What Is A Financial Statement? (With Importance And Types)
Updated 18 December 2022
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Financial statements are essential accounting documents that an organisation uses to report their financial information, like expenses and profits. These statements provide information on a company's income and changes in equity, help a company grow in its competitive market and address the financial challenges a business is facing. If you have an interest in working in the finance sector, understanding the different financial statements, along with their importance can help you build a rewarding career. In this article, we answer "What is a financial statement?", look into the four main types and explore their importance.
Related: What Is A Profit And Loss Statement? (Formulas And Examples)
What Is A Financial Statement?
The answer to the question “What is a financial statement?” is that it is a document that shows a company's financial information and activity. This statement conveys an organisation's business activity and financial performance. Investors, company board members and other stakeholders use a financial statement to know the financial strength and understand its current and future success. Shareholders use this statement to review the state of their investment into a business.
One of the most reliable resources of financial statements is the company's annual report. Often, accountants, audit organisations and government agencies audit the financial statements to verify the accuracy of a company's financial reporting. The four financial statements are:
Balance sheet: It summarises a company's liabilities, assets and stockholder's equity.
Cash flow statement: This statement provides information about the company's ability to generate cash for paying debts, fund investments and pay operating expenses.
Income statement: The income statement provides detail about a company's revenue and expenses during an accounting period.
Statement of shareholder's equity: The shareholder's equity statement shows the changes in the value of a shareholder's or stockholder's equity from the starting of the accounting period to the end of that period.
Related: Revenue Accounts: With Definition, Types And Examples
Why Are Financial Statements Important?
Preparing and analysing the financial statements is essential because of the following reasons:
Determines the company's financial position: One of the major benefits of preparing and analysing these statements is that it provides financial information and a company's performance at a particular date. Business stakeholders and shareholders use these statements to make meaningful and strategic business decisions.
Helps investors in decision making: These financial statements contain every information an investor requires in making investing decisions. Using this information, they can calculate the price per share for making investments.
Helps in getting credit: Lenders use the financial statements to determine how much they can invest in a business. It also helps them provide additional credit for business expansion and measures the ability of a business to pay back its debts.
Investigates business transactions: An auditor or accountant uses financial statements to investigate a business transaction and check its accuracy.
Derives financial ratios: A financial analyst uses financial ratios to calculate different ratios, such as profitability, valuation and solvency ratios.
Related: How To Conduct Analysis Of Financial Statements (With Steps)
Types Of Financial Statements
There are several types of financial statements a company uses for various reasons. Some commonly used financial statements are:
The balance sheet addresses the company's financial standing at a particular time period by providing details about the assets, liabilities and shareholder's equity. It helps in understanding a company's net worth and equity. Here are a few components of a balance sheet:
Assets: Assets are resources owned or controlled by a company that they can sell for cash. An organisation's assets can include physical properties such as machinery, land and building, inventory and equipment, trademarks, investments and patents.
Liabilities: Liabilities are debts that an organisation owes. The liabilities of an organisation can include short-term debt, unearned revenue, accounts payable, long-term provisions, rent or taxes owed to the government.
Shareholder's equity: Shareholder's equity refers to the money a company has after paying its liabilities and selling its assets. It is the company's net worth or value.
A company's balance sheet identifies how a company funds its assets. It identifies whether a company uses liabilities such as debt or shareholder's equity such as retained earnings to fund its assets. In a balance sheet, you list assets in order of liquidity and liabilities in the order in which the company would pay them. The formula for a balance sheet is:
Assets = liabilities + shareholder's equity
Related: Everything You Need To Know About How To Become A Stockbroker
This statement provides a summary of a company's performance to the investors. The income statement displays a company's revenue, expenses, net worth or net income and earnings per share (EPS) over a specific accounting period. You can calculate profit or loss using the income statement. You can refer to it as the profit-and-loss statement or statement of revenue and expense. Expenses refer to the cost a company spends on producing products and income refers to the money it generates after selling its goods and services.
By deducting expenses from the income, you can find whether the company made a loss or profit in a particular accounting period. Here are a few components of an income statement:
Revenue or sales: The sales or revenue forms the top line of an income statement.
Operating expenses: These are expenses that a business incurs to stay operational and conduct its business operations. Examples of operating expenses are rent, payroll, property taxes, depreciation, advertising and loans.
Non-operating expenses: It is a cost or expense that does not relate to a businesses' core operations. Examples of non-operating expenses are restructuring costs, interest on loans and payments to settle lawsuits.
Gross profit: Gross profit or gross income is the amount of money a company makes after subtracting the manufacturing and selling cost of goods and services. You can calculate gross profit after deducting the cost of goods sold from total sales.
Net income: Net income or net earnings or net profit is the bottom line for a company and evaluates the company's profitability. It is the total income a company generates by selling goods or services to customers.
The formula for an income statement is:
Net income = revenue – expenses
Related: What Is Revenue? Definition, Types, Examples And More
Cash flow statements
A cash flow statement tracks the cash that flows in and out of a company during a particular accounting period. This statement uses income and balance sheet information to understand whether the company generates enough cash to stay solvent. A cash flow statement is a great way to show how a company spends and generates money during a specific period. It helps stakeholders and investors understand how a company is faring financially. A positive cash flow shows that a company has money left after deducting all expenses. Here are some essential components of a cash flow statement:
Cash flow from operating activities: The cash flow from operating activities tracks a company's daily income and expenses associated with core business operations, such as purchasing from vendors, sale of products and payroll. This section adjusts the net income to the cash a company uses during its operating activities.
Cash flow from investing activities: This section tracks the investment activities associated with purchasing and selling assets outside its inventory. Though positive investment cash flow is desirable, most investors prefer companies that generate incomes from their business operations.
Cash flow from financing activities: Th last section of a cash flow focuses on the money used in financing activities. It gives stakeholders and investors an idea of how much money a company pays in dividends or buying back shares.
Related: How To Become A Financial Advisor: A Complete Guide
Statement of shareholder's equity
A company issues a statement of shareholder's equity as a part of its balance sheet. This financial statement provides information about the changes in the value of shareholder's equity during an accounting period. It highlights activities that help understand whether the value of shareholder's equity increased or decreased. Here are some essential components of this statement:
Preferred stock: Preferred stock is a type of ownership stake in a company that provides the holder with a higher claim on the earnings. These stockholders receive dividends before people who have common stock, but they do not have voting rights in the company.
Common stock: A common stock is a type of ownership stake in a company that gives the holder voting rights.
Retained earnings: Retained earnings are the accumulated portion of the business profit that a company has yet to distribute as dividends. The company reserves them for reinvesting back in the company.
Treasury stock: A treasury stock is a stock that an issuing company repurchases. Often, a company repurchases their stock to boost the stock price and prevent a hostile takeover by another company.
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