Interpreting financial statements is a skill that all investments and shareholders require. It consists of evaluating each statement individually and combinedly. By doing so, investors can receive information crucial for their relationship with the company. More specifically, interpreting the financial statements allows investors to make better business decisions. However, the process does not have a specific method or procedure.
Instead, interpreting the financial statements depends on the purpose that investors seek. On top of that, the specific financial statement they consider may also differ. In some cases, other stakeholders apart from investors may also consider the financial statements. For them, the purpose or objective of interpretation may vary from others. Therefore, the whole process or procedure may also vary.
Overall, there is no specific method or procedure to interpret financial statements. Nonetheless, some tips exist to make the process more straightforward. Users must also consider the particular financial statement they must review to examine them. However, it is crucial to understand what these statements are. By studying those statements, users can analyze and interpret them better.
What are Financial Statements?
Financial statements are written records of a company’s operations for a period or at a specific date. Usually, these records come in two primary forms for companies. These include the balance sheet and the income statement. In most jurisdictions, companies must prepare them to present a picture of their operations. Usually, another financial statement also accompanies these financial statements. It is known as the notes to the financial statements.
On top of the two above statements, companies also prepare two others. In some jurisdictions, they may not be mandatory. However, companies can still prepare them voluntarily to present a better picture of their operations. These include the cash flow statement and the statement of changes in equity. With the balance sheet and income statement, there are four financial statements.
Each financial statement presents a different aspect of a company’s operations. Therefore, each of them has a specific purpose. The balance sheet shows the financial position at a date. In contrast, the income statement shows financial performance for a period. The cash flow statement shows cash performance for that period. Lastly, the statement of changes in equity presents the movements in equity balances.
Most investors focus on the income statement to decide on their relationship with a company. However, the balance sheet is also crucial in showing them how to manage their resources. The cash flow statement and statement of changes in equity are as critical. However, they present a different aspect of a company’s activities, which investors may not consider. Nonetheless, each of them plays a role in reporting several aspects.
Overall, financial statements are written records that help companies report their financial operations. These statements may include the balance sheet and income statement. On top of these, companies may also prepare two others, as mentioned above. Each financial statement shows a different aspect of a company’s operations. Therefore, interpreting them for better business decisions also differs on the user’s needs.
How to interpret financial statements for better business decisions?
Apart from investors, companies must also interpret their financial statements. While most companies use management accounting for that need, those statements can also be crucial. The primary objective of doing so is to make better business decisions. As mentioned, however, each financial statement has its purpose. Therefore, companies must understand how to interpret each of them individually.
Balance Sheet
The balance sheet is a financial statement that shows a company’s financial position. For companies, it presents three crucial components. These include assets, liabilities and equity. The balance sheet follows the accounting equation to report that information. Usually, each element in the balance sheet presents an insight into the different areas of the business.
Assets are financial resources that can result in inflows of economic benefits in the future. Usually, these include fixed assets, inventories, cash and cash equivalent, accounts receivable, intangible assets, etc. Usually, the higher they are, the more resources companies must invest in their operations. However, companies must use them efficiently to create profits.
Liabilities, on the other hand, are obligations from past events. These are the opposite of assets and result in outflows of economic benefits. Usually, they include loans, leases and payable balances. Investors prefer these balances to be lower since they can have adverse implications. However, liabilities are a source of inexpensive finance.
Equity represents the residual interest owed to shareholders after deducting liabilities from assets. Usually, they include balances such as share capital, share premium, retained earnings and reserves. Like liabilities, equity presents a finance source. However, it is usually more expensive than liabilities. For companies, higher equity can have adverse implications as well.
Income statement
The income statement presents a view of the financial performance of a company. This performance spans over a specific period, usually quarterly or annual. In essence, the income statement includes three crucial components. These include revenues, expenses and profits. Each of these can have an impact on the company’s financial performance.
Revenues represent any income generated from the sale of products or services for a period. Usually, the higher they are, the better it is for companies. On the other hand, expenses are outflows of economic benefits. They represent any costs incurred on generating revenues. Companies must strive to keep these costs minimal to maximize their profits.
Lastly, profits represent the difference between income and expense. However, a company’s income must exceed its expenses to profit. If the opposite applies, it falls under a loss. For companies, viewing the difference is crucial in ascertaining a profitable business. In that regard, both the revenues and expenses play a massive role. Overall, the income statement is critical to making better business decisions.
Cash flow statement
The cash flow statement presents a cash management perspective of a company’s operations. For most companies, it divides the cash flows into three categories. They include cash flow from operating, investing and financing activities. Each of these categories presents a different perspective of the cash flows generated.
The cash flow statement plays a crucial role in business decisions. It helps companies ensure they have enough resources to fund future operations. On top of that, it also shows cash movements in the cash balance. By doing so, it enhances the business decisions made based on cashflows. For most companies, the cash flow statement is critical in decision-making.
Most decision-making activities consider cash flows instead of financial profits. Therefore, the cash flow statement helps present a ground for decision-making. Companies can use the information presented in this statement to enhance their investment appraisal process. By doing so, they can make better business decisions.
Statement of changes in equity
The statement of changes in equity is the final financial statement that companies prepare. It shows a movement in the equity balances on the balance sheet. Usually, it derives its information from the other financial statements. For shareholders, it provides insights into how companies manage their equity finance. Therefore, it is also crucial for investors.
However, the statement of changes in equity does not play a significant role in business decisions. In most cases, the information presented in this statement is available in the other three. Therefore, users can obtain that information elsewhere. For decision-making based on equity finance, this statement may be beneficial, nonetheless.
Conclusion
Interpreting financial statements is crucial for decision-making for most users. These financial statements include four primary written records. Usually, the user’s objectives determine how they interpret the financial statements. On top of that, each financial statement can show a different aspect of a company’s operations. Therefore, it is crucial to evaluate them individually and combinedly.
