What are financial statements? Think of them as the storybook of a business told through numbers. Didn’t get it, no worries.
Read further as we explore what are financial statements in detail, how they work, along with types of financial statements with examples, and other aspects, including their functioning and relevance, step by step in the accounting and finance realms.
What are Financial Statements?
Let us begin discussing what are financial statements. These are formal reports that demonstrate a business’s financial performance. They give a complete picture of the financial transactions done by the company regarding its income, expenditure, assets, and liabilities during a specific period.
In the most straightforward terms, they aid in answering such questions as, Is the enterprise earning money?, What is its total property?, and Is it capable of paying its liabilities?
The preparation of financial statements is obligatory for every business, irrespective of its size or nature, to monitor its financial condition.
These documents are the very basis of the accounting process and are relied upon by various stakeholders such as investors, managers, and even teachers and students for their understanding of the money movement in a business. So, now if anyone asks you, What are financial statements, you are done and dusted.
How Financial Statements Work
Since what are financial statements is clear to you, how they work is also essential to know. These function as a thorough summary of all the financial activities of a business.
The financial movement into and out of the company through sales, expenses, or investments is recorded, organised, and then presented as a detailed report of the company’s performance. The working process is as follows:
Recording Transactions
The first step is to record each business transaction in the account books, either manually or by using accounting software. This step guarantees that every financial action is observed and recorded. For instance, when a firm sells an item or pays rent, it is instantly logged in the journal.
Classifying Entries
The transactions that have been recorded are then divided into sections such as assets, liabilities, income, and expenses. This arrangement is very useful in keeping track of the sources and directions of the money flow.
Summarising Data
The next step after classification is to condense the records to produce the Trial Balance, which verifies that the debit and credit entries are equal. At this point, the Income Statement, Balance Sheet, and Cash Flow Statement are prepared, which together represent the business’s performance.
Analysing Results
The last step is to analyse the financial statements prepared by management, investors, and other parties concerned to gain insight into the company’s profitability, stability, and growth. This analysis enables making better business decisions and planning for the future.
Through financial statements, raw accounting data is transformed into insights that are easy to understand, and this is the reason why they are considered essential tools for evaluating the health and success of a business.
Types of Financial Statements with Example
By far, we know about what are financial statements and how they work. Let us look at the different financial statements types that make up a company’s financial report. There are mainly four types of financial statements, and each serves a different purpose.
Every financial statement gives us a different view of the business story, starting from the profits earned, to the investments made and the cash generated. In unison, these statements paint a picture of a company’s financial status. Let’s go through financial statements types step by step and start with simple examples.
1. Income Statement (Profit & Loss Statement)
The income statement discloses the total money a company received and the total money it spent in a given time frame. It is an important tool for finding out the profitability of a business or vice versa.
What it shows: Revenue, expenses, and the resulting profit or loss.
Example: In case a company’s sales are worth ₹10,00,000 and the costs of salaries, rent, and other operations are ₹7,00,000, the business will have a net profit of ₹3,00,000.
2. Balance Sheet
Do you know what is a balance sheet in accounting? It illustrates the firm’s assets and liabilities at a specific date. Along with that, it also provides information on the owner’s equity — the portion that remains after subtracting liabilities from assets.
What it shows: The equation of accounting Assets = Liabilities + Equity.
Example: If a firm possesses assets worth ₹15,00,000 (like cash, machinery, etc.) and debts amounting to ₹10,00,000 (such as loans), the equity of the owner will be ₹5,00,000.
3.Cash Flow Statement
The cash flow statement reports the income and costs of the company in terms of cash. It is segmented into three sections— operating, investing, and financing activities. It shows whether a company is producing sufficient cash inflows to support its operations.
What it shows: Movement of cash in and out.
Example: If a company’s net inflow from its regular operations is ₹2,00,000 but its expenditure on new machinery is ₹50,000, then the company’s total cash flow will be ₹1,50,000.
4. Statement of Changes in Equity
This statement explains how the owner’s equity has changed over time. It includes profits retained in the business, dividends paid, or new capital introduced.
What it shows: Movement in equity due to profits, losses, and owner transactions.
Example: If the company made a profit of ₹3,00,000 but distributed ₹1,00,000 as dividends, the retained earnings would increase by ₹2,00,000.
Together, these four financial statements types form the backbone of accounting. They help businesses, investors, and even students understand how money moves and grows within an organisation.
Types of Financial Statements | ||
|---|---|---|
| Financial Statement | Purpose | Key Elements |
| Income Statement | Shows profit or loss over a period | Revenue, Expenses, Profit |
| Balance Sheet | Shows financial position at a specific date | Assets, Liabilities, Equity |
| Cash Flow Statement | Tracks cash inflows and outflows | Operating, Investing, Financing |
| Statement of Changes in Equity | Shows movement in owner’s equity | Retained Earnings, Dividends, Capital |
How to Read Financial Statements
It is not enough to just know what are financial statements; types of financial statements you must also know how to create and read them. Initially, it may seem like a tough task to read financial statements, but as soon as you know what to search for, it turns into an easy one and is ranked as one of the most important abilities in finance and accounting.
You must be wondering what are financial statements of a company and how to read them. So, these are like the various parts of a priceless book on the finances of that company, and every statement can be a pretty good clue as to what the company is doing. The following is a detailed guide on how to read and then interpret them one by one:
1. The Income Statement
To begin with, you find the total revenues generated for a particular period as the first line of the report. After that, go down the list of expenses until the last line where the profit or loss is shown. While you are going through an income statement, your attention should be drawn to:
- Revenue Growth: Has the company easily increased its revenues?
- Expense Control: Are there higher costs than sales?
- Net Profit Margin: What percentage of the total earnings is retained as profit?
A constant rise in sales along with controlled expenses is an indicator of the efficient growth of the company.
2. The Balance Sheet
So, what is a balance sheet in accounting? A balance sheet presents a picture of a company’s financial situation on a certain date. To be more specific, it shows what it has, what it owes, and what it keeps. Always keep in mind the basic equation: Assets = Liabilities + Equity
In the course of scrutinising the balance sheet, you should check for:
- Asset Mix: Which type of assets does the company own — cash, real estate, or outstanding customer invoices?
- Debt Amounts: Very high amounts of liabilities may be a sign of financial difficulties.
- Shareholders’ Equity: It is the part of the company that actually belongs to the shareholders.
An impressive and, at the same time, a healthy balance sheet contains more assets than liabilities and consequently, an upward trend in shareholders’ equity. So now you know what is a balance sheet is for you.
3. Reading the Cash Flow Statement
The cash flow statement then includes operating cash flows as well as investing and financing activities. These are:
- Operating Activities: Money coming from and going out of the company’s basic operations.
- Investing Activities: Money going out or coming in as a result of acquiring or selling assets.
- Financing Activities: Money coming from lenders, investors, or dividends paid to shareholders.
While reading it, pay attention to whether the company always has positive cash flows from operations. This indicates whether the business is self-sufficient or not. However, a profitable business can still have cash difficulties if its cash flow from operations is negative.
4. Reading the Statement of Changes in Equity
This document illustrates the fluctuations in the company’s net worth during a particular period. The detailed information includes: retained earnings, issued capital and dividends paid, which require your attention:
- Retained Earnings Growth: Are profits being invested back into the company?
- Dividend Trends: Regular dividends can be a sign of stability.
- New Share Issues: Indicates whether the company has tapped into the investor’s funds.
Increasing retained earnings are an indicator that the company is laying the groundwork for a bigger and brighter future.
Through learning the art of reading financial reports, students obtain a glimpse into the cash flow and operations of the business and its value creation. It is not simply about numbers but rather about a complete understanding of the decisions taken, the performance, and the financial stability of the company.
How to Read Financial Statements | ||
|---|---|---|
| Statement | What to Look For | What It Means |
| Income Statement | Revenue Growth | Indicates sales performance |
| Balance Sheet | Debt-to-Asset Ratio | Measures financial stability |
| Cash Flow Statement | Operating Cash Flow | Shows business liquidity |
| Equity Statement | Retained Earnings | Reflects reinvestment in business |
Limitations of Financial Statements
You know what are financial statements, so you agree that while these are incredibly useful, they do not always tell the full story. They provide a structured view of a company’s finances, but many important details often remain hidden between the lines.
When you know what are financial statements, understanding these limitations helps readers make better judgments rather than relying only on the numbers. Here are some major limitations you should know:
Based on Historical Data
Financial statements show past performance, not future potential. They tell what has already happened, but they don’t predict how the company will perform next year.
Influence of Accounting Policies
Different companies may use different accounting methods, for example, in valuing inventory or calculating depreciation. This can make comparisons between businesses less accurate.
Ignores Non-Financial Factors
Financial statements focus only on numbers. They don’t reflect factors like employee satisfaction, brand value, or market reputation, which can strongly affect a company’s success.
Subject to Estimates and Judgments
Certain numbers are calculated on the basis of management’s predictions, for instance, bad debt or asset depreciation. These estimations can be different from one company to another and cannot always be accurate.
Inflation Not Considered
The purchasing power of money diminishes or increases over a period, but the financial statements show the assets and liabilities at their original cost. This practice can make the old data appear outdated or even misleading.
Possibility of Window Dressing
On some occasions, firms manage their financial information in a way that makes it more appealing than it is. For example, they may do so by postponing expenses or by reporting non-recurring profits just to catch the interest of the investors.
Though financial statements are significant instruments for analysis, they should never be considered alone. A skilled reader always correlates them with market trends, management comments, and other qualitative factors to derive the whole picture of the company’s real performance.
Conclusion
Financial statements signify through their numerical figures and become the language spoken by the business. They facilitate our understanding of the company’s flow of earnings, spending, investing, and growth. Whichever role you play, whether it is the student of accounting, the investor who analyses the performance of the company, or the decision-maker at the firm, the understanding of the financial statements will give you the full picture of the presentee company.
Nonetheless, it is important to keep in mind that these statements, while very informative, do not provide the complete picture. Numbers, along with logic, observation, and context, will provide real insight. If you learn to read and interpret them wisely, then financial statements will become the very instruments of understanding that account for the true story behind every business.
FAQ’s
What are the 4 parts of the financial statements?
The four main parts of financial statements are:
- Income Statement – shows profits and losses.
- Balance Sheet – shows assets, liabilities, and equity.
- Cash Flow Statement – tracks cash inflows and outflows.
- Statement of Changes in Equity – shows changes in owners’ equity during the year.
Is a trial balance a financial statement?
No, a trial balance is not a financial statement. It is an internal report done before the financial statements. The trial balance confirms that the total debits are equal to the total credits, which means that the accounting records are correct and ready for the final financial statements to be prepared.
What is depreciation?
Depreciation is the allocation of the cost of a fixed asset (for example, machinery or equipment) over the period of its useful life. It indicates how much of an asset’s value has been consumed over time and thus plays an important role in determining the real cost of using long-term assets in business operations.
What is the difference between a financial statement and a balance sheet?
A financial statement is a term that encompasses all the major reports within the realm of accounting – income statement, balance sheet, cash flow statement, and equity changes report. What is a balance sheet, however, is just a segment of these financial statements that discloses the company’s assets, liabilities, and shareholders' equity as of a particular date.
