When a company’s stakeholders want to know its performance, they look to its financial statements. A financial statement is a report summarizing financial documents written to show the financial performance and position of the business. Three statements make up the financial statement: the balance sheet, the income statement and the 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, but they are also graded and contextualized to tell an ongoing story of the company. Examining a current financial statement gives investors information about the current performance of the company. Examining a series of statements reveals a trend and can tell the story of a business’s growth or turmoil.
Here’s what every investor needs to know about financial statements and their role in valuing a business.
What is a balance sheet?
The balance sheet shows the activity of a company assets, liabilities and equity. It is a statement of net worth that gives an accurate picture of the financial health of the business. If the business has strong assets and few liabilities, that’s a good sign. That said, a balance sheet is only a static representation of the health of a business over a period of time. This is why it is grouped together with the income statement and the cash flow statement during the financial reporting period.
What is an income statement?
Also called income statement or income statement, the income statement indicates the income, expenses and net profit. It covers both operational and non-operational activities over a specified period. The income statement provides a context for the larger financial operations of the business, including the balance sheet and statement of cash flows. Specifically, it breaks down the gross profit, operating profit, pre-tax profit, and after-tax profit of the business.
What is a cash flow statement?
The cash flow statement presents the flow of money in and out of a business. It is above all an indicator of the financial health of a company. In other words: more money coming in and less money going out equals a healthier business. In addition, the cash flow table details operating cash flows, investing cash flows and financing cash flows. The ability of a business to pay its operating costs in the short term means that it is positive cash flow. Likewise, a statement that shows low cash flow may indicate a tendency towards insolvency.
Ratings are an essential part of financial reporting
In a formal financial statement, a business combines the balance sheet, income statement, and cash flow statement, along with notes. These notations are particularly important because they help to clarify the context of the figures themselves. For example, the scoring can specify the type of inventory system used, which brings clarity to the balance sheet. Likewise, there might be a note on share buybacks that provides better context for the statement of cash flows.
How often do companies publish financial statements?
The Securities and Exchange Commission (SEC) requires companies to publish quarterly and annual financial statements. Additionally, whenever there is an unexpected change in company finances, it is important to bring it to the attention of shareholders. Investors can expect to be familiar with three main types of financial reporting:
- The Form 10-Q: The quarterly financial statement issued by a company.
- A Form 10-K: The annual financial statement published by a company.
- A Form 8-K: A financial statement published to inform shareholders of financial irregularities.
These reports include the complete financial statements of the company. They play a critical role in tracking business growth (or decline) and emerging financial trends. For example, shareholders can look at the company’s 10-Q to track its cash flow throughout the year, and then look at the 10-K for an overall picture of the year being reviewed. Likewise, investors may want to revisit 8-K following the announcement of an acquisition or the resignation of management.
Audit of financial statements
Because financial statements contain essential information about the cash flow, income, expenses, assets and liabilities of the business, it is essential that they are presented accurately. This is why, with the disappearance of Sarbanes-Oxley Act of 2002, public companies should have their financial statements audited by an impartial third party. Independent CPAs ensure that the data presented is in accordance with GAAP, accurate and free of errors or omissions.
External audits are an important step in being able to take financial statements at face value. If the information presented in a company’s financial statements is inaccurate, it has cascading consequences. The resulting fallout could irritate investors or create tax obligations with the IRS. In fact, a significant 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 non-compliance is not tolerated.
The importance of financial statements
Financial statements convey a company’s financial information to interested parties. This can include shareholders, regulators, and even other companies. It’s a transparent way to talk about the financial health of the business and its operations. Investors use this data to form an investment thesis on the company. The SEC and IRS use it to ensure compliance and accuracy. Competitors use it to compare their own financial data and assess the market.
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To make the best use of financial statements, investors should familiarize themselves with each of the main documents that make them up: the balance sheet, the cash flow statement and the income statement. The ability to understand these documents plays an important role in understanding the larger context of a company’s financial situation. It starts with picking up a 10-Q or 10-K.