What is a Financial Statement?
When a company’s stakeholders want to know how well it’s performing, they look to its financial statements. A financial statement is a report summarizing the written financial records to show the company’s financial performance and position. There are three statements that make up the financial statement: balance sheet, income statement and cash flow statement. Each shows a different aspect of the company’s total finances, and each plays a role in providing context to the overall financial picture of the company.
Financial statements are an integral part of accounting. Not only are they compiled and released quarterly, they’re also notated and contextualized to tell an ongoing story of the company. Looking at a current financial statement gives investors information about the company’s current performance. Looking at a series of statements bears a trend and can tell the story of a company’s growth or turbulence.
Here’s what every investor needs to know about financial statements and their role in assessing a company.
What is a Balance Sheet?
The balance sheet shows a company’s assets, liabilities and shareholders’ equity. It’s a statement of net worth that provides an accurate snapshot into the financial health of the business. If the company has strong assets and few liabilities, it’s a good sign. That said, a balance sheet is only a static representation of a company’s health at a specific period in time. This is why it’s bundled with the income statement and the cash flow statement during the financial reporting period.
What is an Income Statement?
Also called a profit and loss statement or an earnings statement, the income statement shows a company’s revenues, expenses and net profit. It covers both operating and non-operating activities over a specified period. The income statement provides context to the company’s broader financial operations, including the balance sheet and cash flow statement. Specifically, it breaks down the company’s gross profit, operating profit, pre-tax profit and after-tax profit.
What is a Cash Flow Statement?
The cash flow statement showcases the flow of money into and out of a business. Above all, it’s an indicator of a business’ financial health. Simply put: more money coming in and less money going out equates to a healthier business. In addition, the cash flow statement breaks down operational cash flows, investment cash flows and financing cash flows. The ability of a business to pay its short-term operating costs means it’s cash positive. Likewise, a statement that shows poor cash flows may indicate a trend toward insolvency.
Notation is an Essential Part of Financial Reporting
In a formal financial statement, a business packages together the balance sheet, income statement and cash flow statement, along with notations. These notations are particularly important because they provide clarifying context to the figures themselves. For example, notation may specify the type of inventorying system used, bringing clarity to the balance sheet. Likewise, there might be a note about share repurchases that offers better context for the cash flow statement.
How Often Do Companies Issue Financial Statements?
The Securities and Exchange Commission (SEC) mandates that companies issue financial statements quarterly, as well as annually. Moreover, any time there’s an unexpected shift in the company’s finances, it’s important to report it to shareholders. Investors can expect to get familiar with three chief types of financial reporting:
- The Form 10-Q: The quarterly financial statement issued by a company.
- A Form 10-K: The annual financial statement issued by a company.
- A Form 8-K: A financial statement issued to inform shareholders of financial irregularities.
These reports include full financial statements from the company. They’re instrumental in tracking the growth (or decline) of companies and emerging financial trends. For example, shareholders might review the company’s 10-Q to track its cash flow throughout the year—then, review the 10-K for an overall picture of the year-in-review. Likewise, investors may want to review the 8-K after the company announces an acquisition or leadership steps down.
Financial Statement Auditing
Because financial statements contain essential information about the company’s cash flows, income, expenses, assets and liabilities, it’s vital they’re presented accurately. This is why, with the passing of the Sarbanes–Oxley Act of 2002, public companies need to have their financial statements audited by an impartial third party. Independent CPAs ensure the data presented is GAAP compliant, accurate and without error or omission.
External audits are an important step in the ability to take financial statements at face value. If the information presented in a company’s financial statements is inaccurate, it has rippling consequences. The resulting fallout could sour investors or create tax liabilities with the IRS. In fact, a major part of the passage of the Sarbanes–Oxley Act of 2002 was the accounting malpractice of companies like Enron and Worldcom. Today, transparency in financial reporting is paramount and noncompliance isn’t tolerated.
The Importance of Financial Statements
Financial statements relay the financial information of a company to interested parties. This can include shareholders, regulatory agencies and even other companies. It’s a transparent way to be forthcoming about the financial health of the business and its activities. Investors use this data to form an investment thesis about the company. The SEC and IRS use it to ensure compliance and accuracy. Competitors use it to benchmark their own financials and gauge the market.
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To best-use financial statements, investors need to get familiar with each of the major documents that comprise them: the balance sheet, cash flow statement and income statement. The ability to understand these documents plays a big role in understanding the broader context of the company’s financial position. It starts by picking up a 10-Q or 10-K.