In this tutorial we're going to find out what financial statements are, look at examples of the four component statements and learn about their objectives or purpose.
Be sure to check your understanding of this lesson by taking the quiz in the Test Yourself section further below. And right at the bottom of the page, more questions on financial statements submitted by fellow students, including a full company financial statements exercise with solutions.
What are Financial Statements?
The financial statements are simply the key accounting reports of a business.
The financial statements provide summarized figures that give an indication of the current financial health of the business as well as its recent financial performance.
The financial statements can be considered the business's scorecard (or scoreboard) - showing how well (or poorly) the business is doing.
The word statement simply means a report. So the financial statements are simply financial reports.
The Four Types of Financial Statements
Financial statements consist of the following four components (each of these reports are covered in their own full lesson where we'll look at their format and go over a more detailed example):
1. The Income Statement
Theincome statement is the first of our financial statements.
It is also commonly referred to as the profit and loss statement.
The income statement shows the reader the financial performance of the business over a specific period of time.
It does this by listing incomes and expenses as well as the resulting net profit or loss.
The statement of changes in owner's equity is a short report that shows the opening and closing balances of owner's equity, as well as the changes that have affected it during the year.
These changes typically include additional capital (investment by the owner), drawings (owner withdrawals), as well as the net profit or loss for the year (which we calculate in the preceding income statement).
Note that the cash flow statement format shown above uses the simpler direct method (not the more complicated indirect method, which begins with the net profit figure).
Objectives of Financial Statements
Financial statements come in various formats and all provide different information. However, they all have one thing in common: they give useful information about a business (or about an aspect of the business) to the reader.
The specific stated objective or purpose of the financial statements is:
To show the reader the financial position, financial performance and cash flows of a business.
As mentioned above:
The financial position of the business is shown in the balance sheet.
The financial performance of the business is shown in the income statement.
The cash flows are shown in the cash flow statement.
It will become even clearer how each financial statement shows these aspects of the business as you go through each of the individual lessons in this section.
Note that the drawing up of financial statements is a compulsory (legal) obligation for public companies - companies that are listed on a public stock exchange - and must be published on an annual basis.
Also, after they are finalized, their financial statements have to be audited - meaning that they must be verified by an independent external auditor as being truthful and accurate.
The independent auditors publish an audit report on the accuracy of the financial statements, which is then often included as part of the company's published annual financial statements.
It is customary for all types of corporations to prepare their financial statements annually (not just public companies), but company executives often want them prepared more often for internal uses.
Users of Financial Statements
We said that the financial statements give useful information about a business to the reader.
But here's a question: who exactly are the readers or users of the financial statements? Who exactly are these reports prepared for?
Remember how I said that the financial statements are like the business's scorecard?
Well, the people who want to see the financial statements are the people that are interested in seeing this business scorecard - the guys who want to know how well the business is doing, including specific details such as its income, expenses, assets, liabilities, etc.
These people, in rough order of importance, include:
1) Business owners - They have the most direct interest in how well the business is doing. The better the business performs, the more money they make. They want to know how their business is doing.
2) Business executives - Business execs or managers are directly responsible for the performance of the business and as such are very interested in its scorecard. They will get fired if the business performs poorly, or get bonuses if it performs well.
3) Investors - Investors are only going to invest in businesses with good scorecards which show great potential for growth and profits.
4) The bank - They are interested in the financial statements (the business scorecard) of businesses they have a relationship with. For example, they may want to look at the financial statements to see how risky it would be to loan money to the business.
5) The government and tax authorities - They want to know that the business is fulfilling their legal duties, and in particular, that they are paying enough tax! The financial statements give a good idea of how much tax the business should be paying over.
6) Suppliers - Suppliers want to make sure that they will get paid by the business they are supplying goods to. So they may want to check the financial statements of the businessbefore they start to do business with them.
7) Employees - Though this is not often the case, an employee may want to know how well the business is doing so he or she can plan for the future. For example, if the business looks like it might fall apart soon, the employee may want to start looking for another job. They may have even been given shares in the company they are working for, so will want to know that it's doing well.
Before you start, I would recommend to time yourself to make sure that you not only get the questions right but are completing them at the right speed.
Difficulty Rating: Beginner --> Intermediate
Quiz length: 7 questions
Time limit: 8 minutes
Important:The solution sheet on the following page only shows the solutions and not whether you got each of the questions right or wrong. So before you start, get yourself a piece of paper and a pen to write down your answers. Once you're done with the quiz and writing down your answers, click the Check Your Answers button at the bottom and you'll be taken to our page of solutions.
That's the end of our lesson on financial statements.