Meaning & Uses of Financial Statements
The financial statements of a company reveal the exact position of its financial performances. These statements are prepared at the end of all accounting process for a particular period. The internal users of financial statements are owners, managers, and employees. The external users of financial statements are banks, financial institutions, potential investors, tax authorities, suppliers, etc.
Financial statements contain the following reports:
Profit & Loss A/c
Income Sheet
Balance Sheet
Use of Financial Statements
They play a major part in making financial decisions of a business. The main uses of financial statements are as follows:
Assisting the Management
The financial statements exactly reflect the financial position of a company and thus bridge the gap between the management and the owners. Since the shareholders and the public can view the statements they can also watch the performance of the business.
Availing Loans
Financial statements play a major role in availing loans or borrowing funds for better functioning. The lenders may be banks and various other financial institutions.
Assessing the Finances
The financial statements are used to assess the company’s business, thereby figuring out the term of the company’s solvency.
For the Government
The policies laid out by the government are based heavily on financial statements. They use a company’s financial statement to decide on taxation and other regulatory policies.
For the Stock Exchanges
The financial statements are very much useful for regulatory bodies like various stock exchanges for so many reasons. They can assess a company’s internal matters using those statements whilst ensuring the protection of investors.
Information on Investments
Mainly, the shareholders of a company depend on these statements only to know about their investments. This allows them to make more investments in case of profit, whereas to pull out in case of loss.
Limitations of Financial Statements
Investors should be well aware of the factors that they depend on to invest in or pull off from the business.
The following are the limitations of financial statements
Dependence on historical costs
Inflationary effects
Intangible assets not recorded
Based on a specific time period
Not always comparable across companies
Subject to fraud
No discussion of non-financial issues
Not verified
No predictive value
After the limitations of financial statements, let’s now take a look at the P&L statement.
Profit & Loss Statement
This is one of the financial statements that are generated quarterly or annually. This statement summarizes the income gained and the expenses incurred for a particular period. The following is an example of a profit and loss statement.
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One of the examples of Profit and Loss account is given below:
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Uses of Trial Balance
A trial balance is a type of report which is prepared at the end of a financial period. This is generated before preparing the financial statements. The main purpose of preparing a trial balance is to find out accounting errors if any. Further to which needed adjustments are done to make prepare accurate financial statements.
The limitations of trial balance are:
No proof of recorded transactions
No proof of correct ledger entries
Numerous errors may be found even though the columns are balanced
Can miss out journal entries
Cannot find ledger entries
Cannot protect the repeated entries
Cannot protect the offsetting errors
Cannot protect the errors of principles
Cannot protect the errors of commission
Cannot protect the errors of omission
Uses of Balance Sheet
To determine if working capital is enough
To know the business net worth
To see if the company can sustain the future operation
To identify if there’s possible issuance of dividend
Limitations of Balance Sheet
The limitations to balance sheets are assets may be recorded at historical cost, using of estimates, and the omission of valuable assets.
Uses of Financial Statement Analysis
Financial statement analysis is used by all stakeholders whether internal or external, to figure out the performance of a business and value the same. All business entities create a balance sheet, income statement, and cash flow statement that are very important for financial statement analysis. It helps the government agencies to analyze the taxes owed to the firm.
Certain limitations of financial analysis are depreciation, the cost basis that excluded inflation, different accounting methods, unusual data, useful information, and a company's diversification.
FAQs on Financial Statements: Company Essentials
1. What are the primary financial statements a company typically prepares?
Companies primarily prepare four essential financial statements that provide a comprehensive view of their financial health and performance. These include the Statement of Profit and Loss (also known as Income Statement), the Balance Sheet, the Cash Flow Statement, and the Statement of Changes in Equity.
2. What key elements are typically presented in a company's financial statements?
A company's financial statements provide various key elements essential for understanding its position. The Balance Sheet lists assets, liabilities, and equity at a specific point in time. The Statement of Profit and Loss shows revenues, expenses, and profit or loss over a period. The Cash Flow Statement details cash inflows and outflows from operating, investing, and financing activities. Lastly, the Statement of Changes in Equity tracks changes in the ownership capital.
3. What characteristics make financial statements reliable and useful for decision-making?
For financial statements to be reliable and useful, they should possess certain qualitative characteristics. These include relevance (information capable of making a difference in decisions), faithful representation (information is complete, neutral, and free from error), comparability (can be compared across companies and over time), verifiability (different knowledgeable observers can reach consensus), timeliness (available to decision-makers in time to influence their decisions), and understandability (presented clearly and concisely).
4. Why are financial statements considered crucial for understanding a company's financial health?
Financial statements are crucial because they offer a structured summary of a company's financial transactions. They help various stakeholders, such as investors, creditors, management, and government agencies, to:
- Assess profitability and operational efficiency.
- Evaluate solvency and liquidity.
- Understand the sources and uses of cash.
- Make informed investment and lending decisions.
- Monitor management's performance and ensure compliance.
5. How do financial ratios help in analyzing a company's performance and position?
Financial ratios are powerful tools that simplify and standardize financial data, making it easier to analyze a company's performance and position. By comparing different figures from financial statements, ratios can:
- Indicate liquidity (ability to meet short-term obligations).
- Measure profitability (how efficiently a company generates earnings).
- Assess solvency (ability to meet long-term debts).
- Evaluate efficiency in using assets and managing liabilities.
- Enable comparisons with industry averages or past performance to spot trends.
6. What are some common challenges or limitations faced when interpreting financial statements?
While highly valuable, financial statements do have limitations that users should be aware of:
- Historical Data: They present past performance, which may not always predict future results.
- Accounting Policies: Different accounting methods (e.g., depreciation) can affect reported figures, making direct comparisons difficult.
- Non-Monetary Information: They don't capture qualitative aspects like management quality, brand reputation, or employee morale.
- Estimates and Judgements: Many figures involve estimates, which can introduce subjectivity.
- Inflation Effects: Historical cost accounting doesn't always reflect current economic values, especially during inflation.
