Much success in today’s business world is tied in with numbers in the form of accounting and financial statements. Being able to understand and properly read these statements is a critical component in truly knowing a business and properly assessing its overall performance. In the accounting world there are four main financial statements that are universally understood and prepared for most publically traded companies and many small and medium sized businesses: the income statement, the balance sheet, the statement of cash flows, and the statement of retained earnings (sometimes referred to as shareholders’ equity). A fundamental ability to properly interpret the information these statements contain allows internal and external users to make a wide array of decisions affecting company operations and decisions on whether or not to invest. Users of financial statements will look to the income statement to learn assess a company’s performance over a set period of time, often a month or a year. This statement depicts the company’s revenues and expenses with the difference reflecting the net income (or loss) resulting from the firm’s business activities.
The revenue will be broken down by the category from which it derived with expenses broken down in a similar fashion. Those most interested in a company’s income include shareholders, potential investors, banks (for the purpose of assessing past performance and potential loan risk), creditors, and executives charged with ensuring profitability for the business. The complexity of an income statement will vary based on that of the company from whence it derives and the depth of its business activities (www.accountingcoach.com). In larger corporations an accrual basis of accounting is commonly used where revenues are recorded when the money is actually earned, as opposed to cash being received which would count simply as a receipt. The balance sheet functions on the basic accounting equation which is: total assets = liabilities + stockholders’ equity (thus the term “balance”). It depicts assets and liabilities at a particular point in time and is one of the most vital financial documents for a company to maintain, since it states all that the firm owns as well as what it owes to third parties. “And thus, when calculating, it is important to remember that the total net asset value should be equal to the capital and net profit of the business.
In other words, the books need to be in balance.” (www.quickbooks.co.za). Users most interested in a company’s balance sheet include internal managers, creditors (such as banks) and shareholders. It is important to remember that a key part of the balance is owner’s equity, consisting of funding from shareholders in addition to retained earnings (which are normally quite sizable). It is common for shareholders and potential investors to compare years of balance sheets to identify if a firm is increasing debt and inventories or reducing its cash; trends which can have an effect on investing decisions. The statement of cash flows depicts net increases or decreases in actual cash for a specific period of time, as well as the cash on hand at the conclusion of that period. The cash position of a company can provide insights into operational, investing and financing efficiencies or shortfalls by informing the statement user of how the cash was generated, how it was put to use and by how much it changed from one period to the next.
Income statements often include noncash revenues or expenses and the statement of cash flows zeroes in only the actual cash a company’s business activities has produced. Profits can be depicted in income statements by companies that eventually fail due to a lack of proper operating cash. A firm’s statement of retained earnings covers the same period of time reflected by the income statement and appears on its first line. Company profits not paid out to shareholders in the form of dividends are reinvested in the business and are classified as “retained earnings”, a common practice which allows a firm to grow and expand. This practice also reduces a company’s need to turn to outside financing, which also saves on the expense of borrowing money. Investors make great use of this particular financial statement to help in deciding where to sink their money, basing the decision in large part on whether a company typically pays higher dividends or reinvests its profits in itself (in many cases leading to a higher stock price instead).
While each of the four financial statements contains specific information tailored to differing aspects of a company’s performance, there are relationships between them which warrant mention. The balance sheet depicts assets which include cash, yet the statement of cash flows goes a step further in explaining the origin and actual use of the firm’s cash reserves. As mentioned, a company’s retained earnings make an appearance on the first line of the income statement as the retained earnings are a direct function and result of net income. Retained earnings are also considered an asset and consequently appear on the balance sheet as well. Evidently there are items contained within these statements that have a direct impact on each other. The value of these statements will depend largely on the perspective of the particular user. As touched on above, investor’s will take great interest in the statement of retained earnings as well as a company’s profitability (net income) and reserves of cash essential to support operations.
They will also eye the balance sheet for assurances that a company’s debt is suitably offset by its assets. Creditors will seek confidence in a firm’s proven ability to generate consistent profit as a means of paying off short and long term loans and will find that information located in the income statement. They will also look at a firm’s balance sheet to gage they type of debt a company maintains. Lastly, internal managers and executives interested in assessing performance and seeking ways to improve profitability will want to focus on all four, primarily the income statement and balance sheet as evaluation tools and opportunity identifiers. They will be the ones deciding how much of a company’s profits to pay out in the form of dividend’s and how much will be retained based largely on this information.
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