Financial statements What are they and what are they used for? Which are the most relevant? Find out in the following article
What are financial statements?
Financial statements are accounting reports that reflect a company’s economic and financial situation and results for a given period. Their purpose is to provide a clear and structured view of how the company generates income, manages its resources, and meets its obligations. The main financial statements include the balance sheet, income statement, cash flow statement, and statement of changes in equity. They are essential for decision-making by management, investors, creditors, and others interested in the organization’s financial health.
Why are financial reports important?
- Evaluation of financial performance: They allow us to know if the company is profitable or if it is experiencing losses, which is crucial for making decisions on how to manage the business.
- Liquidity control: They help to understand the availability of cash and the ability to meet short-term obligations, such as paying suppliers or employees.
- Strategic decision-making: They provide information to support investment planning, expansion or downsizing.
- Regulatory compliance: They ensure that the company complies with financial laws and regulations, which is important to avoid penalties or negative audits.
- Attraction of investors and financing: Financial reports are key for investors or banks to trust the company and decide to provide capital or loans.
- Operational efficiency analyses: These allow managers to assess which areas of the business are performing well and which need adjustments or improvements.
Balance Sheet
The balance sheet (also called the statement of financial position) is a financial report that shows the financial position of a company at a specific point in time. It details what the company owns (assets), what it owes (liabilities), and the company’s net worth (equity).
The balance sheet follows the following fundamental equation:
Assets = Liabilities + Equity
Key components of the balance sheet:
- Assets: These are the resources controlled by the company that have economic value. They are divided into:
- Current assets: Assets or resources that the company expects to convert into cash or consume within one year (e.g., cash, accounts receivable, inventories).
- Non-current (or fixed) assets: Long-term resources that the company uses to operate (e.g. property, machinery, long-term investments).
- Liabilities: These are the debts and obligations that the company has with third parties. They are also divided into:
- Current liabilities: Debts to be paid within one year (e.g. accounts payable, short-term debts).
- Non-current liabilities: Long-term debts (e.g. bank loans, bonds issued by the company).
- Net worth: It is the difference between assets and liabilities, and represents the residual value that corresponds to the owners or shareholders. It includes:
- Contributed capital: The money that the owners or shareholders have invested in the company.
- Retained earnings: Retained earnings that have not been distributed as dividends and are reinvested in the business.
A simple example of a balance sheet:
| Balance Sheet | |
|---|---|
| Assets | |
| Current assets | $100,000 |
| Non-current assets | $200,000 |
| Total Assets | $300,000 |
| Liabilities | |
| Current liabilities | $50,000 |
| Non-current liabilities | $100,000 |
| Total Liabilities | $150,000 |
| Net Equity | $150,000 |
| Total Liabilities + Equity | $300,000 |
Importance of the balance sheet:
- It provides a snapshot of the company’s solvency, showing whether it has sufficient assets to cover its liabilities.
- It allows investors and creditors to assess the financial soundness of the company, determining its ability to meet its obligations.
- Helps company management make informed decisions on resource management, investment, and financing.
Income statement
Also known as a statement of comprehensive income, this report shows the company’s financial performance during a specific period (e.g., a quarter or a year). It details revenues generated and expenses incurred, revealing whether the company has made a profit or loss during that time.
Main components:
- Revenue: The money the company has earned through its operations.
- Cost of sales or direct costs: Expenses directly related to the production of goods or services.
- Operating expenses: Include salaries, rents, marketing, among others.
- Taxes: Tax payments to be made by the company.
- Net income: What remains after subtracting all costs and expenses from revenues (net profit or loss).
Simple example of an income statement
The income statement shows a company’s revenues, expenses, and net profit or loss for a specific period (e.g., a quarter or a year).
| Income Statement | |
|---|---|
| Income | $500,000 |
| Cost of sales | $300,000 |
| Gross profit | $200,000 |
| Operating expenses | |
| Cost of sales | $50,000 |
| General and administrative expenses | $40,000 |
| Total operating expenses | $90,000 |
| Operating profit | $110,000 |
| Financial expenses | $10,000 |
| Taxes | $20,000 |
| Net income | $80,000 |
Key components:
Example of decisions based on the income statement:
- If operating expenses are too high, the company may choose to reduce personnel or renegotiate contracts with suppliers to increase its operating profit.
- If net income is low, despite good revenues, it may be necessary to increase prices or improve operating efficiency.
Statement of Cash Flows
This report shows how cash (liquid money) moves in and out of the company during a given period. Unlike the balance sheet and income statement, which may include non-cash items, the cash flow only considers transactions that affect actual cash.
Main sections:
- Cash flow from operations: Cash generated by core business activities (sales, payments to suppliers, etc.).
- Investment cash flow: Purchase and sale of assets, such as property, machinery, or investments.
- Financing cash flow: Loans, issuance of shares, dividend payments, etc.
The cash flow statement shows how cash flows in and out of the company in a given period. It is divided into three sections: operating, investing, and financing activities.
Example
| Statement of Cash Flows | |
|---|---|
| Cash flow from operating activities | |
| Sales revenue | $400,000 |
| Payments to suppliers | -$250,000 |
| Salary payments | -$50,000 |
| Net cash flow from operations | $100,000 |
| Cash flow from investing activities | |
| Purchase of machinery | -$30,000 |
| Sale of investments | $10,000 |
| Net investment cash flow | -$20,000 |
| Cash flow from financing activities | |
| Loan repayment | -$20,000 |
| Issuance of shares | $50,000 |
| Net cash flow from financing | $30,000 |
| Net increase/decrease in cash | $110,000 |
| Cash at beginning of period | $50,000 |
| Cash at end of period | $160,000 |
Key components:
- Cash flow from operating activities: Money generated or spent on the main operations of the business (sales, payments to suppliers, salaries, etc.).
- Cash flow from investing activities: Cash inflows or outflows related to the purchase or sale of assets (machinery, property, investments).
- Cash flows from financing activities: Cash flows related to external financing, such as issuance of shares or payment of debts.
- Cash at end of period: The amount of liquid cash the company has at the end of the reporting period.
Decisions based on the cash flow statement:
- If operating cash flow is low or negative, the company may need to improve its collection policies or reduce expenses to avoid liquidity problems.
- If there is a shortfall in cash flow financing, the company could seek additional sources of capital, such as loans or the issuance of new shares.
Statement of Changes in Stockholders’ Equity
This report details the changes in the company’s net worth during a given period. It shows how retained earnings, profits or losses, and distributions to shareholders (such as dividends) affect the equity of the company’s owners.
Key components:
- Contributed capital: New shareholder investments.
- Retained earnings: Earnings that the company decides to reinvest instead of distributing as dividends.
- Ajustes por ganancias o pรฉrdidas: Incluye elementos como la revaluaciรณn de activos o el efecto de transacciones en moneda extranjera.
- Dividendos: Dinero que se paga a los accionistas.
Decisions based on the cash flow statement
- Dividend decision: If retained earnings are strong, the company may choose to distribute dividends to shareholders. However, if the company is looking to reinvest in growth, it could decide not to pay dividends and retain those earnings.
- Capital increase: If equity is low concerning liabilities, the company may decide to issue new shares to attract additional capital and improve its balance sheet.
- Share buyback management: If the value of the company’s shares is low but the company has a good level of cash, one could choose to buy back shares to increase the value per share and return capital to shareholders.
