In any business or operation, Financial Reporting and review is necessary and valuable to understanding the condition of a business; not only from a cash standpoint, but also from an operations sustainability perspective. The Financial Statements are a set of reports containing comprehensive economic data, which typically include the Balance Sheet, the Income Statement and the Statement of Cash Flows. As defined by Accountingtools.com, “Financial statements are a collection of reports about an organization’s financial results and condition”. In the United States, the Federal Accounting Standards Board (“FASB”) sets the Generally Accepted Accounting Principles (“GAAP”) for reporting concepts and accounting guidelines which are followed by most companies operating in the US today. Understanding these reports and how to interpret the findings gives a clear understanding as to how a business operates, whether the business is showing signs of growth and sustainability, or if the enterprise is losing ground and beginning to fail. First, we must have an understanding of what each report is.
The Balance Sheet is a report which indicates a company’s financial position, or health, at a particular period in time. Both sides of the company’s financial situation are defined by the business’ ownerships and debts. This report contains the accounts which reflect the monetary value of Assets, Liabilities and Owners/Shareholders Equity in the company. The term Assets refers to any owned property: including cash, notes, loans and inventories. The inverse is referred to as Liabilities. This includes any property which must be paid, or returned, to another entity. Any cash and cash value equivalents, such as open loans, notes, payrolls and payables to suppliers are liabilities to the company. The final component is the Owners/Shareholders Equity, which is any capital investment made to the company. This may include cash deposits, property, inventories or supplies. A company’s Assets must equal the value of all Liabilities plus the Owners/Shareholders Equity to be in balance. These three components create the financial picture in numbers as to how strong, or weak, a company’s financial situation is within the reporting period.
With a working comprehension of the health of a company, we look to the Income Statement to reveal a picture of the company’s operations. The Income Statement is a report which captures the company’s operating performance over a specific period of time. As the name implies, this report contains all the revenues and income streams less all the costs associated with selling goods or services and running the business, known as the expenses. Adding income and subtracting expenses gives us the resulting net profit or loss from the business. Combined with the Balance Sheet, a potential investor or lender is able to view the operating performance in the Income Statement as well as the company’s net worth, or value, by the Balance Sheet.
However, in order to gain full financial comprehension of a company, the Statement of Cash Flows is an imperative tool to show how a company raises and invests money. This report pulls data from changes in the Balance Sheet and the Net Income between two specified dates to reveal the company’s liquidity movements within operating, investing and financing activities.
For management or third parties to benefit from these reports, a few basic accounting concepts and principles should be introduced. The American Accounting Association (AAA) defines Accounting as: the process of identifying, measuring and communicating economic information to permit informed judgment and decision by users of the information. The basic premise is that business transactions are recorded and tracked as either a debit or a credit within a defined list of accounts, and all debits must equal all credits. Accounting principles outline that each transaction has two sides, and both sides must balance each other. For Balance Sheet accounts, debits increase the value of asset accounts, whereas credits ultimately decrease account worth. In the case of Liability and Equity accounts, the transverse is true. Debits decrease the value and credits result in an increase. The Income Statement recognizes debits and credits in reverse of the Balance Sheet concept. A credit entry on the Income Statement results in recognized revenue, or income, whereas a debit entry results in expenses against the income. The main concept to remember is that in simple bookkeeping and accounting, one side of the entry will debit or credit an account and all debits must equal all credits. For example, a business sold a service or product to a customer which is paid in full at the time of the transaction. This would be recorded into the books as cash received and revenue earned. The transaction’s value would result in recording a debit to the cash account and a credit to the income account. Continuing with this same transaction example, any supplies purchased to create that product or service would result in a debit to the expense account and a credit to the cash account. At the end of the transaction, we have four accounts which now have a monetary value assigned to them and a numerical outline of how the business operated, performed, invested and spent.
Within any given month or recording period, hundreds to thousands of these transactions are recorded and consolidated in order to generate the various reports in the Financial Statements. Continuing with this explanation of basic accounting principles, it becomes clear there are distinct differences between the three reports. The primary difference between the Income Statement and Balance Sheet lies within the components of each report. The Balance Sheet contains the assets, liabilities and equity; each of these is a resource the company utilizes for operating activities. The Income Statement shows what those activities included and the Net Income as a result. The Cash Flow Statement is a numerical diagram of the liquidity, or cash movements the company has taken over a specific period of time, based upon the outcome of the operating activities.
While each report reflects a distinct concept, they must also be viewed as pieces of a larger puzzle; interconnected and required to see the whole picture. All businesses, no matter the industry or product, are dependent upon the most important piece, the customer. The starting point for recording and reporting begins with the customer. Sales generate revenue, which generates cash and increases the assets which give the company opportunities to invest. These financial reports are also linked by the resulting data and accounts to which values have been assigned. The Net Income, from the Income Statement, is also included on the Balance Sheet under Owners/Shareholders Equity, and is also the first line on the Cash Flow Statement. Congruently, the last line item on the Cash Flow Statement flows to the first line of the Balance Sheet as the Cash and Cash Equivalents. Although each report stands on its own containing valuable information, we can now understand that it is the interconnectivity and relationships between the reports that show a true and illuminating picture.
Once a management team has a clear representation of past and present financial activities, informed decisions can be made to determine the future activities of the company. The purposes for establishing, utilizing and understanding financial reports are to provide information as to the health and financial strength of a company. These reports also define where any activities or procedures might or will affect the operations of the company and how current policies and procedures have impacted the sustainability and longevity of the company.