Understanding Financial Statements: Balance Sheets, Income Statements, and More - Henderson Edition

The Balance Sheet:

We all heard of balance sheets before but what is it? It is a brief appraisal of a company’s assets, liabilities, and shareholders’ equity at an exact moment. It provides a basis to calculate rates of return and evaluate the capital structure of a company. Presented with the following formula: Assets = Liabilities + Shareholders’ Equity is balance sheet.

What are Basic Bookkeeping Terms?

1.   Assets: Resources owned by the company, expecting to bring future economic benefits. We can classify them in to two types:

Current assets: can be converted into cash within one year

A.  Current assets: can be converted into cash within one year 
B.  Non-current assets: are more long term, like real estate and equipment.

2.  Liabilities: Represent what the company owes and must be settled over time through the transfer of economic benefits. These benefits include money, goods, services or similar. Liabilities are divided into:

A.  Current liabilities: due within one year.
B.  Long-term liabilities: due after one year.

3.  Shareholders’ Equity: The remaining interest in the assets of the company after deducting all liabilities. It includes funds contributed by shareholders and withhold earnings.

4.  The Income Statement: An income statement, also known as profit and loss statement, outlines a company’s revenues and expenses over a period of time. Typically a fiscal quarter or year. This statement reflects how the revenue is transformed into the net income or net profit.

Revenue starts the statement. It is the total amount of money received from the sale of goods and services related to the company’s primary operations.

Expenses include the cost of goods sold (COGS) and other operating expenses—salaries, rent, and utilities. Deducting expenses from revenue gives the operating profit.

Net Income is calculated by subtracting interest, taxes, and additional expenses from operating profit. This is the profit remaining at the disposal of the company after all obligations are settled.

5.  Cash Flow Statement

Even though it wasn’t initially discussed, the cash flow statement is another crucial part of a group of financial statements. The purpose of the statement is to break down the financial activities of a business or company. We can break them down into operating, investing, and financing activities. This statement provides a detailed analysis of cash inflows and outflows. This document plays an important role at assessing the liquidity and long-term solvency of a company.

Other Financial Reports Apart from the basic financial statements mentioned before, companies often prepare additional reports such as:

Statement of Retained Earnings: This document outlines the changes in withhold earnings over the reporting period.

Notes to Financial Statements: These notes provide additional insights and detail about the financial condition and results of operations.

Why Are Financial Statements Important?

Financial statements are not just about numbers; they show the company’s activities in financial terms, helping to evaluate its performance and set correct strategies for its future. Here are some examples where they come in handy:

Investment Decisions: Investors use financial statements to assess the viability and profitability of investing in a company.

Lending Decisions: Banks and other financial institutions analyze these documents to decide whether to lend money and at what terms.

Performance Evaluation: Management uses these reports to make strategic decisions, aiming for efficiency and profitability.

Regulatory Compliance: Financial statements guarantee compliance with accounting standards and regulations, providing transparency for stakeholders.

Reading Financial Statements

Since they are based on the accounting principles a person must understand them in order to effectively read financial statements, on which they are based. Recognizing the connections between the balance sheet, income statement, and cash flow statement is critical. Let me try and explain it with an example. Profit from the income statement increases the asset base on the balance sheet, while losses decrease it.

Additionally, analyzing financial statements involves looking beyond the figures to understand the relationships among them. Here is an example. A high debt-to-equity ratio on the balance sheet may be a signal of a risky level of borrowing, but at the same time it must be weighed against the profitability shown on the income statement and the cash flows from operations.

Understanding the basics of financial statements is crucial for anyone involved in business. It goes for the new entrepreneurs to experienced investors. These documents show a broad picture of financial health, strategic potential and operational effectiveness of the company. Understanding how to read and interpret these statements with accuracy is the key to making informed and correct business decisions. When done properly it guarantees the financial well-being of the entity.