Financial statements are reports prepared by a company’s management to present the financial performance and position at a point in time. A general-purpose set of financial statements usually includes a Profit and Loss Statement, a Balance Sheet, and a Statement of cash flows.
Financial statements are the main source of financial information for most decision-makers. That is why financial accounting and reporting places such a high emphasis on the accuracy, reliability, and relevance of the information on these financial statements. Companies can be evaluated based on past, current, and projected performance.
In this blog, we will break down the key elements of each financial statement and explain their significance to both internal and external decision-makers.
Importance of Financial Statements for Stakeholders
Financial statements offer a wealth of information crucial for assessing a company’s viability, profitability, and potential for growth. Different stakeholders leverage them for varied purposes:
1. For Management:
The complexities and the size of the business make it necessary for the management to have up-to-date, accurate, and detailed information on the business and its financial position. The financial statements help the management in understanding the performance of the company in comparison to the other businesses and the sector.
Providing management with accurate information enables them to form proper policies for the companies and make correct decisions. These statements rank the performance of management, the performance of these statements helps management justify their work to all the parties involved in the business.
2. For Shareholders:
Shareholders are the owners of the business but do not take part in making decisions and day-to-day activities. However, these results are shared with the shareholders as quarter and annual updates. These statements enable the shareholders to understand how the company has been performing. It also allows them to judge the present and future performance. Financial statements are the most important source of information for current and prospective investors.
3. For Creditors & Lenders:
Factors like liquidity, debt, and profitability are all judged by the essential metrics in the financial statements. Creditors and Lenders are mostly concerned about the company’s debt and liquidity position. Analyzing these statements helps them decide if they want to continue providing goods and services and determine the future course of action.
4. For Government & Regulatory Authorities:
The government and regulatory authorities use these financial statements for taxation and regulatory purposes. Also, these financial statements help authorities assess the business performance of these companies in various sectors to assess the economy’s performance as well.
The Profit & Loss (P&L) Statement
Statement of profit and loss captures the Revenues and expenses a company has incurred from both Operating and Non-Operating activities over a specific period, usually a month, quarter, or a given financial year. It is also called an Income Statement, and captures the basic elements of the following equation:
Profits = Revenues – Costs
P&L statements are additive in nature (unlike Balance Sheets). The revenues/costs/profits for a financial year equals the sum of revenues/costs/profits for all the quarters within the financial year. This statement is based on the accrual method of accounting i.e. revenues and expenses are recognized as and when they are incurred (movement of cash is immaterial). To better understand, consider the following example:
A businessman Ramesh procures computer parts from his supplier Ganesh, assembles them into computers, and sells them to a customer Suresh every month. As per the terms of the contract, Suresh pays Ramesh every quarter and Ramesh pays Ganesh once Suresh has made payments (Quarterly) i.e. all the payments are settled at the end of every quarter. In the Cash method of accounting, all the revenues/costs/profits would be recorded at the end of the quarter, when all the payments take place. But in the Accrual method of Accounting (generally followed practice), all the revenues/costs/profits would be recorded as and when incurred.
Key Components of a P&L Statement
1. Net Revenue/Net Sales:
Net revenue refers to sales made by the company during an accounting period, adjusted for returns, discounts, or replacements. It typically includes income from the company’s main line of business.
2. Cost of Goods Sold (COGS)/Cost of Sales:
COGS includes direct costs for producing goods or services, such as materials and labor. It excludes indirect expenses like distribution and salesforce costs.
3. Gross Profit:
Gross profit is derived by subtracting COGS from net sales, reflecting the profit after production costs. It measures a company’s production efficiency.
4. Other Income:
Other income covers ancillary earnings from interest, dividends, rents, royalties, or capital asset sales. It often represents one-time or non-core business revenues.
5. Operating & Direct Expenses:
These include costs beyond procurement, like packaging, transportation, and commissions. These expenses are directly linked to selling goods or providing services.
6. General & Administrative Expenses (G&A):
G&A expenses are daily operational costs like rent, utilities, maintenance, and employee amenities. These are not tied to specific business departments.
7. Employee Benefit Expenses:
Employee benefits include wages, bonuses, and retirement contributions. These are part of the compensation package offered to employees.
8. Other Expenses:
Other expenses include non-operating or unexpected costs unrelated to the core business, such as impairment losses or restructuring charges.
9. Operating Profit (EBITDA):
EBITDA is the profit from core business operations before interest, taxes, depreciation, and amortization. It shows operational profitability.
10. Depreciation & Amortization:
Depreciation allocates a fixed asset’s cost over its life, while amortization does the same for intangible assets. These represent asset usage costs.
11. Profits/Earnings Before Interest & Taxes (EBIT):
EBIT is calculated as EBITDA plus non-operating income minus depreciation and amortization. It measures earnings from operations, ignoring taxes and interest.
12. Interest Expenses:
This includes costs incurred on loans and credit facilities. Analysts assess these to understand a company’s ability to manage its debt obligations.
13. Profit/Earnings Before Taxes (PBT):
PBT measures profitability before tax payments, helping investors analyze a company’s performance regardless of differing tax rates.
14. Taxes:
This represents direct taxes paid on profits but excludes indirect taxes like GST.
15. Profit After Tax (PAT):
PAT is the net profit remaining after taxes, providing a clear measure of actual profitability. It is derived by deducting taxes from PBT.
The Balance Sheet
A balance sheet is a financial statement that reports a company’s assets, liabilities and shareholders’ equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure. It is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders.
In simple words, the Balance Sheet adheres to the following equation:
Total Assets = Total Liabilities + Shareholders’ Equity
This equation ensures that a company’s financial obligations are balanced against its resources. The balance sheet is a useful tool for investors and creditors to assess a company’s solvency and its ability to meet long-term obligations.
Major Components of a Balance Sheet:
1. Total Assets:
These are everything the company owns, and they are classified as either current or non-current:
Non-current Assets: Long-term investments that are not easily converted into cash. Examples include property, plant, machinery, and intangible assets like patents or trademarks.
Current Assets: Short-term assets like cash, accounts receivable, and inventory, which are expected to be converted into cash within a year.
2. Total Liabilities:
Total liabilities represent what the company owes to others. These are also divided into current and non-current categories:
Non-current Liabilities: Long-term obligations, such as bank loans or bonds payable, due in more than one year.
Current Liabilities: Short-term obligations that must be settled within a year, such as accounts payable or short-term loans.
3. Shareholders’ Equity:
This represents the owners’ stake in the company and is calculated as total assets minus total liabilities. Positive equity means the company has enough assets to cover its liabilities. If equity is negative, it indicates potential financial trouble.
The Cash Flow Statement
The cash flow statement tracks the inflow and outflow of cash over a specific period, categorized into three main activities:
1. Operating Activities:
These are the core business activities that generate revenue, such as sales and purchases. This section tracks cash from operations like product sales or payments to suppliers.
2. Investing Activities:
Investing activities include cash flows related to the purchase or sale of physical and financial assets, like equipment, buildings, or investments in other companies.
3. Financing Activities:
This section captures cash flows from activities related to the company’s financing structure, such as issuing stock, borrowing money, or paying dividends.
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Frequently Asked Questions (FAQs):
1. What are the main types of financial statements?
The three primary types of financial statements are the Profit & Loss (P&L) Statement, Balance Sheet, and Cash Flow Statement. Each provides essential insights into a company’s financial health.
2. Why are financial statements important for stakeholders?
Financial statements help stakeholders assess a company’s profitability, liquidity, and overall financial position. They guide decisions for investors, management, lenders, and regulatory authorities.
3. How does the cash flow statement differ from the P&L statement?
While the P&L statement records revenues and expenses based on accrual accounting, the cash flow statement focuses only on actual cash inflows and outflows within operating, investing, and financing activities.
