Financial statements present the results of operations and indicate the financial position of the company. The three fundamental statements used by companies are:
Balance Sheet / Statement of Financial Position
Income Statement / Profit & Loss Statement
Cash Flow Statement
What does each statement stand for, and how should we distinguish one from the other?
The Balance sheet displays the company’s total assets (i.e. resources owned or controlled by the company), and how these assets are financed, through either liabilities (i.e. legal obligations or debt) or equity (i.e. shared capital and retained earnings). It therefore tells you whether the company is able to pay its bills on time, whether it has sufficient financial flexibility to acquire capital and whether it is able to distribute cash in the form of dividends to the company’s owners.
Current assets refer to cash or cash equivalents that would be expected to be used during the normal operating cycle of the business, usually one year. Non-current assets, on the other hand, are those that cannot be easily converted into cash or cash equivalents. These include buildings, equipment, and trademarks.
Similarly, current liabilities are debts or obligations that need to be paid within one year, such as bills payable and accrued expenses. These should be closely watched by management to ensure that the company possesses enough liquidity from current assets to guarantee that the debts or obligations can be met. Non-current liabilities are those debts or obligations that are to be settled in over a year’s time, such as bonds payable and deferred tax liabilities. They are crucial in determining a company’s long-term solvency. If a company is unable to repay its long-term liabilities when they become due, then the company will face a solvency crisis.
With reference to the equity component, shared capital relates to the amount invested by a company’s shareholders for use in the business. It remains separate from any other equity generated by the business itself, as the latter amounts will flow directly into the retained earnings account.
As a result, the foundation of the Balance Sheet lies in the following key accounting equation:
Whilst the Balance Sheet determines a company’s financial position, the Income Statement focuses directly on the company’s profit and loss over a specific period of time. It is determined by taking all revenues and subtracting all expenses from both operating activities (i.e. regular business operations) and non-operating activities (i.e. all other external operations).
Like the Balance Sheet, the Income Statement comprises of several line items which may slightly vary between different companies, as expenses and income rely on the type of operations or business conducted.
The income generated from continuing operations is the heart of the Income Statement. Operating expenses (which include salaries, rent, insurance and marketing costs) are deducted from the company’s total revenue to provide the Operating Income, also known as ‘Earnings Before Interest and Taxes’ (EBIT). Once that is calculated, the Income Statement goes on to list the non-operational revenues and expenses. The bottom line is ultimately the ‘net income’ (or ‘net loss’), which then goes on to be divided by the weighted average shares to the determine the Earnings Per Share.
Cash Flow Statement
As the name implies, the Cash Flow Statement shows how much cash is generated and used during a given timeframe. It is built on three main categories: (1) operating activities, (2) investing activities, and (3) financing activities of a company.
The total cash resulting from or used by all three activities is summed to obtain the total change in cash for the specified timeframe, which is then added to the opening cash balance to arrive at the cash flow statement’s bottom line, the closing cash balance.
Following up on this, there are essentially two kinds of cash flows:
- Positive cash flow: when inflowing cash exceeds outflowing cash
- Negative cash flow: when outflowing cash exceeds inflowing cash.
The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company.
Businesses fail in the long term through lack of profit, but in the short term, they fail because they don’t have enough cash to pay their bills. Managing your cash flow effectively is therefore absolutely essential and it is the key to business survival.