Financial Statement

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What is a Financial Statement?

Financial statements are written reports created by a company’s management to summarize the business’s financial condition over a certain period (quarter, semester, or year).

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They provide crucial information to investors and other stakeholders who can learn about the current financial status of a company before they make investments or other strategic decisions.

Statements can be compared with other reports from previous years to identify trends and major changes in the company’s financial performance or with those of other companies to establish valuable comparisons.

How Does a Financial Statement Work?

Financial statements are made regularly to suit the different needs of the management and stakeholders who rely on this info.

Even though companies can summarize their financial performance in a single report, it is difficult for the stakeholders to depend on such a narrow overview to make major decisions.

Therefore, more than one statement is available to ensure that readers get a clear picture of the financial status and performance of the business.

Companies prepare a minimum of four financial statements, including a balance sheet, income statement, cash flow statement, and statement of changes in equity.

By using financial ratios and other calculations, stakeholders can analyze a company’s performance and financial health either to rate it as a potentially attractive investment (investors), take action regarding their portfolio exposure to the business (portfolio managers and analysts), or make strategic changes that can have a positive impact in its top and bottom line in the future (managers).

Businesses that generate robust cash flows are typically perceived as highly valuable as they can generate returns to shareholders that can be distributed in the form of dividends, or that will cause an increase in the company’s stock price.

Moreover, positive cash flows can be used to reinvest in the business, pay off its debts, and finance intense research and development (R&D) initiatives.

How are Financial Statements Calculated?

The preparation of financial statements requires that different transactions are classified appropriately. Accounts are separated into various categories, and they constitute the elements or components that make up the financial statements.

Some of these broad categories are:

The result of each financial statement is calculated by using a specific formula:

1. Balance Sheet Formula

Assets = Liabilities + Shareholders’ Equity

2. The Income Statement

Net profit is expressed as total revenues minus total expenses.

3. The Cash Flow Statement

Net cash used or generated by a company. This result is determined by deducting non-cash items and adding cash inflows and outflows not reflected in the income statement to the company’s net income to calculate the ending cash balance.

4. Statement of Changes in Equity 

Ending shareholders’ equity by calculating beginning equity plus net income minus dividends plus other comprehensive Income.

What are the Types of Financial Statements?

4 Types of Financial Statements

There are four main types of financial statements. Below is an overview of each:

Balance Sheet

The balance sheet is a financial statement that provides a snapshot of the status of a company’s assets, liabilities, and shareholders’ equity.

It adheres to the accounting equation:

Assets = Liabilities + Shareholders Equity

Key Components: 

Components Description
Assets This section expresses what the company owns and how much those possessions are worth. Assets are listed in descending order based on their liquidity. The most liquid assets are listed on top, starting with cash, while the less liquid ones are listed below such as property, plant, and equipment (PPE).
Liabilities This category expresses how much the company owes to third parties, including suppliers, employees, and the government. Liabilities are listed in descending order based on their due date. The debts that are due the soonest are listed on top, like accounts payable, while those that will be paid years from now are listed below like long-term debt and leases.
Shareholders’ Equity This is the amount of money that shareholders have invested into the business. Other items included in this section are retained earnings, treasury stock, and special reserves.

Income Statement

The income statement reports a company’s revenues, expenses, and bottom-line profit or net income during a specific period. It is used to gauge a business’s financial performance and profit-generation capacity.

Key Components:

Components Description
Revenues Revenues reflect the money a company has earned for selling goods or rendering services. This money is paid by customers.
Expenses Expenses are divided into various sub-categories. The first is known as the cost of goods sold (COGS), which reflects how much a company has spent to produce or buy the products it has sold. Next up, the income statement lists all operating expenses starting with administrative, sales, and marketing disbursements and followed by certain non-cash items like depreciation and amortization. Taxes and interest payments are also considered expenses and deducted from revenues.
Net Income This is the “bottom line” profit figure. It indicates how much the company was able to keep from the revenues it produced after all expenditures had been deducted.

Cash Flow Statement

It expands on the different items that affect the cash account to determine if the business has been producing or spending its liquid reserves during the observation period.

Key Components: 

Components Description
Cash from Operations This is the sum of a company’s net income plus changes in its working capital, like increases and decreases in accounts payables, receivables, and inventory.
Cash from Investing Here, capital expenditures and financial investments, including those associated with mergers and acquisitions, are listed.
Cash from Financing Activities The money obtained from or paid back to lenders is listed here, along with funds received from investors and dividends paid to shareholders
Net Cash Used or Produced This is the net result after all cash items have been deducted or added to the company’s net income. The result is a negative or positive figure that affects the company’s cash reserves and explains how they moved from the initial to the ending balance.

Statement of Changes in Equity

This statement highlights how shareholder’s equity has evolved during the period by revealing movements in related accounts like retained earnings, paid-in capital, and treasury stock.

Key Components: 

  • Beginning and ending shareholder’s equity.
  • Beginning and ending retained earnings:
  • Changes resulting from net income, dividends paid, new shares issued, or buybacks.

What are the Pros and Cons of a Financial Statement?

Pros

  • Provide transparency regarding a company’s financial performance.
  • Help investors and creditors make decisions.
  • Track the business’s progress over time.
  • Require standardized reporting for consistency.
  • Identify financial strengths and weaknesses.

Cons

  • Open to manipulation or creative accounting.
  • Do not reflect qualitative factors.
  • Require a certain level of financial literacy to be understood.
  • Historical nature limits their ability to be used for predictive ability.

Financial statements play a vital role in communicating crucial financial information to investors, creditors, regulators, and internal management.

Though they are not necessarily accurate unless strict guidelines are followed during their preparation, financial statements are still the most powerful tools that both internal and external parties have to analyze a company’s performance and financial situation.

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Alejandro Arrieche Rosas
Financial Reporter
Alejandro Arrieche Rosas
Financial Reporter

Alejandro has seven years of experience writing content for the financial industry and more than 17 years of combined work experience, serving under different roles in multiple business fields, including tech and financial services. Before joining Techopedia, Alejandro collaborated with numerous online publications such as Seeking Alpha, The Modest Wallet, Capital.com, Business2Community, EconomyWatch.com, and others, covering finance, business news, trading platform reviews, and educational articles for investors. Alejandro earned a Bachelor's in Business Administration from UNITEC, Venezuela, and a Master's in Corporate Finance from EUDE Business School, Spain. His favorite topics to cover are value investing and financial analysis.