This balancing proves the dual principle concept that states that every credit has an equal debit, which implies that every transaction involving an outflow will have a corresponding inflow. You can equate this to the third law of Newton!
Cash Flow Statement
A cash flow statement projects the outflow and inflow of cash and cash equivalents. Cash equivalents include all those short-term financial instruments that can be converted into cash in a short period.
This cash flow statement is divided into three major parts, cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Each has its own significance.
Cash flow from operating activities is the most important section. This section reveals the cash inflow and outflow pertaining to the primary activity of the business.
Cash flow from investing activities explains how much cash is expended on acquiring and maintaining fixed assets and any income earned. The cost of the fixed assets, depreciation charged on them, and any gain realized on disposing of the fixed asset are included in this section.
Cash flow from financing activities explains the inflow and outflow of debt and equity. Debt includes long-term loans, debentures, or other funds procured, and equity refers to the share capital that the company owns.
The total of the above items gives the increase or decrease of cash and cash equivalents during that period. This statement explains the liquidity position of the company.
Statement of changes in equity
As the name suggests, this statement reveals the changes in the shareholders’ equity, accumulated reserves, and retained earnings of an organization. It gives comprehensive information regarding the bifurcation, amount received and balances on shares issued, types of shares issued, and any amount transferred from the reserves or retained earnings. It also explains the various reserves that a company has and their respective balances.
Notes and other statements
The items mentioned in the above statements are done in the form of line items which means one figure is mentioned for an item. For example, there are a line item “investments” under non-current assets in the balance. You will find only a single amount on the balance sheet. That does not necessarily mean that there is just one investment. The company could have invested in various avenues. This detailed information is mentioned in the notes to accounts. For every line item mentioned in the statement, sections of notes to accounts give an explanation. So the next time you look into one of the above statements and need clarification, you know where to head to!
Notes to accounts also specify the various accounting policies and procedures that a company undertakes to prepare the statement, the contracts entered into, the accounting standards applied, and other relevant information.
Importance of financial statements
Financial statements help the management, owners, government, financial institutions, investors, and other users of accounting information, get a clear picture of the various financial transactions that occur.
For individuals who have just stepped into the game of stock market investing, the figures in the financial statements are sufficient to understand the financial performance and position of the company.
For the management, professional investors, and financial analysts, financial statement analysis is crucial. The statements prepared provide them information to use tools like ratios and perform further analysis.
Also, these statements are presented for 2 years, that is, the current and the previous year. This eases comparison.
Now that we know the various financial statements and their importance let’s look into the concept of window dressing.
Sometimes, when a company with many shareholders does not perform well, the management manipulates the statements to project better figures and better performance to its shareholders. It is also done to procure funds from a lender or qualify for a loan. This is what is known as the “window dressing” of financial statements.
Many Indian companies have been doing this. The most famous is the “Satyam scandal.”
Of course, this process is unethical. One way you can stay away from companies window dressing their statements is by comparing the financial statements for a period of at least 5 years. Doing this may help one understand any discrepancies.
Financial statements are an important element of a business for legal and other purposes. They serve a variety of purposes. What we understood today was a fundamental concept of these statements. But if dug deeper, it’s a huge pool of information to be understood and analyzed.
As an investor, financial statements hold a vital role in decision-making, and you should properly analyze them before jumping into investing in any company.
Invest in what you know.