Every month, every financial-advisory firm should produce three financial statements:
These three are inter-related, but each has its own importance. Unfortunately some firms consider the balance sheet as the cover page and the income statement as a scorecard.
The Balance Sheet
The accountingbalance sheetis one of the major financial statements used by accountants and business owners. (The other major financial statements are theincome statement, statement of cash flows). The balance sheet is also referred to as thestatement of financial position.
The balance sheet presents a company's financial position at the end of a specified date. Some describe the balance sheet as a "snapshot" of the company's financial position at a point (a moment or an instant) in time. For example, the amounts reported on a balance sheet dated December 31, 2011 reflect that instant when all the transactionsthrough December 31have been recorded.
Because the balance sheet informs the reader of a company's financial position as of one moment in time, it allows someone—like a creditor—to see what a companyownsas well as what itowesto other parties as of the date indicated in the heading. This is valuable information to the banker who wants to determine whether or not a company qualifies for additional credit or loans.
Others who would be interested in the balance sheet include current investors, potential investors, company management, suppliers, some customers, competitors, government agencies, and labor unions. We will begin our explanation of the accounting balance sheet with its major components, elements, or major categories:
Assetsare things that the company owns. They are the resources of the company that have been acquired through transactions, and have future economic value that can be measured and expressed in dollars. Assets also include costs paid in advance that have not yetexpired, such as prepaid advertising, prepaid insurance, prepaid legal fees, and prepaid rent.
Contra Assetsare asset accounts withcreditbalances. (A credit balance in an asset account is contrary—or contra—to an asset account's usual debit balance.) Accountants usually prepare classified balance sheets. "Classified" means that the balance sheet accounts are presented in distinct groupings, categories, or classifications. Theasset classificationsand their order of appearance on the balance sheet are:
Liabilitiesare obligations of the company; they are amounts owed to creditors for a past transaction and they usually have the word "payable" in their account title. Along with owner's equity, liabilities can be thought of as asourceof the company's assets. They can also be thought of as a claimagainsta company's assets.
Liabilities also include amounts received in advance for future services. Since the amount received (recorded as the asset Cash) has not yet been earned, the companydefersthe reporting of revenuesand instead reports a liability such as Un earned Revenues or Customer Deposits.
Owner's Equity—along with liabilities—can be thought of as a source of the company's assets. Owner's equity is sometimes referred to as the book value of the company, because owner's equity is equal to the reported asset amountsminusthe reported liability amounts.
Owner's equity may also be referred to as the residual of assets minus liabilities. These references make sense if you think of the basic accounting equation:
Assets = Liabilities + Owner's Equity
and just rearrange the terms:
Owner's Equity = Assets – Liabilities
"Owner's Equity" are the words used on the balance sheet when the company is asole proprietorship. If the company is a corporation, the words Stockholders' Equity is used instead of Owner's Equity. An example of an owner's equity account is Mary smith, Capital(where Mary Smith is the owner of the sole proprietorship). Examples of stockholders' equity accounts include:
The Income Statement
Theincome statementis one of the major financial statements used by accountants and business owners. The income statement is sometimes referred to as the profit and loss statement (P&L), statement of operations, or statement of income. We will use income statement and profit and loss statement throughout this explanation.
The income statement is important because it shows theprofitabilityof a company during the time interval specified in its heading. The period of time that the statement covers is chosen by the business and will vary.
People pay attention to the profitability of a company for many reasons. For example, if a company was not able to operate profitably—the bottom line of the income statement indicates anet loss—a banker/lender/creditor may be hesitant to extend additional credit to the company. On the other hand, a company that has operated profitably—the bottom line of the income statement indicates anet income—demonstrated its ability to use borrowed and invested funds in a successful manner.
A company's ability to operate profitably is important to current lenders and investors, potential lenders and investors, company management, competitors, government agencies, labor unions, and others.
The format of the income statement or the profit and loss statement will vary according to the complexity of the business activities. However, most companies will have the following elements in their income statements:
If the net amount of revenues and gains minus expenses and losses is positive, the bottom line of the profit and loss statement is labeled asnet income. If the net amount (or bottom line) is negative, there is anet loss.
The Statement of Cash Flow
In financial accounting, acash flow statement, also known asstatement of cash flowsorfunds flow statementis a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and cash out of the business.
The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7 (IAS 7), is the international accounting standard that deals with cash flow statements.
People and groups interested in cash flow statements include:
The cash flow statement reports thecashgenerated and used during the time interval specified in its heading. The period of time that the statement covers is chosen by the company. For example, the heading may state "For the Three Months Ended December 31, 2011" or "The Fiscal Year Ended September 30, 2011".
The cash flow statement organizes and reports the cash generated and used in the following categories:
converts the items reported on the income statement from the accrual basis of accounting to cash.
Reports the purchase and sale of long-term investments and property, plant and equipment.
Reports the issuance and repurchase of the company's own bonds and stock and the payment of dividends.
Reports the exchange of significant items that did not involve cash and reports the amount of income taxes paid and interest paid.
Cash Flow Dynamics
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