What are financial statements?

If you had to analyse the details of your income and how you spent it in the previous month, what would you do? Typically, you’d prepare a list of all the sources of your income and match it against a list of all  the expenses that you incurred in the last month, isn’t it? In the world of  finance, this list of income and expenditure that you’ve just prepared - that is known as a financial statement.

Like this, each company, whether or not it’s listed on a stock exchange, prepares several financial statements every year. These statements are generally prepared for a period of 12 months. Known as a financial year, this 12-month period generally starts on the 1st of April each year and ends on the 31st of March the next year. 

And just like how you can get a better idea of your financial situation by going through your list of income and expenditures, you can also gauge a company’s financial performance and its fiscal situation by just reading through its financial statements. 

In this lesson, we’ll break down the basics of financial statements for you. We’ll also take a quick look at the various financial statements of a company and try to understand how they can help you as an investor.  

What are financial statements?

According to the technical definition, reports that showcase the financial and accounting information of any entity, an individual, or a business are termed as financial statements. Since these statements are essentially reports of the financial position and performance of an entity, they’re also known as financial reports. Companies prepare financial statements on a regular basis to keep investors like you informed about their status and to give a clear and concise picture of their financial activities.        

What are the various financial statements of a company?

Now that you know what these statements are, let’s take a quick look at the various financial statements of a company. Basically, there are three primary statements that you should know about - profit and loss statement, balance sheet and cash flow statement.      

Profit and loss statement 

Also known as the income statement, a profit and loss statement gives you information regarding the income and the expenditures of a company and ultimately, its net profit or loss at the end of the financial year for which the statement is prepared. 

The income section of this statement includes details of all the sources of the revenue earned by the company. This includes both operating income (income from its business) and non-operating income (income that’s not derived from its business). For example, in the case of a company like Tata Motors, the income derived from manufacture of automobiles is operating income, while any other income, like say, from the sale of an asset, would be non-operating income. 

The expenditure section includes details of all the expenditure incurred by the company, such as salaries, travel costs, equipment costs and depreciation of assets, among others. In addition to this, the statement also includes details of taxes paid by the company.

As an investor, you can easily identify how much the company made and how much it spent in a year using the profit and loss statement. You can gauge its profitability as well.   

Balance sheet

The balance sheet of a company is a report that gives you an overall view of the assets and the liabilities of that company. It is generally broken down into two parts - assets and equity and liabilities. 

The assets side of the balance sheet shows all the long-term (non-current) and the short-term (current) assets owned by the company. For instance, if a company possesses a piece of land, it will be shown in the balance sheet under the section for non-current assets. Similarly, the cash in the company’s bank account would show up under the current assets section.

The equity and liabilities side of the balance sheet of a company shows the share capital of the company and its long-term (non-current) and the short-term (current) liabilities. For example, if a company has borrowed a loan from a bank, it will be shown in the balance sheet under the section for non-current liabilities. Similarly, if the company owes some money to its creditors within the coming year, then that would show up under the current liabilities section.

As an investor, the balance sheet of a company is very useful to you since it gives you a snapshot of what a company owns and owes.

Cash flow statement 

The cash flow statement shows just how much cash was earned and spent by a company in a financial year. While you might think that the cash flow statement is similar to the profit and loss statement, that’s not the case.

The profit and loss statement generally includes non-cash items like depreciation as well, whereas the cash flow statement includes only those items that cause an inflow or an outflow of cash. 

The cash flow statement is typically broken down into three main parts - cash flows from operating activities, cash flows from investing activities and cash flows from financing activities.

With the cash flow statement, you can easily measure a company’s capacity to generate cash. You can also use this report to get to know exactly where a company gets its cash from and how it spends the said cash. 

Notes forming a part of financial statements

Although the notes are generally not regarded as one of the core reports, they’re an integral part of the financial statements of a company. The notes forming a part of financial statements give you additional in-depth details and breakups on the various items contained within the above three statements. They give you a much better perspective and allow you to better understand the financial statements. 

This chapter is just the tip of the iceberg. In the lesson and modules that follow, we’ll be delving even deeper into financial statements to learn how to effectively read and analyse them.   

Wrapping up

Aside from these three main financials, there’s another document that also forms a central part of company analysis. This is the annual report. What is it? Who prepares it? And what does it tell you? Find out the answers to these questions in the next chapter of this module. 

A quick recap

• Reports that showcase the financial and accounting information of any entity, an individual, or a business are termed as financial statements.
• Each company prepares several financial statements every year, generally for a period of 12 months. 
• Known as a financial year, this 12-month period generally starts on the 1st of April each year and ends on the 31st of March the next year. 
• There are three primary financial statements: profit and loss statement, balance sheet and cash flow statement.
• Also known as the income statement, a profit and loss statement gives you information regarding the income and the expenditures of a company and its net profit or loss at the end of the financial year for which the statement is prepared.    
• The balance sheet is a report that gives you an overall view of the assets and the liabilities of a company. It is generally broken down into two parts - assets, and equity and liabilities.    
• The cash flow statement shows just how much cash was earned and spent by a company in a financial year.
• The notes forming a part of financial statements give you additional in-depth details and breakups on the various items contained within the above three statements.