2.1 Financial Statements
Suppose you decide to start a company to manufacture iron rods for building construction. How do you know if your company is doing well? What are the key business objectives that you have to keep in mind? If you are looking for investors to expand your business, what information do you have to present to them? What data do investors and management use to gauge the company’s performance? The answers to these questions lie in the financial statements of the company.
Financial statements are official records of the financial standing and activities of a business. These statements contain the data necessary to evaluate financial strength of the company. The two primary objectives of every business are profitability and solvency. Profitability is the ability to generate income. Solvency is the ability to pay debts as they become due. Unless a business can generate satisfactory income to pay its debts, the business cannot survive.
There are three basic financial statements. Together they present the profitability and strength of a company:
- An income statement, sometimes referred to as a statement of profit and loss, reflects a company’s profitability.
- A balance sheet, sometimes referred to as a statement of financial position, reflects a company’s solvency.
- A statement of cash flows shows the cash inflows and outflows for a company over a period of time (e.g. a month, a quarter or a year).
The details reported in the financial statement are related to the goal of the statement. That is, the statement contains only the information needed for the goal of that specific statement, e.g. the income statement only includes data that indicates the profitability of the company for a certain period of time. Although the specific headings and elements included on each statement depend on the company’s type of business, they are often very similar and follow accounting standards. Standardized formats were established to ensure company reported accurately honestly and transparently. This also enables comparison of the financials between companies. For example, without standardized formats it could be difficult to compare the financial data of a company in the service industry to the one in manufacturing. The structures of the companies, as well as how they generate income are very different. The standardized nature of financial statements, however, allows anyone to see the key information about the companies’ performance in a similar way, despite the differences. This allows the management team and potential investors to navigate the statements and obtain relevant financial information about the company without having to delve into the intricacies of a company’s business.
Financial statements contain a lot of specific terminology. We will be explaining some of the most common terms used on the statements as we go.
An essential part of financial statements are the notes that accompany them. These notes are generally located at the end