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A Dummy's Guide for Understanding the Financial Statements!

This is the first part of the series on Financial Statements, which covers:

  • What are financial statements?

  • Importance of financial statements.

  • 3 main types of financial statements (i.e. Balance Sheet, Income Statement, and Cash Flow Statement)

  • Purpose of financial statements (each of 3).



What are Financial Statements?


Financial statements are important because they provide a snapshot of a company's financial performance and position at a specific point in time.


Snapshot of 3 Financial Statements i.e. Balance Sheet, Income Statement, and Cash Flow Statement!
Snapshot of Financial Statements!

Financial statements are used by key stakeholders i.e. investors, analysts, creditors, and management, to evaluate a company's financial performance and make informed decisions about investing in or lending to the company. They are usually prepared on a regular basis (monthly, quarterly, or annually.)


Note: Financial statements should be prepared in accordance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) to ensure that they are accurate and comparable to other companies financial statements.



Importance of Financial Statements


Here are a few key reasons why financial statements are important:


  • Assessing a Company's Financial Performance: Financial statements, such as the income statement and cash flow statement, show a company's revenues, expenses, and net income over a period of time. This information helps investors and analysts understand how well a company is performing financially and whether it is generating enough cash to pay its bills and invest in growth.


  • Evaluating a Company's Financial Position: Financial statements, such as the balance sheet, show a company's assets, liabilities, and equity at a specific point in time. This information helps investors and analysts understand a company's financial position and whether it has enough assets to cover its liabilities.


  • Making Informed Investment Decisions: Financial statements provide investors with the information they need to make informed decisions about whether to buy, hold, or sell a company's stock.


  • Assessing Creditworthiness: Creditors, such as banks, use financial statements to assess a company's creditworthiness and determine whether to extend credit or lend money.


  • Planning and Forecasting: Financial statements can also be used by management to plan and forecast future performance, such as by projecting future revenues and expenses.


  • Compliance and Regulations: Financial statements are often used by companies to comply with regulatory requirements, such as for tax or accounting purposes.



3 Types of Financial Statements


There are 3 main types of financial statements that are commonly used to evaluate a company's financial performance and position:


  • Balance Sheet: It shows a company's financial position at a specific point in time, including its assets, liabilities, and equity. It provides a snapshot of the company's net worth and helps to evaluate its liquidity, solvency, and financial stability.


  • Income Statement: It shows a company's financial performance over a specific period of time, such as a month or a year. It shows revenue, expenses, and profit or loss. It helps to evaluate a company's profitability and operational efficiency.


  • Cash Flow Statement: It shows the inflow and outflow of cash over a specific period of time. It helps to evaluate a company's ability to generate cash and manage its cash resources. It's important because it helps to show the company's ability to pay its bills, debts, and other financial obligations.



Let's delve deep into each of these 3 statements.


Income Statement


An income statement, also known as a profit and loss statement, is a financial document that shows a company's revenues and expenses over a period of time, typically a quarter or a year. The income statement shows how much money a company made (revenue) and how much it spent (expenses) during the period, and the difference between the two is the company's net income or net profit.


The income statement is divided into two sections, revenues, and expenses. Revenues are the money a company makes from its business operations, such as from sales of goods or services. Expenses are the costs a company incurs in order to generate those revenues, such as the cost of goods sold, salaries, rent, and utilities. By subtracting the expenses from the revenues, the net income (profit) or loss can be determined.


Purpose of Income Statement


The income statement is important because it gives investors and analysts an idea of how well a company is performing financially. A company with high revenues and low expenses will have a higher net income than a company with lower revenues and higher expenses.


Additionally, the income statement also helps in understanding the company's operating performance, gross margin, net profit margin, etc. It also helps in forecasting future cash flows, understanding the company's ability to generate profits, and evaluating the company's efficiency and profitability over time.



Cash Flow Statement


A cash flow statement is a financial document that shows the flow of cash in and out of a company over a period of time, typically a quarter or a year. It is one of the three key financial statements that companies use to give investors and analysts an idea of their financial performance. The statement shows the cash that a company has coming in, such as from sales, and the cash that is going out, such as for expenses and investments.


Purpose of Cash Flow Statement


By looking at a cash flow statement, you can get a sense of whether a company is generating enough cash to pay its bills, invest in growth, and return money to shareholders.



Balance Sheet


A balance sheet is a financial document that shows a company's assets, liabilities, and equity at a specific point in time (quarterly or yearly).


Assets and liabilities are two key components of a balance sheet, so you would find that the balance sheet is divided into two sections, assets and liabilities.

  • Assets are resources that a company owns or controls and have monetary value, such as cash, investments, property, equipment, and inventory. Assets can be used to generate income or cash flow for the company.

  • Liabilities, on the other hand, are obligations or debts that a company owes to others, such as loans, mortgages, and accounts payable. Liabilities represent the money that a company owes to its creditors and must be paid back in the future.

  • The difference between the two is the company's equity, also known as net assets or shareholders' equity.


Balance sheets are typically organized based on the formula:

Assets = Liabilities + Owners’ Equity

Purpose of Balance Sheet


The balance sheet gives investors and analysts an idea of a company's financial position, specifically its liquidity and solvency. A company with more assets than liabilities is considered to be in a stronger financial position than a company with more liabilities than assets. Additionally, the balance sheet also helps in understanding the company's liquidity, leverage, and working capital. It's often helpful to look at a company's balance sheet over time to get a sense of how its financial position is changing.

 

The next and final part of this series on Financial Statements covers, "How to Prepare Financial Statements for Your Startup?"

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