Financial Statements: Uses, Purposes, Advantages and How they relate together?

Cash is the vital resource that is necessary for any business to function effectively. It is required to meet debts that become due and to acquire other resources (such as inventories). Cash has been described as the ‘lifeblood’ of a business. However, reporting and monitoring cash movements alone is not enough to portray the financial health of the business especially that business wealth can be held in various forms like cash, inventories, property, equipment, motor vehicles...etc. From here we can start realizing the importance of the financial statements and how they interrelate together.

Financial statements are records to convey the business activities and the financial performance of a business, they aim to provide a picture of the financial position and performance of a business based on three financial statements produced on a regular, recurring basis and together they provide an overall picture of the financial health. Financial statements are often audited by government agencies, accountants, firms, investors etc. To ensure accuracy and for tax, financing, or investing purposes. The three financial statements (cash, income, financial position) are often referred to as the final accounts of the business and they include:

·        The statement of cash flows; it shows what cash movements took place?

·        The income statement (also known as the profit and loss account), it answers how much wealth was generated?

·        The statement of financial position (also known as the balance sheet), it answers what is the accumulated wealth of the business at the end of the period and what form does it take?

The statement of financial position shows the various assets (including cash) and claims (including the shareholders’ equity) of the business at a particular point in time. The statement of cash flows and the income statement explains the changes over a period to two of the items in the statement of financial position. The statement of cash flows explains the changes to cash. The income statement explains changes to equity, arising from trading operations. The statement of financial position shows the relationship, at a particular point in time, between the business’s assets and claims. The income statement explains how, over a period between two statements of financial position, the equity figure in the first statement of financial position has altered as a result of trading operations. The statement of cash flows also looks at changes over the reporting period, but this statement explains the alteration in the cash (and cash equivalent) balances from the first to the second of the two consecutive statements of financial position.

For external users (that is, virtually all users except the managers of the business concerned), these statements are normally backwards-looking because they are based on information concerning past events and transactions. This can be useful in providing feedback on past performance and in identifying trends that provide clues to future performance. However, the statements can also be prepared using projected data to help assess likely future profits, cash flows and so on. Normally, this is done only for management decision-making purposes.

The statement of financial position may help users in the following ways:

·        It provides insights about how the business is financed and how its funds are deployed. The statement of financial position shows how much finance the owners contribute and how much is contributed by outside lenders. It also shows the different kinds of assets acquired and how much is invested in each kind.

·        It can provide a basis for assessing the value of the business. Since the statement of financial position lists, and places a value on, the various assets and claims, it can provide a starting point for assessing the value of the business. We have seen earlier, however, that accounting rules may result in assets being shown at their historic cost, which may vary quite considerably from the current valuation, and that the restrictive definition of assets may completely exclude certain business resources from the statement of financial position.

·        Relationships between assets and claims can be assessed. It can be useful to look at relationships between various statements of financial position items, for example, the relationship between how much wealth is tied up in current assets and how much is owed in the short term (current liabilities). From this relationship, we can see whether the business has sufficient short-term assets to cover its maturing obligations.

·        Performance can be assessed. The effectiveness of a business in generating wealth can usefully be assessed against the amount of investment that was involved. Thus, the relationship between profit earned during a period and the value of the net assets invested can be helpful to many users, particularly owners and managers.

The balance sheet formula..............assets = liabilities + owner's equity

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The income statement – or profit and loss account, as it is sometimes called – measures and reports how much profit a business has generated over a period. It is, therefore, an immensely important financial statement for many users. To do so, we need to record all business revenues and expenses.

Revenue is simply a measure of the inflow of economic benefits arising from the ordinary operations of a business. These benefits will result in either an increase in assets (such as cash or amounts owed to the business by its customers) or a decrease in liabilities. Different forms of business enterprise will generate different forms of revenue. Some examples of the different forms that revenue can take are as follows:

·        Sales of goods (for example, by a manufacturer)

·        Fees for services (for example, of a solicitor)

·        Subscriptions (for example, of a club)

·         Interest received (for example, on an investment fund).

Expense is really the opposite of revenue. It represents the outflow of economic benefits arising from the ordinary operations of a business. This loss of benefits will result in either a decrease in assets (such as cash) or an increase in liabilities (such as amounts owed to suppliers). Expenses are incurred in the process of generating revenue or, at least, in attempting to generate it. The nature of the business will again determine the type of expenses that will be incurred. Examples of some of the more common types of expense are:

·        The cost of buying or making the goods that are sold during the period concerned – known as the cost of sales or cost of goods sold

·        Salaries and wages

·        Rent motor vehicle running expenses

·       Insurance

·        Printing and stationery

·       Heat and light

·       Telephone and postage.

The income statement simply shows the total revenue generated during a particular reporting period and deducts from this the total expenses incurred in generating that revenue. The difference between the total revenue and total expenses will represent either profit (if revenue exceeds expenses) or loss (if expenses exceed revenue). Therefore:

Profit (or loss) for the period = total revenue for the period _ total expenses incurred in generating that revenue

The income statement and the statement of financial position are not substitutes for one another. Rather, they perform different roles. The statement of financial position sets out the wealth held by the business at a single moment in time, whereas the income statement is concerned with the flow of wealth (profit) over a period of time. The two statements are, however, closely related.

The income statement links the statements of financial position at the beginning and the end of a reporting period. At the start of a new reporting period, the statement of financial position shows the opening wealth position of the business. At the end of that reporting period, an income statement is prepared to show the wealth generated over that period. A statement of financial position is then prepared to reveal the new wealth position at the end of the period. It will reflect changes in wealth that have occurred since the previous statement of financial position was drawn up.

Assets (at the end of the period) = equity (amount at the start of the period + profit (or - loss) for the period) - liabilities (at the end of the period)

From the income statements, we can calculate and conclude different types of profits as follows:

·        The gross profit, which represents the profit from buying and selling goods, without taking into account any other revenues or expenses associated with the business.

·        When we consider the operating expenses (overheads) incurred in running the business (salaries and wages, rent, insurance and so on) and then deduct them from the gross profit. The resulting figure is known as the operating profit. This represents the wealth generated during the period from the normal activities of the business.

·        After reaching the operating profit, we add any non-operating income (such as interest receivable) and deduct any interest payable on borrowings to arrive at the profit for the period (or net profit).

The income statement may help in providing information on:

·       How effective the business has been in generating wealth. Since wealth generation is the primary reason for most businesses to exist, assessing how much wealth has been created is an important issue. The income statement reveals the profit for the period, or bottom line as it is sometimes called. This provides a measure of the wealth created for the owners. Gross profit and operating profit are also useful measures of wealth creation.

·        How profit was derived. In addition to providing various measures of profit, the income statement provides other information needed for a proper understanding of business performance. It reveals the level of sales revenue and the nature and amount of expenses incurred, which can help in understanding how profit was derived.

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The statement of cash flows. This statement reports the movements of cash over a period and the effect of these movements on the cash position of the business. It is an important financial statement because cash is vital to the survival of a business. Without cash, a business cannot operate.

The income statement sets out the revenue and expenses for the period, rather than the cash inflows and outflows. This means that the profit (or loss), which represents the difference between the revenue and expenses for the period, may be quite different from the cash generated for the period.

The importance of cash lies in the fact that people will only normally accept cash in settlement of their claims. Cash generation is vital for businesses to survive and to be able to take advantage of commercial opportunities.

The statement of cash flows summarises the inflows and outflows of cash (and cash equivalents) for a business over a period. To aid user understanding, these cash flows are divided into categories. Cash inflows and outflows falling within each category are added together to provide a total for that category. These totals are shown on the statement of cash flows and, when added together, reveal the net increase or decrease in cash (and cash equivalents) over the period.

The cash flows of a business are divided into categories:

·       Cash flows from operating activities

These represent the cash inflows and outflows arising from normal day-to-day trading activities, after taking account of the tax paid and financing costs (equity and borrowings) relating to these activities. The cash inflows for the period are the amounts received from trade receivables (credit customers settling their accounts) and from cash sales for the period. The cash outflows for the period are the amounts paid for inventories, operating expenses (such as rent and wages), tax, interest and dividends. Cash inflows and outflows during a period that appear in the statement of cash flows, not revenue and expenses for that period. Similarly, tax and dividends that appear in the statement of cash flows are those actually paid during the period.

·      Cash flows from investing activities

These include cash outflows to acquire non-current assets and cash inflows from their disposal. In addition to items such as property, plant and equipment, non-current assets might include financial investments made in loans or shares in another company. These cash flows also include cash inflows arising from financial investments (loans and shares). The main forms of cash inflows from financial investments are normally interest received on loans made by the business and dividends received from shares held in other companies.

·        Cash flows from financing activities.

These represent cash inflows and outflows relating to the long-term financing of the business such as cash movements relating to the raising and redemption of long-term borrowings and to shares.

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General benefits of financial statements

Other than the legal ramifications of not keeping good books, there are many other benefits of financial reporting that financial statements provide to the long-term health and growth of a company. Each has its own role to play in the snapshot it offers.

Better debt management. The amount of debt your company carries and in what form is an important measure of the financial health of your company. Financial statements separate your assets from liabilities and give you a picture of what you owe versus what you are bringing in.

One of the advantages of financial statements is knowing what your liquid assets are so you can help you manage those debts you have – and pay off the highest-cost liabilities first.

Identifying trends. Financial statements help a company's management take a quick and detailed look at the ways in which they have been doing business over a period of time, as well as to identify any past or present trends that can either lead to problems down the road and need to be tackled right away. They can also be used to to identify sales and growth trends that could lead to increased profitability.

Progress tracking in real-time. Financial statements are designed to be fluid documents that change many times over the course of a reporting period, depending on many different income and expense factors. Therefore, paying close attention to statements such as the balance sheet can make it easier to make important decisions while things are happening, rather than having to retroactively respond to receiving bad news later on.

Managing liabilities. Every business has liabilities ranging from business loans to credit cards to vendor accounts and other accounts payable. It’s always a good idea to have this information available, and if you apply for most loans or lines of credit, it’s usually expected that you will have this information available quickly and in an easy-to-read format.

Progress and compliance. Another of the many advantages of financial statements is that by having a series of accurate financial documents, it will be much easier for you to gauge whether or not your business is making progress or falling behind.

In addition, if the company is ever audited, the first thing an accountant will ask for are the company’s financial statements to stay in compliance with generally accepted auditing standards that govern their industry.

What’s more, they are bound to financial reporting requirements required by law to report if your documents are not up to standards. That can look bad to government regulators and investors.

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by:

Mohammed Ziyad Al-Zghool, 2020

Taken from:

Accounting and Finance: An introduction, 8th Edition by Eddie McLaney and Peter Atrill.

Investopedia

AzCentral