“Show me the money!” is no doubt one of the most popular movie lines ever. 24 years after the Jerry Maguire movie, the statement makes even more sense. That’s because this is exactly what accountants do with Financial Statements. We show you where the money is!
Imagine running a business without keeping tabs on what money flows into and out of the enterprise. Financial Statements represent a formal record of the financial activities of a person, business, or entity. These are written records of the financial situation of a business. A Financial statement is what you get from documenting masses of data obtained primarily from the accounting system of a business.
Being one of the essential components of business information, Financial Statements showcase the financial strength, performance and liquidity of a company. They are also the primary means of communicating financial information to external (outside) parties.
Components of financial statements
There are five main components of financial statements. Together, they operate to give an accurate picture of the overall health of your business. These components are as follows:
- Income statements
- Balance sheets
- Cash flow statements
- Statements of shareholders’ equity; and
- Notes to financial statements
To help you better understand what financial statements are and what they do, we will explain each of these components.
Income Statement
The income statement is the most commonly used instrument of a financial statement. Also known as the Profit and Loss Statement, it is a report that shows the financial results of a person or business over a specific period of time whether monthly, quarterly or annually.
The Income Statement highlights the financial performance of an entity in terms of net profit or loss over a period of time. It also comprises two elements:
- Income: This is the totality of revenue. It includes earnings over a period of time. These includes sales, revenue, rentals, royalties, dividend income etc.
- Expense: These are the costs incurred by a business. These often include selling, general and administrative expenses, wages and salaries, depreciation, rental charges, etc.
Eventually, it is by deducting expenses from income that the overall net profit or loss is calculated and determined.
Balance Sheet
The Balance Sheet, also known as the Statement of Financial Position, indicates the financial position of an entity at a given date. It is typically of essence to lenders, investors, and creditors to estimate the liquidity of a business. This is because the Balance Sheet is a report that summarizes the assets, liabilities, and equity of an entity at any particular period. It is often stated at the end of the reporting period.
The specific type of business operated will determine what items should be included in the balance sheet. These items are often presented in their order of liquidity. Thus, the assets most easily convertible into cash are listed first. Likewise, the liabilities due for settlement soonest are also listed first. Typical line items included in the balance sheet (by general category) include:
- Assets: The list of ‘things’ owned by a person or entity. These include cash, inventory, marketable securities, prepaid expenses, accounts receivable, and fixed assets.
- Liabilities: The list of ‘things’ that is owed. Usually, these covers accounts payable, accrued liabilities, customer prepayments, taxes payable, and short-term and long-term debts.
- Equity: This basically covers the interests of the owners. The Equity in a business represents the amount of capital that remains after assets are used to settle outstanding liabilities. In essence, Equity represents the difference between the assets and liabilities.
For a balance sheet to be considered ‘balanced’, the total amount of assets listed must equal the total liabilities and equity listed on the balance sheet. Thus: Assets = Liabilities + Equity.
Statement of Cash Flow
As the name implies, the statement of cash flow is the financial statement that describes the flow of cash into and out of your business. The Cash Flow Statement showcases the movement in cash and bank balances over a period of time. Cash flows in a financial statement are typically classified under the following headings:
- Operating Activities: These represent the cash flow or revenue-generating activities of a business. Cash received or paid out for product sales, supplier and lender invoices, payroll, etc., are examples of operating activities.
- Investing Activities: These are cash flows from the procurement or sale of assets other than inventories. Investing Activities constitute payments made to acquire long-term assets. They also include cash received from the sale of assets.
- Financing Activities: Cash flow generated or spent on raising and repaying share capital and debt including, the payments of interest and dividends are regarded as Financing Activities. These generally cover activities that will alter the equity or borrowings of a business. Sale or repurchase of company shares and dividend payments are typical examples of financing activities.
A Statement of Cash Flow can be used to detect trends in business performance that are not readily visible. In fact, many investors feel that the statement of cash flows is the most transparent of the components of financial statements. This is because it can be used to determine the sources and uses of cash.
Statement of Changes in Equity
Equity is the value of an asset minus the value of all liabilities on that asset. The statement of changes in equity, also known as the Statement of Retained Earnings, is used to showcase key information about equity reserves.
Statement of Changes in Equity provides details on the movement in the Equity of the business owner over a period of time. The statement of changes in Equity is usually derived from the following components:
- Net profit or loss during the period reported in the income statement attributed to shareholders;
- Share capital issued or repaid during the period;
- Payment of dividend made to shareholders;
- Changes recorded in accounting policy; and
- Changes in accounting policy or correction of accounting errors.
Notes to Financial Statements
Notes to Financial Statements are a crucial component that most people just forget about. These notes however contain other details relevant to the financial statements.
It is important to note that Notes to Financial Statements is a requirement mandated by the International Financial Reporting Standards (IFRS). According to the IFRS, entities have to disclose all information that matters to financial statements. This will no doubt enhance better understanding.
For instance, detailed information on those fixed assets is not included in the balance sheet. The Notes to Financial Statements however contains further information on those fixed assets that may be relevant to the overall financial statement.
What is the purpose of Financial Statements?
Financial Statements have already been identified as the records that outline how a business functions. The 5 components discussed above have also been used to identify the importance of Financial Statements. However, here are some other reasons that highlight the necessity of financial statements:
- Financial statements show an accurate state of the economic assets and liabilities of a business.
- Financial Statements are often relied upon to make financial decisions and predict the capacity of a business to earn profits.
- Financial statements depict the effectiveness of its management. The records are used to determine the profitability of a business or company.
- Readers can discern the accounting policies of a business by going through its financial statements.
- Importantly, financial statements also explain the social impact of a business. This is because it shows how external factors have affected the functioning of the business.
Who are the users of Financial Statements?
It is already obvious that a business owner needs to have financial statements. Financial Statements are not however only required by a business owner. There are other entities to whom it may be required or useful. These are divided into Internal and External Users.
Internal Users refer to managers or employees of a business directly involved in making decisions related to the operations of the company.
External Users are not directly involved in the operations of the company. Nonetheless, they hold some financial interest in the business. External Users may be further classified into:
- Users with direct financial interest (owners, investors, creditors); and
- Users with indirect financial interest (Government, employees, customers and others).
Financial Statements are often required by several categories of people falling under these two groups, including:
- Lenders (banks and other financial institutions) interested in the ability of the company to pay liabilities. It is important to note the most banks require a minimum of three years financial statements for credit facilities applications. In addition, once ongoing credit facilities (whether commercial mortgage, term loan, overdraft, or credit card) are enjoyed by a business the bank will request annual financial statements for review.
- Trade creditors or Suppliers interested in the company’s liquidity and its ability to pay short-term obligations. There are certain suppliers who as apart of their process to grant credit accounts request a copy of the company’s financial statements for review.
- Government, especially the tax authorities, interested in the financial information of an entity or business for taxation and regulatory purposes. Both individuals and companies are required to disclose both their profit and loss statements and balance sheet with their tax returns.
- Customers interested in the ability of the company to continue its existence and maintain stability of operations.
- General Public (researchers, students, analysts and others) interested in the financial statements of a company for reasonable purposes.
Conclusion
There can’t ever be too much ado about Financial Statements. They are the summation of the financial performance and position of a business at a given time.
Financial Statements are in fact the primary source of financial information for business owners and decision makers. That is why financial accounting and reporting emphasizes the importance of accuracy, reliability, and relevance of the information provided in financial statements.
