What are Financial Statements?

The term “financial statements” refers to the written reports that are prepared by companies to represent their financial performance in a given period. The three basic financial statements are the income statement, balance sheet, and cash flow statement, which are prepared according to the standardized accounting principles to ensure consistency in financial reporting across levels.

What is an Income Statement

An income statement (also known as a profit & loss statement) measures the net income during a given period by capturing the inflow and outflow of money. The sources of inflow or income include revenue, dividend from investments, interest income, etc., while the avenues for outflow or expenses include rental expense, interest payments, utility bills, etc. The net income for a given period is calculated by subtracting the expenses from the income. Mathematically, net income is represented as,

Net income = Income – Expenses

Income Statement Example

Example 1: Let us look at the following example of company XYZ Inc. to understand how net income is calculated in an income statement. There are some expense line items along with the revenue that has been provided below. Determine the net income of the company based on the available information.

• Revenue: $150 million
• Cost of goods sold: $95 million
• Research & development expense: $10 million
• Selling, general & administrative expense: $35 million
• Interest expense: $3 million
• Taxes: $2 million

Now, the total expenses of the company can be calculated as,

Expenses = Cost of goods sold + Research & development expense + Selling, general & administrative expense + Interest expense + Taxes

    = $95 million + $10 million + $35 million + $3 million + $2 million

    = $145 million

Now, the net income of the company can be calculated as,

Net income = Revenue – Expenses

        = $150 million – $145 million

        = $5 million

Therefore, the net income of the company XYZ Inc. for the given period is $5 million.

What is a Balance Sheet?

A balance sheet provides a snapshot of the financial position of a company at a given point in time, which is presented in terms of assets, liabilities, and shareholders’ equity. The things that are owned by the company, such as cash & cash equivalents, property, equipment, current & non-current investments, etc., are classified as assets. On the other hand, the liabilities the things that are owned by the company, such as short-term & long-term debt, trade payables, etc., are classified as liabilities. The shareholders’ equity of a company is measured by deducting total liabilities from total assets and mathematically it is represented as,

Shareholders’ equity = Total assets – Total liabilities

Balance Sheet Example

Example 2: Let us take the example of ABC Inc. to illustrate how a balance sheet works. The following are several line items from a balance sheet as of December 31, 2020. Calculate the shareholders’ equity of the company based on the given information.

Assets

• Plant, property & equipment: $50 million 
• Marketable investments: $20 million
• Cash & cash equivalent: $5 million
• Accounts receivable: $10 million

Liabilities

• Long-term debt: $45 million
• Short-term debt: $5 million
• Trade payable: $4 million
• Other liabilities: $16 million

Now, the total assets of the company can be calculated as,

Total assets = Plant, property & equipment + Marketable investments + Cash & cash equivalent + Accounts receivable

        = $50 million + $20 million + $5 million + $10 million

        = $85 million

Now, the total liabilities of the company can be calculated as,

Total liabilities = Long-term debt + Short-term debt + Trade payable + Other liabilities

              = $45 million + $5 million + $4 million + $16 million

              = $70 million

Therefore, the shareholders’ equity of the company can be calculated as,

Shareholders’ equity = Total assets – Total liabilities

             = $85 million – $70 million

                     = $15 million

Therefore, the shareholders’ equity of ABC Inc. stood at $15 million as of December 31, 2020.

How to Use the Balance Sheet?

The balance sheet is mostly used by investors, and analysts to assess the financial health of companies. Typically, a balance sheet is used alongside the income statement and the cash flow statement. Besides calculating the net worth of a company, it also helps in assessing whether or not a company has enough liquidity to cover its short-term and long-term obligations.

Elements of Financial Statement

In a balance sheet, there are three broad elements – assets, liabilities, and shareholders’ equity, an income statement contains two key elements – revenues and expenses. So, the financial statements revolve around these five major elements:

• Total assets
• Total liabilities
• Shareholders’ equity
• Revenues
• Expenses

Applying Financial Statements to Business

The financial statements provide a glimpse of a company’s financial health, giving meaningful insight into its operations, performance, and the most important cash flow. In simple terms, the financial statements are important because they present the company’s revenue, expenses, profitability, liabilities, investments, etc. in a very succinct manner.

Financial Statement Ratios and Calculations

The analysis of the financial statements is largely done through a set of financial ratios, which are classified into four major categories – liquidity ratios, solvency ratios, efficiency ratios, and profitability ratios. The formula for the important ratios under each category has been provided below.

Liquidity ratios

• • Current ratio = Total current assets / Total current liabilities
  • Quick ratio = (Cash & bank balance + Accounts receivable) / Total current liabilities

• Cash ratio = Cash & bank balance / Total current liabilities

Solvency ratios

• Debt-to-equity (D-E) ratio = Total debt / Total shareholders’ equity
• Debt ratio = Total debt / Total assets
• Interest coverage ratio = EBITDA / Interest expense

Efficiency ratios

• Receivables turnover ratio = Revenue / Accounts receivable
• Inventory turnover ratio = Cost of goods sold / Inventory
• Payable turnover ratio = Cost of goods sold / Accounts payable
• Asset turnover ratio = Revenue / Total assets
• Net fixed asset turnover ratio = Revenue / Net fixed assets
• Equity turnover ratio = Revenue / Total shareholders’ equity

Profitability ratios

• Gross margin = (Revenue – Cost of goods sold) / Revenue
• Operating profit margin = EBIT / Revenue
• Net margin = Net income / Revenue
• Return on total asset (ROA) = EBIT / Total assets
• Return on total equity (ROE) = Net income / Total shareholders’ equity