All you need to know about financial statements

What are financial statements? 

Financial statements are summary-level written records of a business’s financial status, financial position, and cash flows. Both internal and external parties need the financial status of a firm. It helps in taxation, financing, and investing. For organizations apart from NGOs, the financial statement includes three statements:

• Balance Sheets
• Income Statements (Profit & Loss Statement)
• Cash Flow Statements

 

Why are financial statements important?

The financial statements offer all financial information to investors and creditors, portraying how your company is performing. The decision to invest in any firm primarily depends on the financial statements. The current stakeholders also decide whether they want to continue investing in your company. 

Besides the top stakeholders, your employees are also interested in the financial statements. They need these statements to learn the basis of their current wage and future appraisal. Usually, firms can issue financial statements quarterly, and you must file these reports on time. Otherwise, the government can levy penalties on your firm. Plus, you must not dodge the financial statements, as dodging misleads the stakeholders.

What do you need to consider before preparing financial statements?

Financial statements are a fundamental source of financial information for any company. To prepare financial statements, you must learn basic accounting principles to ensure accuracy and consistency. The most basic principles that you need to consider are: 

• Recorded Facts

Recording the origins or historical costs helps in the preparation of financial statements. The historical cost of assets must be recorded in the balance sheet, even if the market price has surged up in value over time. 

• Accounting Conventions

Accounting conventions ensure that all companies record transactions, similarly, making the financial statements comparable. For instance, two companies in the same industry are following accounting conventions. So, the investors can easily compare the financial performance of both companies.

• Personal Judgements

Your financial statements are dependent on your judgments. For instance, the value of assets and liabilities depends on which accounting standards you follow. Moreover, based on your personal assessment, you choose a depreciation method and the amortisation of assets. 

 

Let’s dive in and understand the three financial statements in detail:

• Balance Sheet

A balance sheet elucidates the true picture of a company’s assets, liabilities, and equity balances. It shows the financial position of a business at a particular date. The formula of the balance sheet includes all three components. The formula is liabilities subtracted from assets to get equity. 

Assets- Liabilities= Equity

As per the double-entry system, both sides of the equation should be equal. Otherwise, you need to identify the errors made in the preparation of the balance sheet. It also helps in calculating the working capital and various accounting ratios. 

• Income Statement

An income statement portrays a detailed picture of a business’s revenue and expenses for some time. By preparing an income statement, you can get your net income. The income statement consists of expenses and revenue. However, it would be best if you did not confuse revenue with receipts. Revenue is simply money earned from your core business. In comparison, receipts account for all cash receipts like revenue, loans repaid to you, sale of scrap, etc.

Are the Balance sheet and Income statement connected? 

The element connecting the balance sheet and income statements are net income. To compute net income (net profit), subtract expenses from revenue. The income statement is a temporary account, whereas the balance sheet is permanent. The balance in the income statement is adjusted to zero at the end of each period. In contrast, balances in the balance sheet are carried forward from one month to the next. 

At the end of a period, you close all books and compute net income. This net income is posted on the balance sheet and added to the capital on the Liability side. Hence, your equity balance increases in the balance sheet. 

• Cash Flow Statement

In cash flow management, the first step is to prepare a cash flow statement. A cash flow statement is also called a statement of changes in financial position. It is a document that shows what happens to your company’s cash. It shows the ability of your company to operate in both the short and long term. It has three categories as follows:

Operating activities include the outflow and inflow of cash once your company delivers a good or service. It accounts for both revenues and expenses. Investing activities consist of the cash flow related to purchasing and selling of assets (tangible as well as intangible). Financing activities comprise the cash flow from debt and equity financing. 

 

Is the Balance sheet and Cash flow statement connected? 

After computing the cash flow from all three activities, add them to get the cash flow statement. This end balance in the cash flow statements must equal the ending cash balance in the balance sheet. 

Learning the type and method of preparing financial statements seems easy while reading. However, it is complicated and equally essential to prepare accurate statements. There are a few common mistakes that you might make while preparing it. 

 

Common Mistakes While Preparing Financial Statements

• No comparative Data

Check the financial statement of any publicly listed company. They always provide the prior year, prior month, or budgeted amounts besides the current data. It eases the process of comparison of current, previous, and forecasted performance. 

• Errors in the categorization of assets and Liabilities

Preparing a balance sheet requires more than basic accounting knowledge. Classifying assets and liabilities helps you understand how much money you should receive from clients and how much money you owe to someone. Hence, categorizing them is of utmost importance.

• Errors of omission and data entry

When you enter data, the chances of human errors are possible. For instance, you may write the closing value of furniture as 253000 instead of 263000. This error is called an error of data entry. In an error of omission, you completely forget to mention the furniture and its balance in the balance sheet. 

 

Read here: Common Errors in Financial Statements.

 

Conclusion

Without any accounting education background, you cannot be an accounting expert. Therefore, the chances of accounting errors in preparing financial statements are inevitable. However, these errors can disrupt your business and portray an untrue picture. It requires time and resources to find and correct them. 

To save your valuable time and effort, you can outsource your entire accounting or hire a virtual CFO. An in-house accounting department will also be able to help you. However, as a small business, you must be cost-conscious. Outsourcing to us at SKB Accounting is not only time & cost-effective but also brings industry experts to your firm. 

Schedule a call with us now if you want to show an accurate and true picture of your business.