Financial Statements: What, Why and How?

Do you know what the financial statements are? You have probably already heard about the balance sheet, the income statement , the cash flow statement or the statement of retained earnings . These documents provide information on the financial position and performance of a business. They are very useful for closing your accounting year and will be used to establish a financial diagnosis of your company. With the information gathered in the financial statements, you will be able to make informed business decisions and have the right time on your numbers.

Understanding Financial Statements

The financial statements are a set of documents demonstrating the current financial situation of the company. These states indicate more precisely:

• How much money does the company generate and spend – shown in the statement of operations
• What the company owns and how much it needs – indicated in the balance sheet
• The source and use of funds – indicated in the Statement of Changes in Financial Position
• The amount retained in the business by the owners – shown in the statement of retained earnings

Entrepreneurs need to know what to look for in the financial statement and how to analyze them properly in order to make informed decisions for their business. Several pieces of information are available at a glance while others require further analysis. Businessmen and investors view and further analyze financial statement to determine whether they are investing more in or withdrawing from a business.

Three Financial Statements

This article will explore in particular the 3 financial statements: the balance sheet, the income statement and the cash flow statement. It is necessary to understand and master these terms to ensure proper management of your business and be effective with your accounting software.

 1 – The Balance Sheet

The balance sheet is a picture of your business at particular point in time. It serves to see what you own and what you owe to your creditors. In accounting, the balance sheet equation is:

Assets = Liabilities + Owner’s Equity

It shows resources of business, the outside obligations and what the owner owns during the given year. The balance must always be balanced. The total assets of the balance sheet must be equal to the total equities of the balance sheet. The balance sheet is based on the principle of financial equilibrium. That is, each item of balance sheet assets corresponds to a liability or owners’ equity item.

2 – The Income Statement

In terms of the income statement, it effectively demonstrates the revenues and expenses you have generated over a period of time.

Revenue – Expenses = Net Profit

The income statement is an accounting document showing all the income and expenses of a company during a financial year. Like the balance sheet and the cash flow statement, it is part of the financial statements of the companies. The income statement is intended to inform the performance of a company. By focusing on its variations in wealth (gains and losses), it makes it possible to release its net result (profit or deficit). The income statement is important for two types of audience. On the one hand, it allows the tax administration to see the profit made by a company. On the other hand, it allows potential financiers to know their performance and profitability .

Difference Between the Income Statement and the Balance Sheet

The balance sheet and the income statement are two mandatory documents for a company. They are a little alike because each have two columns that must be balanced. Unlike the balance sheet that summarizes the assets of a company and its variations since the creation of the company (a kind of picture of the financial position of the company), the income statement focuses only on the year that has just passed. It should be noted that the result, which results from the income statement, includes the equity shown in the balance sheet.

3 – Cash Flow Statement

Finally, there is the cash flow statement. This last financial statement is actually the cash flow of the company. This is another picture of the money coming in and out of your business. In short, it’s a bit of a picture of your company’s bank account. Cash flow measures the money that a company collects against what it spends. If money accumulates more than it is spent, the cash flow is positive. Otherwise, the cash flow is negative.
When the cash flow is positive for an extended period of time, consider the business in good health. However, even profitable businesses can go through short periods of negative cash flow. When a company shows a negative cash flow for a long time, it usually becomes insolvent. She may have to go bankrupt .

How to Prepare Financial Statements

To facilitate the analysis and comparison of results between companies, the financial statements are prepared according to a set of rules called the International Financial Reporting Standards (IFRS) . Here is an overview of these rules: 

• The rules allow for three types of basic financial statements : audited, reviewed and compiled .
• These financial statements may be prepared on either a cash basis or an accrual basis .
• A cover letter should be included to indicate the types of statements prepared.
• Notes to the financial statements should be included to present the assumptions that the accountants used in preparing the statements. These also provide additional information to help readers interpret and analyze the reports.
• Accounting rules can be complicated, especially for companies doing business in other countries. This explains why most companies hire professional accountants to prepare their financial statements.

Further Readings:

Financial development and Economic Growth