Module 02 Understanding Financial Statements

Module Two: Understanding Financial Statements

Financial statements are the communication tools for the organization. Many aspects of a business's financial dealings are reported in financial statements. Revenues coming in and expenses going out are vital data that require reporting. Tangible items like equipment, property, and cash reserves are also reported in financial statements. Understanding these financial statements opens the door to analyzing finance data for budgeting, controlling, and making decisions.

This module will discuss the following topics:

  • Balance sheets
  • Income statements
  • Statement of retained earnings
  • Statement of cash flows
  • Annual reports

The two most widely known statements are the balance sheet and income statement.

Balance Sheets

The balance sheet is a report on the financial condition of an organization and is required by GAAP. In the balance sheet, assets are expressed in liabilities and capital, which must equal each other. Assets are the cash on hand, properties owned, and monies owed to the organization and can be liquidated and paid the organization's debt. 

Liabilities are the debts the organization owes to its creditors, which go against assets. In addition, the organization's assets belong to the owners, which is called capital, which goes against the assets. Therefore, the balance sheet can reveal a lot about a company. For example, the level of debt the company owes against what it owns in cash and properties could reveal a liquidity problem.

Furthermore, suppose a company has no debts and a huge level of assets. In that case, this may be a sign that the company is not running efficiently and is allowing the assets to remain idle instead of using them for a return.

Balance sheets are usually set up as columns, constantly comparing the assets versus the liabilities and capital. In addition, balance sheets often show the previous month's or year's data for comparison.

Later in this course, you will get a chance to use the figures from the balance sheet to determine specific financial ratios that will help you understand the organization's financial condition.

Income Statements (AKA Profit & Loss Statements)

The income statement is a summary of the income and expenses of an organization in a given period and is required by GAAP. Usually, companies create monthly and yearly income statements. Income statements list all the areas where income is generated. Sometimes, the income is categorized into specific categories:

  • Income from sales
  • Income from interest
  • Income from investments

The income statement also contains the expenses, and this can be categorized too:

  • Dividend expense
  • Operating expense
  • Cost of goods sold
  • Taxes

The net income or loss is calculated by subtracting the expenses from the income. This number represents the income or loss after all expenses are applied. This number is usually incorporated into the statement of retained earnings discussed later in this module. 

The income statement allows you to determine how well the company brings in income. If the expenses are more significant than the income, then the net income will become the net loss, subtracting from the owner's equity in the statement of retained earnings.

The income statement is called the Profit and Loss Statement because it indicates the calculations mentioned earlier. The income statement format is usually in column format and can be presented along with the previous month's or year's information for quick comparisons. In addition, you may see the changes expressed in percentages. 

Statement of Retained Earnings

The statement of retained earnings can appear on a balance sheet, income statement, or a separate financial report. GAAP requires this report and reports the change in owner's equity from one period to another.

The essential components of the statement of retained earnings include the following:

  • Beginning balance
  • Net Income/loss
  • Dividends paid
  • Ending balance

The resulting calculation is then applied to the owner's equity under the capital heading on the balance sheet.

Statement of Cash Flows

The cash flow statement helps determine how cash flows in and out of the company. This statement is considered a mandatory financial report. The statement of cash flows doesn't necessarily factor in cash flows from credit transactions or accounting maneuvers like depreciation expense. The statement of cash flows can be a detailed report, but understanding it is not so difficult.

There are three main components of the statement of cash flows. They are the following:

  • Cash flow from operations
  • Cash flow from investing
  • Cash flow from financing

When the cash flow reveals that most of the cash flows are from operations, this is a good sign for regulators, stockholders, and investors. 

A negative cash flow does not necessarily mean the company is doing poorly. For example, equipment or inventory could have been invested significantly. However, negative cash flow situations require more analysis to determine why it is negative. 

However, a negative cash flow resulting from poor operations could signify a company going bankrupt. Understanding the cash flow will help you understand how the company obtains the cash and uses it.  

Annual Reports

The annual report is an annual document that provides a comprehensive report on the financial activities of the past year of an organization. The financial reports are from critical people in and out of the organization.

Here are the essential components of an annual report:

  • Chairman's report
  • CEO's report
  • Auditor's report
  • Mission statement
  • Corporate governance statement
  • Statement of director's responsibilities
  • Balance sheet
  • Statement of retained earnings
  • Income statement
  • Cash flow statement
  • Notes to the financial statements
  • Accounting policies

Investors and stockholders use the annual report, and the government reviews these reports for compliance with regulations. Understanding that all company activities eventually are incorporated into the annual report.

As a manager, you may not see the relevance of the annual report for your daily job, but realizing how you run your department may reflect on this annual report makes it worthwhile to know what reports go into the annual report.

Lesson Summary

Financial statements are essential communication tools for organizations. This module discusses four essential statements: 1. Balance Sheets: a report on the financial condition of an organization, expressed as assets versus liabilities and capital, which must equal each other. Can provide insight into a company's liquidity. 2. Income Statements (aka Profit & Loss Statements): summary of income and expenses over a given period. Net income or loss is calculated by subtracting expenses from income. 3. Statement of Retained Earnings: required report displaying change in owner's equity from one period to another. 4. Statement of Cash Flows: indicates how cash flows in and out of a company. Additionally, the module mentions the Annual Report which includes Chairman's report, CEO's report, Auditor's report, Mission statement, Corporate governance statement, Statement of director's responsibilities, Balance sheet, Statement of retained earnings, Income statement, Cash flow statement, Notes to the financial statements, and Accounting policies. Managers may not realize how their departments reflect on the annual report but understanding the financial statements gives them information needed to analyze data for decision-making.

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