Financial statements are the end results of business activities undertaken by the business entity during a year period. It is the combination of the three major reports on a business.
It contains the cash flow statement, the income statement and the balance sheet of the business. All three together produce an overall picture of the health of the business.
Financial statement relationship
Why is a financial statement important?
The financial statement determines:
- If a business has to ability to repay loans
- If it has the cash flow to meet bills and purchase stock.
- It will also tell from where the business is generating cash and where the cash goes.
- The financial statement tells if the business is profitable or if it will stay profitable.
- If there are any large problems approaching, such as a continuous drop in sales over time.
It will give an overall view of the condition of the business and if there are any warnings signs of possible future problems. A bank or other such institution will look to the financial statement as the first indicator of how the business is performing and if there is a need for further investigation.
When will a company prepare a financial statement?
Every business will ready a financial statement to go with their end of year results, to give interested parties the overview of how the business is functioning.
If a business is looking to increase credit facilities with a bank or trying to raise capital for an expansion, it will produce a financial statement for the end of a fiscal quarter or the most recent month.
When preparing a financial statement, the best practice is to use general accountancy language, understood by all parties.
Contents of financial statements
- Balance sheet: the balance sheet, also referred to as the statement of financial position, reports the financial position of a business at a point in time. It reports the assets, liabilities, and capital of the business at the end of the year.
- Income statement: an income statement is the list of expenses and incomes made during the year and prepared in order to find out operating results (i.e. profit or loss). It is also called profit & loss account and includes manufacturing and trading account.
- Cash flow: the statement of cash flows generally shows how cash moves in and out of the business during any two consecutive balance sheet dates. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills.
Objectives of financial statements
- To know the profitability of a business: financial statements are required to ascertain whether the enterprise is earning adequate profit and to know whether the profits have increased or decreased as compared to the previous year(s), so that corrective steps can be taken well in advance.
- To know the solvency of the business: financial statements help to analyze the position of the business as regards to the capacity of the entity to repay its short as well as long term liabilities.
- To judge the growth of busines: through comparison of data of two or more years of business entity, we can draw a meaningful conclusion as regard to growth of the business. For example, increase in sales with increase in the profits, indicates a healthy sign for the growth of the business.
- To judge the financial strength of the business: financial statements help the entity in determining solvency of the business and help to answer various aspects. Eg, whether it is capable to purchase assets from its own resources and/or whether the entity can repay its outside liabilities as and when they become due.
- To make a comparison and select appropriate business policy: to make a comparative study of the profitability of the entity with other entities engaged in the same trade, financial statements help the management to adopt sound business policy by making intra firm comparison.
- To forecast and prepare budgets: financial statement provides information regarding the weak-spots of the business so that the management can take corrective measures. It helps the management to make forecast and prepare budgets.
- To communicate with different parties: financial statements are prepared to communicate with different parties about their financial position.
Limitations of financial statements:
- It fails to present qualitative information such as quality of management, labour relations, conflicts between managers, etc. Due to its non-monetary measure. But it certainly adversely affects the activities adversely & the profits may suffer.
- Financial statement is accounted in historical data and fails to give true view of business to date. It fails to consider the price level changes.
- It fails to give true and fair position of business as the figures shown in the statement may have been manipulated by the management.
- It fails to suggest remedial measures to problems being faced by the business.
- It uses the diverse procedures. There are two or more ways of treating a particular item and when two different business enterprises adopt different accounting policies, it becomes very difficult to make a comparison between them.
Users of financial statements:
- Company management: the management team needs to understand the profitability, liquidity, and cash flows of the organization every month, so that it can make operational and financing decisions about the business.
- Customers: when a customer is considering which supplier to select for a major contract, it wants to review their financial statements first, in order to judge the financial ability of a supplier to remain in business long enough to provide the goods or services mandated in the contract.
- Employee and trade unions: a company may elect to provide its financial statements to employees, along with a detailed explanation of what the documents contain. This can be used to increase the level of employee involvement in and understanding of the business.
- Governments: a government may request for from the company’s financial statement in order to determine whether the business paid the appropriate amount of taxes.
- Owners: investors will likely require financial statements to be provided, since they are the owners of the business and want to understand the performance of their investment.
- Banks: an entity loaning money to an organization will require financial statements in order to estimate the ability of the borrower to pay back all loaned funds and related interest charges.
- Suppliers: suppliers will require financial statements in order to decide whether it is safe to extend credit to a company.
- Others: consumers, economists, community, researchers, investment analysts, etc. May also use financial statements.
Financial statement analysis
The financial statement analysis is concerned with arranging, classifying, grouping, comparing and establishing the relationship of financial data in a meaningful manner by which financial position, profitability position, operational efficiency and growth potential of a firm can be assessed easily.
It is the process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data.
Objectives of financial statement analysis
- Its objective is to know about the current earning capacity & future possibility of the business that helps to measure the profit, loss and financial positions.
- Its objective is to judge the solvency position of the business, which describes whether the firm will be able to pay its obligations
- Its objective is to access the past performance and trend of sales, profits, dividends, share price, etc.
- Its objective is to judge the liquidity position of the firm that includes firms’ short term & long-term financial soundness.
- Its objective is to access the operational efficiency that measures the assets management capacity, debt management capacity, etc.
- Its objective is to act as an effective tool for simplifying and summarizing the monotonous figures that helps for a decision-making purpose.
Techniques of financial statement analysis
- Ratio analysis: it is a technique to analysis the interrelationship between two comparable variables figures.
- Funds flow analysis: it is a technique to analyze the sources and uses of funds in the business during a specific period.
- Cash flow analysis: it is a technique used to analyze the cash position or movement of cash of a firm during a specific period.
- Trend analysis: it is a technique used to analyze the trend of the financial figures and ratios. This method is important to find out the past trend of the business firm.
Note: parties involved (users); objectives, importance and limitations is similar to previous ones.