All businesses, from small start-up companies to larger multinational corporations, utilise financial statements to determine their financial viability. They play a critical role for internal management processes but also act as important resources for investors, creditors, analysts, and regulators. So knowing the different kinds of financial statements, and learning to read through financial reports can give you valuable insights into a company’s performance, stability and prospects.
In this ultimate guide, we will take a look at the core financial statements, what the components of these statements contain, and how to read the numbers with confidence.
What are Financial Statements?
Financial statements are official documents that disclose the overall business transactions and situation of any business. Three statements financial models offering a summary of an organisation over a time frame and usually prepared over a month, quarter, or year. They are used to:
- Track revenues and expenses
- Analyse profits and losses
- Monitor cash flows
- Examine financial standing and solvency
Financial statements are key to strategic decision-making for any stakeholder, from company executives to investors and lenders.
The Four Major Financial Statements
There are four major financial statements that provide different views of a company’s finances:
- Income Statement
- Balance Sheet
- Cash Flow Statement
- Statement of changes in equity
Now, let’s dive deeper into each of these.
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Income Statement
The profit and loss statement (also referred to as income statement) articulates a companys revenues and expenses for a specific period. It indicates whether an entity is making profit or loss while doing business.
Key components:
- Revenue (Sales): All income produced through business operations.
- Cost of Goods Sold (COGS): Expenses directly related to the products that were sold.
- Gross Profit: Revenue − COGS
- General Expenses: Overhead, marketing, R&D, and administrative related expenses
- Net profit (Net income): The final profit after deducting expenses and taxes.
It helps you evaluate the profit of a business, which is why understanding the income statement is important. This allows you to see trends in revenues and expenses and how effectively a business is running its operations.
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Balance Sheet
A balance sheet gives a snapshot of a business financial position at a specific moment in time. This is organised around the basic equation that comprises
Assets = Liabilities + Equity
Key components:
- Assets: All that belongs to the company. This encompasses current assets (such as cash and accounts receivable) and non-current assets (such as property and equipment).
- Liabilities: What the company owes. This consists of current liabilities (such as accounts payable) and long-term liabilities (such as loans and bonds).
- Equity: Owner share in the company, such as retained earnings and common stock
Understanding a balance sheet allows us to assess the liquidity, solvency, and capital structure of a company. It enables stakeholders to assess whether the company has sufficient assets to settle its obligations.
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Cash Flow Statement
You also have the cash flow statement, which is a record of how much cash actually went in and out over a period of time. As opposed to the income statement, which operates on an accrual basis, the cash flow statement looks at cash as it happens.
This is split into three domains as follows:
- Operating Activities: Cash generated or used from core business operations.
- Investing Activities: Outflow or inflow of cash used for investments such as purchased equipment, purchased property, or acquisitions.
- Financing Activities: Cash from, or used for, debt and equity issuance, dividends and other financing related items
The cash flow statement is necessary to analyse the liquidity and cash management of an enterprise. This tells whether a company can bring in enough cash to keep the business running and pay off its debts.
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Statement of Changes in Equity
Something that is usually not analysed by someone who is not an accountant would be, the equity statement which presents the changes in the equity of a company during a reporting period in a detailed manner. It includes:
- Net income or loss
- Dividend distributions
- Share issuance or buybacks
- Retained earnings adjustments
It acts as a link between the income statement and the balance sheet and clarifies the changes in shareholder equity through time.
How to Read Financial Reports Effectively?
Learning how to read financial reports can be difficult if you are new to the field of finance. That said, if you can break the process down into manageable steps, then you can gain learnings out of some of the most complicated documents.
Start With the Big Picture
Look for the time period the report covers and general context— Is the business expanding? Are there economic headwinds? Then, shift to singular statements.
Analyse the Income Statement
Look at:
- Revenue growth over time
- Changes in COGS and operating expenses
- Margins — Gross & Operating & Net
It indicates how well the company has converted sales into actual profit.
Review the Balance Sheet
Check:
- Current ratio: current assets ÷ current liabilities
- Debt-to-equity ratio: Total liabilities ÷ Shareholder equity
It also gives you these indicators that you can use to assess the financial and risk profile of the company.
Explore the Cash Flow Statement
Focus on:
- Operating cash flow: Does the company generate positive cash from its core business?
- Free cash flow: Operating cash flow minus Capital expenditures — This indicates the amount of cash available for growth and returns to shareholders
Statement of Changes in Equity: What to Know
This report is a bit more technical and it gives invaluable insight into how profits are either retained or distributed, as well as how new equity is managed.
Compare with industry benchmarks
Raw figures are only part of the full picture. Example compare metrics to lines of business and competitors, so that performance relative to peers can be contextualised.
The Importance of Financial Statements in Decision-Making
Financial statements are essential for determining the direction of business decisions, from the boardroom to the bank loan office. They:
- Be transparent and truthful.
- Help in financial planning & budgeting
- Assist in enticing investors and arranging funding
- Help ensure adherence to regulatory obligations
DROI are utilised by investors for determining the potential of return, lenders for risk assessment, and managers for indication of areas in need of improvement or potential cost-saving areas.
Common Mistakes Forged When Reading Financial Statements
These reports are useful, but you can avoid a few common pitfalls:
Net income only: This does not tell the whole story.
Cash Enabled: A company can be profitable but still short on cash.
Footnotes and disclosures go unread: A good reader skims the footnotes and disclosures where accounting policies, risks, and pending obligations are detailed.
Ignoring historical trends: 1 year’s data is insufficient. Identify patterns by looking across multiple periods.
Ignoring one-off items: Special or non-recurring gains or losses may skew underlying performance.
Keep these issues in mind, and your analytic and interpretative skills will be sharper.
Final Thoughts
To all accountants out there, we hope you know how to read financial statements! These reports have key value for decision-makers: entrepreneurs, investors, managers, and analysts need to know how to approach them. Understand the various financial statements — the income statement, balance sheet, cash flow statement, and the statement of equity — and you gain access to the numbers behind the story.
If you understand how to read financial reports, you are far better placed to allocate resources, weigh up opportunities and challenge issues. Financial Literacy is an extremely handy tool if you are planning a fresh investment, looking at a loan application or even wanting to just keep tabs on business health.
