The next 5 parts will provide an introduction to financial statement another key component of the investment tool kit. Firms report their financials in order to show their financial performance over a period to enable investors, lenders, and creditors etc. to make economic decisions.
Analysts, investors, lenders etc. use the financial statement data and other information to evaluate the firm’s past performance and current financial position in order to make decisions whether to invest, lend and so on.
The key components of the financial statement are:
1. The Balance Sheet or Statement of Financial Position: This reports the firm’s financial position at a point in time, for example 31st December 2013. The Balance Sheet consists of:
a. Assets: Theses are the resources controlled by the company.
b. Liabilities: These are amounts owed to lenders and other creditors.
c. Owners Equity: The difference between Assets and Liabilities. This is what belongs to the owners of the company after all claims have been accounted for.
The Balance Sheet follows the fundamental Accounting equation thus:
Assets = Liabilities + Equity
2. Profit and Loss Account or Income Statement or Statement of Comprehensive Income: This reports the financial performance of a firm over a period of time, for example one year. The components of the income statement are:
a. Revenues: These are inflows received or due for goods sold, services rendered or other activities of the firm.
b. Expenses: These are outflows relating to goods sold, services rendered and so on.
c. Other Income and Expenses such as interest paid and received.
3. Statement of Cash Flows: This reports the firms cash receipts and cash payments. Cash Flows are categorized into operating, investing and financing Cash Flows. Due to the concept of matching and accruals in accounting, not all transactions reported in the Balance Sheet and Income statement are cash related. The Cash Flows statement on the other hand only reports cash based transactions. This facilitates other forms of financial analysis that help in understanding the true health of the firm.
4. Other important parts of the financial statement are the Statement of Changes in Equity which shows the sources of the changes in owners equity over a period of time, the notes to the accounts and the Chairman’s and Chief Executive’s comments. The notes to the accounts provide explanatory information and disclosures relating to accounting methods, assumptions, disposal and acquisition of assets, contingencies etc.
In the next part, we will examine the Balance Sheet of a manufacturing company.