What are financial statements?

Financial statements (or financial reports) are the formal records of the financial activities that are undertaken by a firm. They are convenient instruments used for analyzing a company’s financial position and performance. Financial ratios are created with the help of the numerical values that are derived from the financial statements. They give meaningful information about the financial performance of the company.

External and Internal financial statements

External financial statements are designed and issued for external reporting reasons and they can be accessed by any person outside the firm. They are used by the stock investors, and tax authorities. They are typically issued on an annual basis or a quarterly basis.

Internal financial statements are issued to be accessed only by the individuals within the firm and they organize the financial information helpful for the management of the firm since these statements have relatively high analytical components. Also, they are issued on a more regular basis (weekly, monthly, or quarterly).

Components of financial statements

The three types of the financial statements are:

• Income Statements
• Balance Sheet 
• Cash Flow Statements

Income statements

The income statement is also termed a profit and loss statement.

It depicts the revenue that is earned by the firms and the costs and expenses incurred by the firm during a specific period. It can be prepared on a monthly, quarterly and annual basis.

It tells about the profitability of the firms’ business. It depicts the picture of how well the company is doing overtime.

The top line of the income statement gives information about the total revenue earned by the firm.
The total revenue is earned by the total sales of the firms during the specific period.
The costs of the gold sold are subtracted from the total revenue, to get the gross profit.
From the gross profit, the total operating expenses and other costs (such as income taxes and interest) have to be deduced. This procedure gives the net profit/net loss.
The bottom line of the income statement gives information about the net profit or net losses of the firm.

Notes regarding the income statement

• Gross amount - The total amount earned by a company before the deduction of taxes and other deductions.
• Costs of the gold sold - The costs that are incurred by a firm to produce its products and services that are sold during a specific period. Examples - are labor costs and raw materials costs.
• Operating expenses - The expenses that have to be paid by the firm to maintain its regular ongoing business operations. Examples - salaries and marketing expenses.
• Depreciation - It takes into consideration the wear and tear of some assets (like machinery)
• Interest - The amount that can be earned from the deposits kept by the firm in the interest-bearing bank accounts and in the financial instruments.
• Earnings per share - They are also reported in the income statements. This gives information about the money the shareholders would earn if the firm decided to distribute all of the net earnings/ net profits for a specific period amongst the shareholders. (Companies rarely distribute all of their earnings. Some amount of the earnings are reinvested in the firm)

Balance sheet

• It depicts the financial health of the company on a specific date.
• It supplies detailed information about a company’s assets, liabilities, and shareholders’ equity.

Assets

Assets are valuable things that a company owns. Tangible assets examples include land, vehicles, machinery, and inventory whereas the intangible assets examples are trademarks and copyrights.

Types of the assets

• Current assets - If the assets are expected to be converted into cash within a year. An example is inventory.
• Non-current assets or fixed assets - If the assets are not expected to be converted into cash within a year. Non-current assets are the assets that are used to operate the business and are not available for sale. Examples are land, factories, intellectual property, real estate, etc.

Liabilities

Liabilities are amounts of money that a firm owes to others. Examples - bank loans, rental obligations for the use of the building.

Liabilities are of two types

• Short-term Liabilities- Current Liabilities or short-term liabilities are the obligations that are expected to be paid off within a year.
• Long-term liabilities- These are obligations that are not expected to be paid off within a year.

Shareholders’ equity

It is also known as net worth or capital. It is the amount of money that would be leftover if a firm sold all of its assets and paid off fully all of its liabilities/obligations. The remaining amount of the money belongs to the shareholders (who are the owners) of the firms.

The balance sheet equation:
$\text{Assets = Liabilities + Shareholder’s equity}$

Cash flow statements

It illustrates the cash inflows and cash outflows of the firm during a specific period. It is significantly vital to be aware of the cash position of the firm as it requires cash to pay for expenses and obligations and to purchase assets.

The cash flow statements can be categorized into three subdivisions:

• Operating activities
• Investing activities
• Financing activities

Operating activities

Cash flow from the operating activities depicts the amount of money a firm earns from its regular and ongoing business activities, such as selling goods and services to clients.

This portion of the cash flow statement first tells about the net income (that is derived from the income statement) and then the changes by the adjustments regarding the non-cash items (like adding back depreciation) are done. Any cash flows that were to be used or supplied by any other operating assets and liabilities also need to be adjusted.

Investing activities

It shows the cash flow from all the investing activities. If a firm purchases machinery, this purchasing activity would be reflected as a cash outflow and would be categorized as an investing activity.

The activities carried out in cash flow from investing actives are capital expenditures, lending money, and the sale of investment securities. Also, expenditures on property, plant, and equipment fall within this category as they are long-term investments.

Financing activities

An inflow of cash due to the selling of the stocks/shares and bonds or due to an increase in the bank loans. Repayment of the bank loan would lead to cash outflow.

To compute the cash flow of the financing activities, we use this equation:

CFF = CED - (CD + RP)

Where,

CFF = Cash flow for financing activities

CED = Cash inflows from issuing equity or debt

CD = Cash paid as dividends

RP = Repurchase of debt and equity

Examples of financing activities include selling or purchasing stocks from the stock exchange, issuance of bonds, payment of dividends, etc.

Note: $\text{The ending cash balance in the cash flow statement = Net cash flows from all the activities (Operations + Investments + Financing)}$

Context and Applications

A financial statement is a fundamental topic in accounting and engineering economics.
Understanding the financial statements is an essential must-have skill for stock investors.
It is taught in schools, undergraduate courses, and post-graduate courses.
Thorough knowledge of financial statements is required for clearing financial examinations such as Chartered Certified Accountant (ACCA), Chartered Financial Analyst (CFA), and so on.

Related Concepts

• Accountable Fundraising
• Center of Audit Quality (CAQ)
• Model audit
• Comprehensive annual financial report

Practice Problems

Q1) Which information do you get from the bottomline of the income ststement?

1. Total Expenditure
2. Total Revenue
3. Net profit or net loss
4. It does not give any information

Answer: Option b

Explanation: The top line of the income statement gives information about the total revenue earned by the firm. The bottom line of the income statement gives information about the net profit or net losses of the firm.

Q2) What is the full form of CFF and CED?

1. Currency flow for finished activities and Cash inflows from issuing elements or debt
2. Cash flow for forecasting activities and Cash free from issuing equity or depreciation
3. Cash flow for financing activities and Cash inflows from issuing equity or debt
4. None of the above

Answer: Option c

Explanation: To compute the cash flow of the financing activities, we use this equation CFF = CED - (CD + RP). Where, CFF is Cash flow for financing activities and CED is Cash inflows from issuing equity or debt.

Q3) If in the balance sheet, total assets are worth $20,000 and total liabilities are worth $ 10,000 then what will be the value of shareholders’ equity?

1. $10,000 
2. $5,000
3. $2,000
4. $20,000 

Answer: (a) 

Explanation: $$\begin{gathered} \text{Shareholder’s capital = Total assets – total liabilities} \\ = \$20,000 - \$10,000 \\ = \$10,000 \end{gathered}$$

Q4) If in a balance sheet, total current assets are worth $ 5,000 and the total non-current assets are worth $ 10,000, then what is the worth of total assets?

1. $ 5,000 
2. $10,000
3. $ 20,000
4. $15,000

Answer: (d) 

Explanation: Total assets are equal to the sum of Current assets and Non-Current Assets.

Total assets: $ 5,000 + $10,000 = $ 15,000

Q5)  In which of the following cash flow activities would you place the given action of selling goods and services to clients?

1. Operating activities
2. Investing activities
3. Financing activities
4. All the above

Answer: Option a

Explanation: Cash flow from the operating activities depicts the amount of money a firm earns from its regular and ongoing business activities, such as selling goods and services to clients.