Beginner’s Guide to Understanding Financial Statements

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 of goods or to render services to customers.

In a business, revenue comes from the sale of goods and services. After deducting cost of producing goods or services from the revenue, you may arrive at 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 dividend. The amount of profit retained by the investor after paying dividend is known as retained earnings.

financial statements profit and loss account balance sheet cash flow and equity

As the business grow, 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 prepare financial statements by using accounting system. 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 on the company and do business without any fear of losing money.

For instance, shareholders are interested to know company’s top line, bottom line and whether their wealth will increase. Creditors want to know company’s liquidity position so that they can be less assured about the repayment of loan 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
  • Customers
  • Government
  • Suppliers or vendors
  • The public
  • Investors or analysts
  • Economists

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 company’s net income and what is his ownership 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 publishes their financial statements. Once in a year, these companies publishes financial statements for the whole year in the annual report. You can check their web sites as well.

Components of Financial statements

Based on the size of a company, there can be millions or billions of transactions for a financial year. At the end of a period, we execute following reports that shows us what’s going on:

  1. Income statement – 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 profit and loss account.
  2. Balance sheet – it gives a snapshot of 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?
  3. Statement of retained earning or stockholders equity – it will show you how retained earning changes during the year
  4. Statement of cash flow – it will show how the company generate and spend cash from operating, financing and investing activities during the year. Cash flow basically shows you where did the money go?

Independent auditors attest to the fairness of the financial statements by submitting auditor’s report to shareholders. You can find auditor’s report in 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 company’s annual report or quarterly report filed with stock exchange

You can analyze financial statements of a company to get 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 firm’s borrowings and future requirements.
  • How well the company has performed during the quarter or year.
  • What return is this company making, how much has been kept to reinvest in the business for future growth and how much has been paid to the owners as dividend.
  • What is the amount of risk you will be taking as a investor for your investments.
  • Does the company has adequate capital to fund its future growth.
  • How much the business owe to outsiders for short-term and long-term.
  • What is the liquidity position of a company.
  • What is company’s net-worth.
  • Does the company has sufficient cash? How much cash does the organisation generate from operating, investing and financing activities? You can get these details from company’s statement of cash flow.

Statements of owner’s equity provides detail changes to the shareholding position of the company as at the end of the year or quarter.

Notes to accounts

To clarify and expand the material presented in the body of the financial statements, number of notes are prepared by the management. Immediately following above four statements, you will find this section in the annual report as “notes to financial statements” or “notes to accounts”. Its presented as a part of financial statements with reference in the body of 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 company’s financial statements and annual report. 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 company’s growth and relate it to the present situations.