What is Financial Statement? Types & How to Read Them

A Financial statement is critical to making informed investment decisions and understanding a business’s economic well-being. The comprehension of a financial statement is key to profitable investments and business decisions.

Whether you are an investor seeking to assess the viability of potential investments or a business owner financial statements are an indispensable tool for right fiscal decision-making.

This guide will explore various types of financial statements and provide a framework for analysing them. It will enable you to gain valuable insights into a company’s financial health and performance.

What is Financial Statement?

Knowing what is Financial Statement is the first step in understanding the different categories and uses of these Statements.

A collection of records known as financial statements illustrates the state of your business’s finances at a certain moment in time. They provide important information on your company’s assets and liabilities as well as its earnings and expenses. 

The understanding of what is Financial Statement is incomplete without taking a close look at the users and kinds of these statements.

Users of Financial Statements

Financial reports are tailored to meet audiences’ needs and specific requirements. Recognising the individuals who depend on these reports and the reasons behind them is essential in understanding their significance. Let’s look at the users of statements and how this data helps them:

1. Investors: Determine potential risks and rewards of investment. Evaluate profitability, solvency, and future growth prospects.
2. Creditors: Assess a company’s ability to repay loans. Analyse factors like debt levels and cash flow to determine creditworthiness.
3. Management: Track company performance, identify areas for improvement and make strategic decisions.
4. Analysts: Research and evaluate companies and provide investment recommendations to clients.
5. Consumers: Gain insights into a company’s financial health, particularly when considering large purchases or establishing long-term relationships.

What are Different Types of Financial Statements?

Financial reports serve as the foundation for understanding a business’s well-being. They offer a view into a company’s performance, profitability, and overall economic standing. These pivotal records are utilised by investors, lenders, analysts, and even company leadership to make informed decisions. There are various financial statements types.

A Financial statement varies in its content and purpose. They offer insights into a company’s status. By examining these statements, one can view a business’s financial strength, profitability, and overall status. Typically, financial statements come in three forms, each offering a viewpoint on the financial condition:

1. Balance Sheet

The balance sheet, often known as a statement of position, provides a snapshot of a company’s assets, liabilities, and shareholder equity at a moment in time. It essentially showcases the equation Assets = Liabilities + Shareholders Equity. This gives users insight into the company’s stability and liquidity, showing its capacity to meet short-term obligations.

Key Features of Balance Sheet

The following are the important characteristics of balance sheets

• It contains the assets and liabilities of the business along with shareholders’ funds.
• It shows the net income derived by the business.
• It is prepared at a particular point of time right before the end of a financial year.
• It gives an insight into the profitability and solvency of a business.

2. Income Statement

The income statement, also known as the profit and loss (P&L) statement, summarises a company’s performance over a defined period, such as a quarter or year. It outlines the company’s revenue, expenses, and net income (profit) or net loss. This statement aids users in assessing the company’s profitability and growth potential.

Key Features of Income Statement

Listed below are the key features of the income statement.

• It contains the revenue, expenditures and net profit of the business.
• It is prepared over a period of time and entries are made regularly.
• This statement shows the profitability and financial health of the business.

3. Cash Flow Statement

The cash flow statement monitors how cash moves within a company over time. It divides cash flow into three sections: operating activities, investing activities, and financing activities. Understanding a company’s cash flow offers insights into its ability to generate cash for operations, investments, and debt payments.

Key Features of Cash Flow

Listed below are the important features of cash flow.

• It shows the inflow and outflow of cash.
• Unlike the income statement and balance sheet, it does not record credit transactions.
• The major components of this statement are operating cash flow, investing cash flow and financing cash flow.
• It is prepared over a period of time.

Comparison of the Three Financial Statements

The table below gives a detailed breakdown of distinctions between the Financial Statement types.

Particulars	Balance Sheet	Income Statement	Cashflow
Purpose	Establish the financial health at a particular date.	Shows the profitability over a period of time.	It shows the liquidity through the inflow and outflow of cash.
Tenure	It is prepared at a particular point in time before the end of a financial year.	It is maintained over a period of time. The statement is updated regularly with transactions over a particular financial year.	It is maintained over a period of time. The statement is updated regularly with transactions over a particular financial year.
Opened with	The preparation of the balance sheet starts with cash balance.	The preparation of the income statement starts with Revenue (sales).	The preparation of the cash flow starts with the Net income.
Accounting basis	Accrual basis. It accounts for transactions done on credit.	It is also done on an Accrual Basis.	It records only Actual cash movements.
Closing balances	The closing balance is Retained earnings.	The closing balance is Net Income.	The closing balance is the cash balance, i.e., the amount of cash left.
Key target user	It is primarily for creditors and investors to assess solvency.	It is primarily for investors and analysts to assess profitability.	It is primarily for managers and creditors to assess liquidity and creditability.
Primary components	It contains Assets, liabilities and shareholders equity.	It contains Revenue, expenses and net income.	It contains Operating, Investing and Financing Cashflow.

How to Read Financial Statements?

Understanding reports can be overwhelming initially. However, by following this approach, one can decode insights hidden within these documents. It’s crucial to grasp these types of statements, but delving into them effectively requires employing the following additional strategies:

Tip 1: Review the Accompanying Notes

Financial statements are often accompanied by notes that offer context and specifics regarding specific accounting treatments for the company’s different transactions and financial instruments.

Tip 2: Analyse Changes in Statements over Time

Examining trends across periods gives a comprehensive view of the company’s financial performance and direction. Look for patterns in revenue growth, profit margins, and debt levels. Are these metrics trending upward or downward or staying consistent?

Tip 3: Compare with Industry Peers

Comparing ratios with competitors in the industry helps assess the company’s performance in its sector. Is the company’s profit margin better or worse than its competitors? Does it maintain a debt-to-equity ratio? Benchmarking offers insights for interpreting the company’s statements.

Tip 4: Seek Advice

Consider consulting a qualified financial advisor or analyst if you need financial analysis. These professionals can dissect statements, identify risks and opportunities, and provide personalised guidance based on your requirements.

How are these Three Financial Statements Used in Financial Modeling?

Financial models use maths and statistics to formulate relationships between various parameters based on which they make predictions for the company’s financials.

The three financial statements help in the preparation of financial models in the following ways.

1. The line items mentioned in the financial statements are interrelated. For example, when sales mentioned in the income statement increase, the net profit mentioned in the balance sheet is expected to increase. These relationships help in building models.

2. The financial statements also give historical records used to build calculated assumptions and trends.

Financial Statement Analysis Ratios

Financial statement analysis ratios are powerful tools that can help you gain deeper insights into a company’s financial health. Understanding what are financial statements is incomplete without the ratios. Here are some common ratios to consider:

1. Liquidity Ratios

These ratios measure a company’s ability to meet its short-term financial obligations, typically within one year. Some liquidity ratios are
a. Current Ratio
b. Quick Ratio
c. Working Capital Ratio

2. Solvency Ratios

These ratios assess a company’s ability to repay its long-term debt and meet its financial obligations over an extended period. Some Solvency Ratios are
a. Debt Equity ratio
b. Debt-asset ratio
c. Interest Coverage ratio

3. Profitability Ratios

These ratios evaluate a company’s ability to generate profits from its revenue and resources. Some profitability ratios are
a. Profit margin ratio
b. Return on asset
c. Return on capital employed
d. Gross margin ratio

Importance of Financial Statements

Financial statements are the essence of financial reporting, providing a comprehensive picture of a company’s financial health. They are crucial for various stakeholders to make informed decisions, acting like a transparent window into a company’s financial performance and position.

Here’s a breakdown of their importance in multiple contexts:

1. Risk Assessment: Investors leverage financial statements to evaluate a company’s economic stability and potential risks associated with an investment. By analysing factors like profitability, debt levels, and cash flow, investors can gauge the likelihood of a company generating returns and meeting its financial obligations.
2. Return Potential: Financial statements reveal a company’s past performance and growth prospects. Investors can assess a company’s profitability through metrics like net income and revenue growth, which helps them estimate potential returns on their investment.
3. Creditworthiness Assessment: Lenders rely on financial statements to determine a company’s ability to repay loans before extending credit. They analyse a company’s debt levels, cash flow generation, and overall economic health to assess the risk of default.
4. Loan Terms and Interest Rates: The information gleaned from financial statements influences lenders’ loan terms and interest rates. Companies with strong economic performance typically qualify for lower interest rates and more favourable loan terms.
5. Performance Monitoring: Financial statements provide valuable insights into a company’s performance, such as profitability, operational efficiency, and resource allocation. By analysing these metrics, management can identify areas for improvement and make strategic decisions to optimise performance.
6. Strategic Planning: Financial statements are vital tools for strategic planning. Management teams can use financial data to set realistic goals, forecast future performance, and make informed decisions regarding resource allocation, budgeting, and investments.
7. Regulatory Compliance: Regulations require publicly traded companies to file audited financial statements with relevant authorities. This transparency ensures accountability and protects investors’ interests.
8. Mergers and Acquisitions (M&A) Activity: Financial statements form the basis for valuation during mergers and acquisitions. Companies use financial data to determine the fair value of a target company and negotiate M&A deals.

Limitations of Financial Statements

While financial statements offer valuable insights, it’s important to acknowledge their limitations. Here is a detailed comparative study:

1. Financial statements rely on estimates and assumptions for inventory valuation, bad debts, and asset lifespans. Inherent uncertainties in these estimates can impact the accuracy of the reported financial position and performance.
2. Financial statements primarily reflect a company’s past financial performance and position. Unexpected economic factors, industry changes, or company-specific events can significantly influence future results.
3. Accounting principles provide a framework but allow for some degree of subjectivity in their application. Different companies may use slightly different accounting methods to value assets or recognise revenue, which can affect the comparability of financial statements across companies.

Final Thoughts on What do You mean by Financial Statements

Understanding financial statements isn’t just about reading numbers on a page—it’s about having a powerful tool for answering what a financial statement is. With this newfound knowledge, one can identify strong companies with growth potential. 

Interpreting financial statements helps to optimise strategies and secure funding with confidence. Furthermore, understanding financial news and market trends becomes easier when one grasps the language of business. After all, developing financial knowledge is a process, and with practice, one can build the expertise needed to navigate the financial terrain with greater insight and confidence.