The Three Main Financial Statements

Financial statements act as a record of the financial activities of a business. These statements are useful to investors and analysts as they can examine them in order to gauge the financial performance of a company. The three main financial statements are the balance sheet, the income statement, and the cash flow statement. These three each offer different information but remain interconnected, altogether they complement each other and provide comprehensive view of a business [1].

The balance sheet acts as a snapshot of the financial position of a company at a given point in time. It has three main sections displaying all of the company’s assets, liabilities, and shareholders’ equity [2]. Assets are resources owned by the firm that have value. This can be in the form of physical resources such as machinery/equipment, and property. Assets can also be intangible in the form of patents and trademarks. Cash is another example of an asset. Assets tend to be listed on the balance sheet based on their liquidity (how quickly it can be converted to cash). Current assets can be expected to be converted into cash/sold within one year, whereas non-current assets are expected to take longer for example property.

The liabilities are what the business owes to others. This can be money that was borrowed from a bank for financing, rent owed for use of a building, payments owed to suppliers etc. The liabilities are essentially any outstanding obligatory payments that the company has. Typically, the liabilities are listed according to their due date. These can be in the form of current liabilities which are due within one financial year or long-term liabilities that are expected to be paid off later. The final part of the balance sheet shows the shareholders’ equity. This is the remaining money if all assets were sold and all liabilities were fully paid off. The key accounting formula of the balance sheet is Assets = Liabilities + Shareholders’ Equity [3]. While the balance sheet displays the assets, liabilities and shareholders’ equity at certain time period, it does not show the flows in and out of the company’s accounts for the duration of the period, which is why it is important to take a look at the other statements.

The Income statement shows the revenues and expenses of a firm over a specified period of time, this can be a financial quarter, a full year or for only a part of the year. It provides information on what the business earns and the costs of its operations that generate its revenue [4]. The top of the statement will display its gross revenue/sales for the given period. This is all of the revenue generated from the sale of goods and services by the firm. Then it deducts the expenses associated with earning that revenue, these are direct expenses (the cost of the goods and services sold), giving the gross profit for the firm. Next the indirect expenses are deducted, these are the operational costs of the firm which differ to the previous expenses as they are not directly related to the production of the goods and services. Indirect expenses can be the administrative costs, maintenance costs, marketing costs etc. Then, depreciation is factored in which is deducted from gross profit. Depreciation accounts for the fall in the value of an asset over time, this can be the wear and tear of machinery owned by a firm that are used for long time periods. The cost of these assets can be spread over the length of time they are used for, through the process of amortisation.

Once the direct and indirect expenses are deducted from the gross profit, it gives the operating profit of the company. But this is before interest and taxation have been taken into account. This is referred to as the operating profit of the firm. Interest payments must now be taken into account. Firms can earn interest income from cash stored in savings accounts which bear interest, or from money market funds and investment portfolios. Interest expenses are the costs of borrowing for the firm, if they have borrowed money they will have to pay interest to their creditor. The income statement may display these interest income and expenses separately or sum both of them, which is then either added or subtracted from the operating profits depending on if it is positive or negative. This will give the operating profit before taxation. The last step is to subtract the total income tax paid to the government which will result in net profit or net loss. The is called the “bottom line” of the income statement and shows the net earnings/losses of the business over the specified period. Earnings per share (EPS) can also be included, this is the net income divided by the number of outstanding shares. EPS gives the amount of money one would receive for owning one share of the company if they distributed all of its net income as dividends. The income statement helps to assess the profitability of the firm as it shows whether it made or lost money for the given time.

The cash flow statement is a report of the firm’s inflows and outflows of cash. It shows the transaction of money over a certain time period. It shows how money where money entering the business is coming from, and how it is being spent. This statement consists of three main parts: the operating, investing, and financing activities of the company. The first part displays the operating activities, showing the cash generated from net income/losses. The first line of this section is the net income as shown in the income statement. The net income is a measure of the profitability of the company, but no the net cash flow. To obtain the net income non-cash expenses were deducted (depreciation & amortisation) so these are added back. It also adjusts according to any cash that was generated or used for operating activities.

The second part contains the cash flows from the investing activities of the firm. This can be due to the purchase/sale of long-term assets (property, plant and equipment), as well as buying or selling from the firm’s investment portfolio. The sale of these assets would be a cash inflow and purchasing assets would be a cash outflow. The third part is the cash flow from financing activities. Selling stocks/bonds or borrowing from a bank to raise funding would be a cash inflow, whereas paying back the loan would be a cash outflow. These three parts combines show the total cash flow of the company, with the “bottom line” showing whether there has been a net increase or decrease in cash for the time period. The cash flow statement helps to gain a better understanding of the financial health of a company, how much cash it has on hand and if it has enough to pay its expenses [5].

In conjunction, these three financial statements are important in evaluating the financial performance of a company, each providing unique information. The figures from the statements can then be used for further analysis via financial calculations such as price-to-earnings (P/E), debt-to equity ratio (D/E), working capital [6] The statements also play a key role in the building of financial models and projections of the future performance of a company.