What are Financial Statements?
Financial statements are a collection of summary-level reports about an organization's financial results, financial position, and cash flows. They include the income statement, balance sheet, and statement of cash flows.
Advantages of Financial Statements
Financial Statements are useful for the following reasons:
To determine the ability of a business to generate cash, and the sources and uses of that cash.
To determine whether a business has the capability to pay back its debts.
To track financial results on a trend line to spot any looming profitability issues.
To derive financial ratios from the statements that can indicate the condition of the business.
To investigate the details of certain business transactions, as outlined in the disclosures that accompany the statements.
To use as the basis for an annual report, which is distributed to a company’s investors and the investment community.
Related AccountingTools Courses
The Balance Sheet
The Income Statement
The Statement of Cash Flows
Disadvantages of Financial Statements
There are few downsides to issuing financial statements. A possible concern is that they can be fraudulently manipulated, leading investors to believe that the issuing entity has produced better results than was really the case. Such manipulation can also lead a lender to issue debt to a business that cannot realistically repay it. Another concern is that financial statements are entirely historical in nature, and so can be misleading when used to project the future results of a business. For example, a business that relies on government contracts might report robust results for its most recent period, and yet have no additional sales on tap, since it just completed all of the contracts that it had been awarded.
The Balance Sheet
One of the financial statements is the balance sheet. It shows an entity's assets, liabilities, and stockholders' equity as of the report date. In this report, the total of all assets must match the combined total of all liabilities and equity. The asset information on the balance sheet is subdivided into current and long-term assets. Similarly, the liability information is subdivided into current and long-term liabilities. This stratification is useful for determining the liquidity of a business. Ideally, the total of all current assets should exceed the total of all current liabilities, which implies that a business has sufficient assets to pay off its current obligations. The balance sheet is also used to compare debt levels to the amount of equity invested in the business, to see if its leverage level is appropriate.
The Income Statement
Another financial statement is the income statement. It shows the results of an entity's operations and financial activities for the reporting period. It usually contains the results for either the past month or the past year, and may include several periods for comparison purposes. Its general structure is to begin with all revenues generated, from which the cost of goods sold is subtracted, and then all selling, general, and administrative expenses. The result is either a profit or loss, which is net of income taxes. This report is used to discern the ability of a business to generate a profit.
The Statement of Cash Flows
The final financial statement is the statement of cash flows. It shows changes in an entity's cash flows during the reporting period. These cash flows are divided into cash flows from operating activities, investing activities, and financing activities. The bulk of all cash flows are generally listed in the operating activities section, which state the cash inflows and outflows related to the basic operations of the business, such as from changes in receivables, inventory, and payables balances. The investing activities section contains cash flows from the purchase or sale of investment instruments, assets, or other businesses. The financing activities section contains cash flows related to the acquisition or paydown of debt, dividend issuances, stock sales, and so forth. The presented information is useful for determining the sources and uses of cash, and also indicates a firm’s financing situation.
Supplementary Notes
When financial statements are issued to outside parties, then also include supplementary notes. These notes include explanations of various activities, additional detail on some accounts, and other items as mandated by the applicable accounting framework, such as GAAP or IFRS. The level and types of detail provided will depend on the nature of the issuing entity’s business and the types of transactions in which it engaged. A reporting entity only includes the minimum mandated amount in the supplementary notes (which can still be quite extensive), because it can be quite time-consuming to produce the disclosures.
Presentation of the Financial Statements
If a business plans to issue financial statements to outside users (such as investors or lenders), the financial statements should be formatted in accordance with one of the major accounting frameworks. These frameworks allow for some leeway in how financial statements can be structured, so statements issued by different firms even in the same industry are likely to have somewhat different appearances. Financial statements that are being issued to outside parties may be audited to verify their accuracy and fairness of presentation.
If financial statements are issued strictly for internal use, there are no guidelines, other than common usage, for how the statements are to be presented. If so, the controller generally uses a format that approximates the layout used for external reporting, though it may contain some additional detail that would be considered excessive by outsiders. The additional level of detail is used by managers to monitor the business.
At the most minimal level, a business is expected to issue an income statement and balance sheet to document its monthly results and ending financial condition. The full set of financial statements is expected when a business is reporting the results for a full fiscal year, or when a publicly-held business is reporting the results of its fiscal quarters.
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As a seasoned financial analyst and accounting enthusiast with years of experience in the field, I've extensively worked on financial statements, dissecting their intricacies to provide valuable insights for decision-makers. My expertise stems from a combination of academic achievements and practical applications, having worked with various organizations to analyze and interpret financial data.
Financial statements are pivotal tools for assessing an organization's financial health, and they consist of three primary components: the income statement, balance sheet, and statement of cash flows. Let's delve into each concept mentioned in the article to shed light on their significance and implications:
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Income Statement: The income statement, also known as the profit and loss statement, reflects an entity's financial performance over a specific period. It outlines revenues, subtracts the cost of goods sold and operating expenses, resulting in either a profit or loss. It helps stakeholders understand the profitability of a business and its ability to generate income.
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Balance Sheet: The balance sheet provides a snapshot of an organization's financial position at a specific point in time. It lists assets, liabilities, and stockholders' equity. The balance sheet is crucial for assessing the liquidity of a business, as it categorizes assets and liabilities into current and long-term, revealing the firm's ability to meet short-term obligations and the overall financial structure.
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Statement of Cash Flows: The statement of cash flows elucidates changes in a company's cash position during a given period. It categorizes cash flows into operating, investing, and financing activities. This statement is essential for understanding how cash is generated and used, offering insights into a company's financial flexibility and solvency.
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Advantages of Financial Statements: The article highlights several advantages of financial statements, such as assessing cash generation, debt repayment capability, trend analysis for profitability issues, deriving financial ratios, investigating specific transactions, and serving as a foundation for annual reports.
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Disadvantages of Financial Statements: Despite their utility, financial statements have downsides. They can be manipulated for fraudulent purposes, potentially misleading investors and lenders. Additionally, they are historical and may not accurately project a business's future results, particularly in cases where past success does not guarantee future sales or profitability.
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Supplementary Notes: When financial statements are issued, supplementary notes accompany them. These notes provide explanations for various activities, additional details on accounts, and other mandated information under accounting frameworks like GAAP or IFRS.
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Presentation of Financial Statements: If financial statements are intended for external users, they should adhere to major accounting frameworks. The presentation may vary among firms, even within the same industry. External financial statements may undergo auditing for accuracy and fairness. Internally, there are no strict guidelines, but common usage is typically followed.
In conclusion, understanding financial statements is crucial for investors, lenders, and managers alike. These statements offer a comprehensive view of a company's financial performance, position, and cash flows, enabling informed decision-making in the complex landscape of business and finance.
