Financial Statements

Why do businesses prepare financial statements?

There are numerous reasons why businesses prepare financial statements:

• The law - In many countries financial statements are obligatory. For example, in the UK it is a legal requirement for companies to publish financial statements. Moreover, they have to be prepared according to recognised accounting standards and in an agreed format. Companies that fail to do so may be fined or even forced to shut down.

• To help managers make decisions - Financial statements can be very useful for managers when making business decisions. For example, if they see that a company is making losses, they can refrain from spending money and try to introduce actions to improve profitability.

• To guide investors - As financial statements provide information about profits or losses and the overall value of a company, they can be a useful guide for people and organisations considering investing in it. For example, when an investor decides on which firm to invest in, they can have a look at their financial statements and compare their profits.

What financial statements are there?

There are two main financial statements:

• Income statements

• Balance sheet

Financial Statements: Income statement

The income statement provides information on revenues that a business has incurred over a particular period of time. Revenue is money a company has earned from its sales.

The income statement also provides information on expenses that a business has incurred over a particular period of time. An expense is money a company has spent to operate. Expenses can include costs related to manufacturing and selling products, interest, taxes, and any other expenses.

The income statement matches all the revenues and expenses to show a profit or loss made by a business. This way it can arrive at a net profit which is the final feature of the income statement. Net profit is the profit made by a business after all of its expenses have been subtracted from revenues.

Financial Statements: Balance sheet

The balance sheet provides information on assets that a business possesses at a specific point in time. An asset is everything that a company owns.

The balance sheet also provides information on liabilities that a business owes at a specific point in time. A liability is everything that a company owes.

The balance sheet matches all the assets and liabilities to show the equity of a business. This way it can arrive at total equity which is the final feature of the balance sheet. Total equity is a business's capital that belongs to shareholders. This is the money remaining after the business has subtracted liabilities from its assets.

Interpretation and analysis of financial statements

Different people involved or interested in a business might want to find out about its financial performance. In order to do so, they need to interpret and analyse its financial statements. There are several ways to interpret and analyse financial statements:

Financial Statements: Comparing with previous years

Comparing financial statements with those from previous years is typically the first thing owners, shareholders, managers, and others do to analyse the financial performance of a company. For example, looking at the income statements from previous years, one can see whether a firm’s profits have increased or decreased.

Financial Statements: Comparing with competitors

Another way to examine the financial performance is to compare the financial statements of a business with its competitors. For example, by looking at the balance sheets of competitors, one can assess whether a debt a firm owes is relatively big, small, or typical for businesses in the industry.

Financial Statements: Calculating financial ratios

To deeply analyse the financial performance of a business, it may be useful to take figures from its financial statements and calculate financial ratios that compare the relationship between two or more elements of financial data sourced from a business's financial statements. For example, one can take figures from the income statement to calculate the net profit margin - a ratio showing net profit as a percentage of revenue.

As you can see, financial statements are very helpful when analysing the financial performance of a business. The data and figures they include allow us to find out about the profitability and value of a business, which can be useful for managers and potential investors.