What are Financial Reports?
Financial reports can be defined as financial statements that are prepared by business organizations to disclose crucial financial information to various stakeholders such as creditors, public, investors, government and regulatory agencies to give them a picture of the actual financial capability of the business at a given period (Thakur and Vaidya, 2021).
What is the Purpose of Financial Information?
The general purpose for financial information is the provision of information about the operations of an organization, its financial standing and cash flows. The information contained in the financial statements is used to make various types of decisions such as the allocation of resources. In precise terms, there are different uses of financial information for each specific type of financial statement. The profit and loss statement informs the readers about the ability of an enterprise to make profits or generate income for the shareholders. It does this by revealing the sales volume and the expenses that a business has incurred over a given period. The P&L statement can be used to communicate various business trends in the results of company operations.
The main purpose of the balance sheet is to inform the readers of the current status of an enterprise over a given period. It reveals information related to the business’ liquidity, debts, and funding. Several liquidity ratios can be calculated from the P&L statement.
The main purpose of the statement of cash flows is to reveal information about cash receipts and cash utilization through various categories of activities.
Generally, the financial statements can be collectively used or assigned for various purposes as indicated below.
Credit decisions whereby lenders use the whole information from all the three financial statements in deciding to lend funds to an organization. The banks and other financial institutions can use the entire set of information in determining whether to give additional credit or restrict the loan amounts to the ones that have been already extended.
Investment decisions are made by investors in determining whether to invest and the share prices at which to invest. The acquirers can also use the financial information in determining the amount at which to buy the entire business.
Taxation decisions are made by governments to require taxes from a business based on its level of income and assets owned.
Union bargaining decisions are mostly based on the perceived ability of a business to pay its union contributions. Based on various statements, the union may set reasonable amounts and may not push too hard for a business that has suffered losses for a certain period.
Subsidiary evaluation entails the determination of the performance level for each particular business division or segment (Accounting Tools, 2021).
internal vs external users
What is a P &L Statement?
The profit and loss statement is also called the statement of operations or income statement. It shows the ability of a business to generate income. It usually provides a summary of the revenues, expenditure as well as profit or loss over a given period. It shows three main items as the ability of a business to make sales, manage the expenditures and generate profits for the shareholders. The income statement is usually prepared by the accounting principles such as revenue recognition, accruals and matching. The main category of items that are found in a P&L statement includes sales revenues, cost of sales, selling, general and administration costs, research and development of technology, interest expenses, tax and net income (Corporate Finance Institute, CFI, 2021).
Sample Profit & Loss Statement
Source: CFI (2021)
The above income statement for Amazon Inc shows the performance of the company over 3 years, that is 2015, 2016 and 2017. It can be used for the observation of trends for each item of the P&L statement. For example, it can be seen that the company has had a steady growth trend over the years whereby in 2015 it reported $104 billion in sales, $ 131 billion in 2016 and $173 billion in 2017. An income statement can also show the types of accounts that were used in the preparation of the P&L statement. These include income accounts and expenditure accounts.
How can we Analyze a Profit and Loss Statement?
The analysis of the income statement is important for stakeholders who want to assess the financial strength of a business, its attractiveness for investment or even the acquisition of the entire business. The examples and purposes for P&L analysis include:
- Comparing performance over years and benchmarking
- Assessing various performance margins such as gross and net profit margins
- Analysis of performance trends to check if there is improvement or deterioration
- Assessing rates of returns such as return on assets (ROA) and return on equity (ROE) (CFI, 2021).
What is the Importance of Profit and Loss Statement?
The P&L statement is an extremely important document that communicates the performance of a business enterprise over a given period. The basic purpose of the income statement is to tell if a business is making profits or losses. The of the P&L include:
- Decision-making
- Meeting regulatory requirements
- Meeting the formalities for funding
To make good use of the P&L statement, an analysis must be conducted on various aspects such as different accounting periods, different margins and ratios.
What is a Balance Sheet?
A balance sheet shows the assets, liabilities and equity for a company over a given period. The company’s assets quantity shows the potential for a company to generate revenues. Liabilities shows the obligations that a company has to meet. The working capital indicates the company’s liquidity whereas its capital structure shows how the business is funded by comparing the debt and equity (CFI, 2021). In simple terms, the balance sheet shows what the business owns, what it owes as well as the amount of money that investors and owners have channeled to the business (Girsch-Bock, 2020).
The balance sheet provides a summary of the business assets, liabilities and equity accounts. These three provide the basis for the balance sheet formula.
Assets= Liabilities+ Equity
The balance sheet helps the business owners and investors to monitor the business assets, liabilities and equity.
What is the Element of a Balance Sheet?
The elements of the balance sheet consist of:
Assets
What are assets? These to anything that is owned by a business. Examples of assets include cash and cash equivalents, inventories, and stocks. The assets are classified into two categories of current and non-current assets. Current assets are those that can be easily and quickly converted into cash. Long-term or non-current assets on the other hand are fixed assets that include machinery, land, equipment and intangible assets such as trademarks and patents (Girsch-Bock, 2020).
Liabilities
What are they? Liabilities can be defined as those obligations that a business has towards its stakeholders. These include accounts payable, customer deposits, salaries and wages payable and interest payable. Liabilities are also classified into two categories just like the assets. The current liabilities are those obligations that are to be met within a short time such as one year’s period. Long-term liabilities on the other hand are the obligations that are not to be met within a year. They include notes and loans payable (Girsch-Bock, 2020).
Equity
What is equity?
Equity refers to the finances that the entrepreneur and the investors have channeled into the business. Equity is also termed capital and refers to the company’s net worth. In addition to the liabilities, the equity must be equal to the total assets (Girsch-Bock, 2020).
A balance sheet just like the other financial statements must be prepared according to the GAAP requirements or rules. The information contained in the balance sheet is useful for both the internal users such as the management and external users such as investors and financial institutions.
How Can we use a Balance Sheet?
The balance sheet can be used to analyze a company’s financial position. It can be used to calculate various financial ratios that help in determining the performance of a business enterprise. These ratios can be used to determine the financial solvency, efficiency and liquidity of a business enterprise (Corporate Finance Institute, CFI, 2022).
Sample Balance Sheet
Source: CFI (2022)
What is the Importance of Balance Sheet?
The balance sheet serves many purposes. The importance of the balance sheet can be unveiled through the examination of various performance metrics such as:
Liquidity
The comparison of a company’s current assets to its current liabilities provides the stakeholders with knowledge about the company’s liquidity position. The liquidity ratios used in this concern are current and quick ratios.
Leverage
An examination of how a company is financed shows its average level. It also shows the level of financial risk that a company is taking. The balance sheet helps in assessing the average through comparison of debt to equity.
Efficiency
The balance sheet together with the P&L statement is used to assess how efficiently a business uses its assets. The division of revenues by the total average assets can be used to tell how efficiently the company utilizes its assets to generate revenues for the company. This gives rise to the Asset Turnover Ration (CFI, 2022).
What is a Cash Flow Statement?
The statement of cash flow shows how much cash a company has received and disbursed or utilized over a given period. The statement is usually composed of three sections that cash from operating activities, cash utilized in investment activities and cash generated from financing activities. The cash flow statement is used in assessing the ability of a company to generate cash from operations, the amount of money raised by comparing debt and equity, the net changes in cash position over a given period and the starting and ending period cash balances (CFI, 2021).
What is the Purpose of the Cash Flow Statement?
The cash flow statement serves various purposes such as:
- Indicating the movement of cash regarding cash inflows and outflows.
- Indicating the performance of key decision strategies that have been implemented by the management. If a business is experiencing cash flow problems, the management might decide to liquidate its assets by selling them out to generate cash flow for the business.
- Provision of relevant information about an organization’s financial well-being. The financial condition of a business is not just a matter of positive figures but also of how those figures have been generated as well as the sustainability of those positive figures whereby they should not be a one-time event (Thakur and Vaidya, 2021).
- Indicates information from non-cash investing and financing activities. Even though these activities are non-core, they have a substantial impact on the current and future cash flows for the company.
- Legal compliance is another purpose for the preparation of the statement of cash flow whereby, the report has to be prepared in alignment with the accounting standards. The regulators require businesses to publish their cash flow reports to assure their investors that their investments are safe. This helps in the detection of frauds before they can take a toll on the business (Thakur and Vaidya, 2021).
Sample Cash Flow Statement
Source: Thakur and Vaidya (2021)
Based on the projected cash flow statement above it can be observed that the core activities of the business how negative figures. The cash payment to vendors is a negative figure which implies that the company has a problem in paying out its suppliers. The employee salaries show a negative figure of 4000 which shows that the company has challenges in paying out its workers. The final cash flow from the operating activities shows a big negative figure of 13000 which implies that the company is performing poorly in terms of generating cash through its activities (Thakur and Vaidya, 2021).
For a shrewd investor, it can be observed that it is only the non-core activities of the business that have posted positive figures such as the sale of land and old machinery hence investing in such a business would not be feasible as most of the core activities show negative performance. The positive activities are only one-off transactions hence they have no significant value in the long run operations of the business enterprise.
References
Accounting Tools (November 16, 2021) The Purpose of Financial Statements. https://www.acountingtools.com/articles/what-is-the-purpose-of-financial-statements.htm
Thakur, M. and Vaidya, D. (2021). Financial Reporting. WallStreetMojo. https://www.wallstreetmojo.com/financial-reporting/
Corporate Finance Institute, CFI, (2021). Profit & Loss Statement. https://www.coporatefinanceinstitute.com/resources/knowledge/accounting/profit-and- loss-statement-pl/
Thakur, M. and Vaidya, D. (2021). Purpose of Cash Flow Statements. WallStreetMojo. https://www.wallstreetmojo.com/purpose-of-cash-flow-statements/
Girsch-Bock, M. (2020) What is a Balance Sheet and How Do You Prepare One? The Blueprint. https://www.fool.com/the-blueprint/balance-sheet/
Corporate Finance Institute, CFI (2022) What is the Balance Sheet?. CFI. https://www.corporatefinanceinstitute.com/resources/knowledge/accounting/balance- sheet/