Why Financial Statements are Necessary
There are a few reasons why financial statements are important.
First and foremost, they provide transparency into the company’s financial condition. This allows shareholders and other interested parties to make informed decisions about how to invest in the company.
Second, financial statements are an important tool for management to make decisions about allocating resources and managing risks.
Finally, financial statements can help investors evaluate a company’s performance over time.
In this article, you will understand the importance of financial statements and the elements that will help grow your business to the next level.
Why Financial Statements are Necessary?
Financial statements are necessary in order to provide a comprehensive overview of a company’s financial position. The statements show the company’s assets, liabilities, and equity, as well as its income and expenses.
This information is then used by investors, creditors, and other stakeholders to make informed decisions about the company. Financial statements are also used internally by management to assess the company’s financial health and make strategic decisions.
Financial Statement Components
Financial statements generally track a company’s performance by comparing it to its projected goals and historical trends. The components of financial statements include a balance sheet, income statement, and cash flow statement.
The balance sheet offers information about your company’s assets, liabilities, and owners’ or shareholders’ equity at a specific point in time. Meanwhile, an income statement shows how much revenue your business generated over a specific. The statement of cash flow shows the business’s inflows and outflows.
Let’s dig deeper below.
The income statement, also known as the profit and loss statement (P&L), is a financial statement that summarizes a company’s revenues and expenses over a specific period. The income statement shows a company’s net income or loss for that particular period. It can be used to track a company’s progress over time or compare different periods.
It is one of 3 key financial statements you must have for your business to properly evaluate the company’s financial health.
This statement includes revenue, expenses, and net income. Revenue is money that a company has earned from its sales. While expenses are the costs of doing business, such as salaries, rent, and supplies. Net income is the amount of money that a company has left after subtracting its expenses from its revenue.
In other words, your income statement will show whether or not you made a profit, but it won’t break down which products sold well or how much each product sold for. That information comes on your cash flow statement.
You can also use an income statement to track performance over time. Comparing month-to-month results will give you a sense of how your business grows or declines.
On the other hand, when creating an income statement, you must note that it is only a snapshot of your business’s activities at one point. While it gives information into your overall operations by showing revenues and expenses over a given period, you may need more insight to make informed decisions.
A balance sheet, AKA statement of financial position, represents a snapshot of a company’s assets, liabilities, and shareholder’s equity. The purpose is to show what an organization owns and owes and its net worth at a specific point in time.
This can also help investors understand how stable an organization is from a fiscal perspective. The total value of all assets minus total liabilities equals net worth. Positive net worth or owner’s equity indicates that an organization has more resources than it owes. In contrast, negative numbers indicate there is more debt than assets.
Assets include cash, investments, buildings, and land owned by an organization. Assets also include accounts receivable (money owed to an organization) and inventory (goods that have not yet been sold). Liabilities include short-term debt such as loan payables. Long-term debt includes mortgages on real estate owned by an organization, accounts payable, and taxes owed.
Equity includes capital stock issued by a corporation. It includes retained earnings (profits kept within a business), common stock; preferred stock; contributed capital, and surplus (the difference between assets minus liabilities).
Cash Flow Statements
A cash flow statement is a report of how much money a company has brought in and how much it has spent over a specific period of time. This report is helpful for businesses in order to track their expenses and make sure they are making a profit. An analogy for a cash flow statement could be like a bank statement. It shows how much money came in and went out during a certain period.
There are three categories of cash flow for a business to track: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. All three categories are included in a company’s cash flow statement.
Cash Flow Operating Activities
Cash flow from operating activities is a measure of the cash generated or used by a company’s core business operations. This figure includes the net income for the period as well as adjustments for non-cash items such as depreciation and amortization.
The cash flow from operating activities can be used to assess a company’s ability to generate cash from its day-to-day operations.
Cash Flow Investing Activities
The cash flow from investing activities is the net cash inflow or outflow from a company’s investments in securities, real estate, and other long-term assets. This figure includes both the cash received and paid as a result of investing activities.
For example, if a company sells a security for more than it paid, the cash flow from investing activities would be positive.
Cash Flow from Financing
Cash flow from financing activities refers to the amount of cash that a company generates through its financing activities. This includes issuing new debt or equity or repaying an old debt. The cash flow from financing activities can be positive or negative, depending on how much cash the company generates or spends.
Cash Flow Analysis
The key aspect to look at regarding a company’s financial well-being is the cash flow analysis.
Cash flow analysis evaluates how changes in a company’s cash flow will impact its overall financial stability.
The analysis looks at the company’s historical cash flow and future cash flow projections to determine whether the company has the ability to cover its short-term and long-term obligations.
This process is often used to make predictions about future cash flow, assess the risk of investing in a company, and make decisions about whether or not to extend credit to a company.
The analysis help investors understand how a company is performing and whether it is a good investment.
Ratio analysis is used to evaluate a company’s financial performance and liquidity. The ratios can provide insights into a company’s ability to generate cash, cover its debts, and make profits.
Some common ratios include the debt to equity ratio, the current ratio, and the gross profit margin.
It is helpful to look at a firm’s balance sheet and its profit and loss statement to understand its financial health. Ideally, when comparing two sets of numbers, you should be looking for three things:
- Do you see any profit; is the number positive or negative?
- Are the numbers increasing or decreasing?
- Are they near zero or very high in magnitude?
Why are the Balance Sheet, Income Statement, and statement of cash flow crucial to business growth?
The Balance sheet, Cash Flow Statement, and Income Statement are essential for business growth because they provide snapshots of a company’s financial health.
The Balance Sheet illustrates how much money the company has in assets and liabilities, the Income Statement magnifies how much money the company earned or lost over a given period of time. The cash flow statement shows how much money the company has brought in and out of the business.
Each of these statements provides information where you can run various ratio analyses to gauge the company’s financial performance.
Below is a list of ratios and where each figure can be found:
- Working Capital = Current Assets – Current Liabilities
- This can be found on the balance sheet.
- Inventory turnover ratio = Cost of Goods Sold / Average Value of Inventory
- Average Inventory = (Beginning Inventory + Ending Inventory) / 2
- Figures can be found on the Income Statement
- Debt to Equity Ratio = Total Liabilities / Total Shareholders equity
- The total numbers can be found on the company’s balance sheets
- Current Ratio – Short Term Assets / Short Term Liabilities
- This can also be found on the Balance sheet
- Cash Ratio = Cash + Marketable Securities / Short Term Liabilities
- Cash and Cash equivalents can be found on the statement of cashflow whereas short term liabilities are found on the balance sheet
- Gross Profit Margin or Gross Margin Ratio = (Total Revenue – Cost of Goods Sold) / Total Revenue
- You will find the total revenue and costs of goods sold on the income statement
- Note that the average gross margin is 10%, while 5% is considered low margins and 20% are high margins
Significance of Statement Analysis
Statement analysis is an important technique in accounting that helps analysts understand the financial condition of a company. By analyzing a company’s statements, analysts can identify trends and potential problems that may not be apparent by just looking at the numbers.
Statement analysis can also help investors better understand a company’s financial position and make more informed investment decisions.
These statements use specific reporting standards set by regulators and associations to provide information on a company’s ability to generate profit and withstand losses over time.
Statement analysis breaks down these reports into measurable ratios that help users evaluate how efficiently an organization manages its assets and resources over time to turn them into profits.
The resulting information helps users predict a company’s future profitability. In addition, statement analysis allows comparing one company’s performance against another or industry benchmarks.
Application of Analysis in Business Decisions
The most important reason financial statements are needed is that they provide a basic analytical framework for business decision-making. One of the major tenets of accounting and finance is that management must make decisions based on certain assumptions (usually expressed as the law of large numbers).
That means that no matter how well you’ve researched a decision, it’s important to evaluate your results using a probabilistic framework. This can be done by comparing various data points against one another and quantifying risk.
For example, you may know that your average cost to produce an item has always been $20. Still, if you were to expand production, you might anticipate higher costs. To make a sound decision about whether or not expanding production makes sense, you’d need some way of measuring what those additional costs might be.
Financial statements are important to the company’s bottom line. They help you run your business more effectively by allowing you to analyze and predict the future of the business. It also creates a sense of trust for investors and banks.
By tracking income and expenses regularly and projecting future growth, you can paint a picture of how successful or unsuccessful the business is. In addition, this will enable you to make better decisions for future success.
Financial statements are necessary for a business to track its financial performance over time and make informed decisions about its future. The 3 common financial statements are the balance sheet, income statement, and cash flow statement.
The balance sheet lists out the assets, liabilities, and shareholders’ equity at a specific point in time. The income statement illustrates revenue and expenses over a period of time.
The statement of cash flow shows the money coming in and out of the business through its day-to-day operations.
It’s important to keep track of your finances to have complete control over the business and make sure the company runs smoothly. Financial statements also provide valuable information to investors and creditors.