The main purpose of any business is to add value to its customers and make some money for the owners. If you are a business manager, your key job function includes revenue generation and managing cost. These objectives can only be assessed by recording and reporting information about transactions of the business.
The recorded information about business transactions are generally presented using three key documents: income statement, balance sheet and cash flow statement. They are called financial statements, or just financials.
Financial statements can be prepared on monthly, annual or as the need arises. However, nearly every well-managed business produces financial statements at least once a year. Whiles this is not compulsory for small business, companies are required by law to prepare annual financial statements in many jurisdictions.
What are the 3 Components of Financial Statements ?
1. Income statement or Profit and loss account
Income statement or profit and loss account assess the financial performance of a business over specific period of time. This statement reveals the profit or loss of a firm by comparing the revenues earned to the expenses incurred. If the revenues are more than expenses; than the business will make some profit. If the expenses are more than revenue, a loss will be reported (of course not a good result). For example if your business make a sale of D10,000 in a month but spend D6,000 then a profit of D4,000 will reported through the income statement.
2. Balance sheet or Statement of Financial Position
It is the snapshot which summarizes a firm’s financial position at a given point in time, say at month end or year end. It shows what the firm owns (assets), what it owes, and the differences between the two is called owners’ equity. This relation is usually illustrated through a fundamental accounting equation.
Assets minus Liabilities = Net worth (owners’ equity).
- Assets – any valuable thing the business owns e.g furniture, debtors, investments, cash etc.
- Liabilities – any debt the business owed to others e.g creditors, overdraft, tax payable etc.
- Net worth or capital – is the amount net owners’ equity. Profit will increase net worth whiles loss reduces it.
Balance sheet is like a picture which shows the financial weakness or strength of a business. It is called balance sheet because it has to always balance under the above fundamental account equation. That is the assets must be equal to sum of liabilities and owners’ equity. For example if a business owns D20,000 in assets and owed D5,000 in liabilities, then owners’ equity can only be D15,000.
3. Cash Flow Statement
Cash flow statement is like a bank statement of the firm. It tell you the amount of cash at the beginning and the amount of cash at end of a period. It also show where the cash came from and how the firm spent it within certain period.
Cash being the life blood of the business; this statement attracts the attention of many investors and suppliers. Cash flow gives a better insight into the financial structure of an entity, including its liquidity and solvency, and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities. A company can fail due cash flow issues, even while profitable. So to analyse the economic realities, cash flow statement is prepared.
Cash flow statement usually show three key components
- Cash from the business key operating activities – a key indicator of the extent to which the operations of the entity have generated sufficient cash flows.
- Cash from long term investment activities – These are cash flows arising from investing activities and they represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.
- Cash from financing activities such as borrowing and share capital. This flows are useful in predicting claims on future cash flows by providers of capital to the entity.
Benefits of Financial statements to Small Business
Generally, most small business managers tend to ignore the preparation of financial statements. However, financial records and the related reports are important tools for effective management of any business. Why do you think the bigger businesses are employing many accountants to prepare and audit their financial statements? Here are few benefits of financial statement:
- Self-assessment – Business managers are the first key user of financial statements. Financial report reveals the performance of management itself. These results can be compared to the budget or prior year numbers to assess growth and achievement.
- Book valuation – One key element of a balance sheet is the owners’ equity. This is an indicative value (book value) of the business. The business can be sold at this value without considering any premium or time value.
- Necessary to get bank loan – Have you ever applied for a bank loan and you were rejected due to lack of proper financial records? Well, banks uses financial statements to make decision about lending to businesses. They want to know about the financial health and sources of cash flow in addition to qualitative conditions.
- Decision-making tools – Information from financial statements can support the decision making function of any business. For example the account receivable report can show the list of debtors along with the number of days they are outstanding. Decisions about a potential new investment will require proper planning and financial impact analysis.
Financial statements provide summarized financial information about a firm’s transactions. They don’t provide important but non-financial information like quality of staff or types of customers. Even with these limitation, financial statements are still the key numbers lenders and investors use for decision making.
Now to you. Any comment on financial statements concept? Well, we will be discussing more details on each of these statements. So don’t miss it.