Overview of Financial Reports

Financial statements are written records that illustrate the business activities and the financial performance of a company. In most cases, they are audited to ensure accuracy for tax, financing, or investing purposes. A methodical workthrough of the three financial statements in order to assess the Financial health of a company.

A methodically work through of the three financial statements in order to assess the Financial health of a company.

The Balance Sheet

The Balance Sheet provides the statement of financial position. The balance sheet provides an overview of the company's assets, liabilities, and shareholders' equity at a specific time and date. The date at the top of the balance sheet tells you when this snapshot was taken; this is generally the end of its annual reporting period. A balance sheet portrays the value of assets owned by an organisation, liquidity and solvency of the organisation. The balance sheet is utilised to study the ability of the organisation to meet its financial goals.

The Snippet of the Balance sheet is showcased below:

Statement of Profit and Loss

The Profit & Loss Statement is a crucial financial statement summarising the costs, revenues and expenses incurred by a business during a specific period, usually a quarter or year. All the indirect expenses and incomes, including the gross profit/loss, are reported in the Profit & Loss Statement to arrive at the net profit or loss. It shows the company’s net profit or loss during a specific time for which it is prepared. This statement helps companies make informed decisions about their operations and track their financial performance.

Profit & Loss Statement/Account shows the profits/losses earned/incurred by a business for a month or a year. Companies use Profit & Loss Statement and others use “T Account” for these below-mentioned reasons. Profit & Loss Statement/Account is prepared for two main reasons.

1. To know the profits/losses earned/incurred by a business,

2. Statutory requirements (Companies Act, Partnership Act or any other law)

Traditionally, there were two steps to know the profit/loss. It meant, the preparation of :

1. Trading Account

2. Profit & Loss Account

The trading account reflects the gross profit or loss of the business. Profit & Loss Account shows the net profit or loss earned by the company. Calculations in the Profit & Loss Account would be as follows:

• Add all revenue earned over the accounting period.

• Add all expenditures made throughout the accounting period.

• Subtract total expenses from total revenue to know the difference.

• If the value is positive, it represents profit; if it is negative, it represents a loss.

Understanding Cash Flow Statements

When it comes to preparing cash flow statements, two methods stand out: the indirect method and the direct method. While both ultimately reveal the same insights into a company's financial health, the indirect method is often preferred for its simplicity and alignment with standard accounting practices.

Preparation under the Indirect Method:

Operating Activities:

1. Calculate Operating Profit Before Changes in Working Capital: Begin with the net income from the income statement. Adjust it for non-cash expenses like depreciation and amortization to arrive at the operating profit before changes in working capital.

2. Adjust for Changes in Working Capital: Analyze fluctuations in current assets and liabilities. Increases in assets like accounts receivable reduce cash flow from operating activities, while increases in liabilities like accounts payable boost cash flow. Adjust the operating profit accordingly to determine the net cash provided by operating activities.

Investing Activities:

• Identify cash flows related to long-term asset transactions, such as purchases and sales of property, plant, and equipment, as well as investments in securities.

Financing Activities:

• Determine cash flows related to capital raising and repayment activities, such as issuing or repurchasing stock, issuing or repaying debt, and dividend payments.

By summing up the cash flows from operating, investing, and financing activities, you arrive at the net change in cash and cash equivalents for the period.

Whether using the indirect or direct method, the goal remains the same: to provide a clear picture of how cash is flowing in and out of the business. And while the indirect method may be the more traditional approach, its reliability and simplicity make it a staple in financial reporting.

The Impact of Working Capital Changes

Understanding Working Capital Dynamics

• Current Assets:

  • Increase: Blocks cash, leading to decreased cash inflow.

  • Decrease: Frees up cash, resulting in increased cash inflow.

• Current Liabilities:

  • Increase: Saves cash, causing a decrease in cash outflow.

  • Decrease: Triggers cash outflow due to liability payment.

In a Nutshell:

Cash from operating activities = Operating profit before working capital changes + Net decrease in current assets + Net Increase in current liabilities - Net increase in current assets - Net decrease in current liabilities

Navigating Investment Activities

• Cash Flow from Investing Activities:

• Comprises cash inflows from asset sales or maturity.

• Includes cash outflows for acquiring fixed assets or investments.

Examples of Cash Inflow from Investing Activities:

• Sale of assets like plant, land, or shares.

• Receipts from loan repayments.

Examples of Cash Outflow from Investing Activities:

• Purchase of assets, shares, or loans to third parties.

Simplified Approach to Cash Flow Statements

While the fundamentals of preparing cash flow statements remain consistent between the direct and indirect methods, the direct method offers a more straightforward presentation.

Illustration of the Indirect Method:

In the indirect method, cash flow is derived by adjusting net income for non-cash expenses and changes in working capital.

Cash Flow Statement under the Direct Method:

The direct method streamlines the presentation as follows:

1. Operating Activities: Cash inflows and outflows directly associated with operations are listed.

2. Investing Activities: Cash flows from investments, such as asset purchases and sales, are detailed.

3. Financing Activities: Cash flows related to financing activities, like issuing or repurchasing stock and debt, are outlined.

Frequently asked questions

1. What are financial statements?

Financial statements are formal records that provide a snapshot of a company's financial performance and position. They typically include the income statement, balance sheet, cash flow statement, and statement of changes in equity.

Why are financial statements important?

Financial statements offer valuable insights into a company's profitability, liquidity, solvency, and overall financial health. They are essential for decision-making by management, investors, creditors, and other stakeholders.

What is included in an income statement?

An income statement, also known as a profit and loss statement, summarizes a company's revenues, expenses, and net income over a specific period. It provides a picture of the company's profitability.

What is the balance sheet, and what does it show?

The balance sheet presents a company's financial position at a specific point in time, detailing its assets, liabilities, and shareholders' equity. It provides insights into the company's liquidity and solvency.

What is the difference between the direct and indirect methods of preparing a cash flow statement?

The direct method presents actual cash receipts and payments, while the indirect method starts with net income and adjusts for non-cash items and changes in working capital. Both methods yield the same total cash flow from operating, investing, and financing activities.

Where can I find a company's financial statements?

Publicly-traded companies are required to disclose their financial statements to regulatory authorities like the Securities and Exchange Commission (SEC) in the United States. These statements are often available on the company's website or through financial databases and reports.