In a company, shareholders provide funds to buy equipment, inventory and other assets to get started the business. Managers, in conjunction with shareholders, run the business for profit. The business can be anything either buying and selling goods or rendering services to customers.
In a business, revenue comes from the sale of goods and services. After deducting the cost of producing goods or services from the revenue, you may arrive at a profit.
Out of the profit, some portion is retained by the company after paying a portion to managers for their efforts and to shareholders as dividends.
The amount of profit retained by the investor after paying dividends is known as retained earnings.
As the business grows, management may need more money to buy assets or for working capital requirements to meet its business obligations.
To track its progress and to communicate its financial health to all stakeholders, management prepares financial statements by using an accounting system. To have a coherent view of how the business performs, it’s necessary to understand different component parts of financial statements.
Financial statements are known as the report card of a business for a particular period of time.
This statement will tell you so many important things about the business which include how much money the operation has stashed away, how must debt the business has and the debt-equity proportion, the income coming into the business for the period, and expenses going out the door.
Whether you are a beginner or an experienced investor, you need to understand how to read, analyze, and create financial statements.
Business credibility depends on the accuracy, reliability, and credibility of its accounting system of which financial statements are the end product.
Companies around the world prepare financial statements to measure performance for a year or quarter and publish it for stakeholders to tell them where a business stands in financial terms. Publishing financial information will help stakeholders to have trust in the company and do business without any fear of losing money.
For instance, shareholders are interested to know the company’s top line, bottom line, and whether their wealth will increase. Creditors want to know the company’s liquidity position so that they can be less assured about the repayment of loans or debt payments.
Here is a inclusive list of stakeholders interested in company’s financial statements:
- Owners or shareholders of the business
- Internal management and employees
- Lenders and potential lenders
- Suppliers or vendors
- The public
- Investors or analysts
Stakeholders such as management, shareholders, creditors, and government agencies have vested interest in a company’s financial statements. These internal and external agencies can easily evaluate the company by comparing it with another company of the same industry.
For instance, a shareholder or owner of the company will be interested to know what is the company’s net income and what is his own capital in it. The information related to the first question is provided in the income statement and information related to the second question is provided in the balance sheet.
Financial statements are based on the accounting equation. This means assets of the company are financed by liabilities and equity.
Asset = liabilities + owner’s equity
Every quarter, all publicly traded companies publish their financial statements. Once a year, these companies publish financial statements for the whole year in the annual report. You can check their web sites as well.
Components of Financial statements
Financial statements are the end result of the financial accounting process that records the economic activities of the company.
We have four basic financial statements: the income statement, the balance sheet, the statement of changes in owner’s equity, and the statement of cash flows. These financial statements are contained in the company’s annual report.
There can be millions or billions of transactions for a financial year. At the end of a period, these reports or statements are prepared to shows what’s going on:
- Income statement / Profit and loss account – it will tell you how well did the company perform during the accounting year or quarter, how much money came in, and what costs it has incurred for the period. It’s also known as a profit and loss account.
- Balance sheet – it gives a snapshot of the company’s asset, liability, and owner’s equity position as at the report date, such as the end of the year or quarter. This means it shows you how much money is left with the company on the balance sheet date.
- Statement of retained earnings or stockholders equity – it will show you how retained earning changes during the year
- Statement of cash flow – it will show how the company generates and spend cash from operating, financing, and investing activities during the year. Cash flow basically shows you where did the money go?
These statements are not independent of each other but are linked in the system. Together at the end of the year/quarter, they give you a complete picture of the financial affairs of a business.
Independent auditors attest to the fairness of the financial statements by submitting auditor’s reports to shareholders. You can find the auditor’s report in the company’s annual report along with the profit and loss account, balance sheet, cash flows, and statement of retained earnings.
These financial statements will relate to a specific date and time period. You can find all of them in the company’s annual report or quarterly report filed with the stock exchange.
You can analyze the financial statements of a company to get an answer to many of your investment questions such as;
- What revenue is this organization generating?
- How much the company incurred to generate revenue? or what cost are they incurring to generate revenue? Are these costs exceeding the revenue generated?
- Does the company generate sufficient cash flows to serve the firm’s borrowings and future requirements?
- How well the company has performed during the quarter or year.
- What return is this company makes, how much has been kept to reinvest in the business for future growth, and how much has been paid to the owners as dividends?
- What is the amount of risk you will be taking as an investor for your investments?
- Does the company has adequate capital to fund its future growth.
- How much the business owes to outsiders for the short-term and long-term.
- What is the liquidity position of a company?
- What is the company’s net worth?
- Does the company has sufficient cash? How much cash does the organization generate from operating, investing, and financing activities? You can get these details from the company’s statement of cash flow.
Statements of owner’s equity provide detailed changes to the shareholding position of the company at the end of the year or quarter.
Notes to accounts
To help the readers understand certain details or to clarify and expand the material presented in the body of the financial statements, management has a section called “notes to the financial statements” or “footnotes” in addition to the above financial statements.
Immediately following the above four statements, you will find this section in the annual report. Its also known as “notes to accounts”. It’s presented as a part of financial statements with reference to the body of the income statement and balance sheet.
These notes are an integral part of the financial statements to understand the company better. It’s the responsibility of the management to prepare these statements and notes to accounts.
Notes to accounts gives you lots of information such as
- Company’s accounting policies
- Statutory liabilities such as income tax etc
- Pending legal proceedings if any.
- Contingencies if any
- Operating segments wise revenue and profit details.
As an investor, you will get lots of information from the company’s financial statements and annual reports. However, some of the key information such as present economic condition and market fluctuations will not be available for you. You are required to understand the company’s growth and relate it to the present situations.