Understanding Financial Statements. The term financial statements refer to a complete set of statements that include an income statement, a balance sheet and a cash flow statement. The Income statement (sometimes also called the Profit and Loss statement or P & L accounts) reflects the profit performance of a business. This statement summarizes sales revenue and expenses and reports on the profit for a period. The foremost thing to understand is whether the business has made a profit or loss and if so how much? Profit or loss is also usually determined for a specific period whether it be a month, quarter, half year or year.
Exhibit 1
An integrated understanding all of all the three components of a financial statement – Income statement, Balance sheet and a Cash flow statement is required to understand the operations of any business. The income statement reports the Profit or Loss for a period. The balance Sheet reports on the financial position of the business at any time; what the business owns and what it owes. The cash flow statement on the other hand tracks the movement of cash in the business, answering questions such as what has contributed to the cash inflows and what has contributed to the cash outflows. One should not treat all three statements as independent silos but understand the linkages between the statements.
Let us consider some linkages. Sales revenue is reflected in the income statement as sales for the period. Receivables are in the Balance sheet, indicating the value of receivables on a specific date. Receivables are amounts owed by the customers of the business. Businesses sell on credit. If all sales for a period are locked up in credit to customers, the business may have cash out situation. Cash out situation occurs when a business cannot meet its cash obligations. So technically a business could make a large profit, but if the debts are not collected may become bankrupt. In some situations, the reverse could also be true. A business may purchase the items that it sells on credit, sell to its own customers in cash or by credit card and pay its vendors only after realising the proceeds from its customers.
GAAP is an acronym for generally accepted accounting principles. Financial statements are usually prepared in accordance with generally accepted accounting principles that have been codified over a period of time. It is the responsibility of the management to prepare the financial statements.CPA will verify that it is in fact prepared in accordance with GAAP and issue a report with their findings. Usually, when you look at an unqualified auditor’s report, one can assume that the financial statements are prepared in accordance with it.
It would result in utter confusion, if businesses were to prepare their financial statements in accordance with its own unique accounting methods. Hence the fundamental idea was to provide a well defined set of rules that all can follow. This would make comparison of the same business over a period of time as well as comparisons with other businesses in the same industry possible. The data would be comparable. In preparation of the financial statements, one has to look at all types of transactions and determine the correct application of accounting principles.
Accounting information is a tool used by management to make sound decisions. It is also required by investors, bankers and government entities that do not get a fuzzy feeling by hearing business owners brag about their businesses and show them nothing to back-up their claims. “Business is great” is not as effective as “Business has had sales of $10,000 per month” and then showing a financial report to show it.
Without accounting, you really don’t know if your business is making money and you cannot answer simple questions, such as how much you paid in office supplies this year. If you’re small, you may get away in using your checkbook as an accounting system, but as you grow, you will see how hard it can be to control expenses and to analyze sales without a more formalized system. These days accounting software is so affordable and easy to use that it makes little sense to be operating in the dark — without accounting information.
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