Explaining The Purpose Of The Main Financial Statements Finance Essay

Explaining The Purpose Of The Main Financial Statements Finance Essay A financial statement (or financial report) is a formal record of the financial activities of a business, person, or other entity. In British English-including United Kingdom company law-a financial statement is often referred to as an account, although the term financial statement is also used, particularly by accountants. For a business enterprise, all the relevant financial information, presented in a structured manner and in a form easy to understand, are called the financial statements. They typically include four basic financial statements: Balance sheet: also referred to as statement of financial position or condition, reports on a companys assets, liabilities, and Ownership equity at a given point in time. Income statement: also referred to as Profit and Loss statement (or a PL), reports on a companys income, expenses, and profits over a period of time. Profit Loss account provide information on the operation of the enterprise. These include sale and the various expenses incurred during the processing state. Statement of retained earnings: explains the changes in a companys retained earnings over the reporting period. Statement of cash flows: reports on a companys cash flow activities, particularly its operating, investing and financing activities. For large corporations, these statements are often complex and may include an extensive set of notes to the financial statements and management discussion and analysis. The notes typically describe each item on the balance sheet, income statement and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements. The Balance Sheet The balance sheets purpose is to show the assets of the company. Balance sheets are based on a fix point called a reporting perioda day, a month, a quarter, a year. A quick glance at a balance sheet will show you what the company owns and how much it owes. Balance sheets include assets (property, cash, anything owned of value), liabilities (debt owed) and shareholders equity. Income Statements Income statements show the revenue earned during a reporting period.  Included in this report are the expenses and cost of creating the revenue. Once the expenses and costs are removed from the total revenue, the bottom line of the report reveals whether or not the company lost money or made money. This report is sometimes referred to as the profit and loss statement. Another feature of the income statement is the EPS, or earnings per share. This reveals what a shareholder would receive if you were being paid dividends per each share owned. Cash Flow Statements Cash on hand is important because it supports the daily activities of a business. There must be enough cash on hand to pay expenses and buy assets as needed. Cash flow statements track the inflow and outflow of cash. They reveal whether or not cash was generated by the business. The data for a cash flow statement comes from an income statement and the balance sheet. The cash flow statement reveals net decreases or increases of cash for the reporting period. Retained Earnings Once liabilities and assets are known and a balance sheet is created, it is known whether or not the shareholders have a positive or negative equity. From the equity is taken retained earnings. Retained earnings are broken down and explained in the statement of retained earnings. This statement reveals what the company keeps and does not distribute to the owners and how that amount changes over the reporting period. Losses are called accumulated losses, retained losses or accumulated deficit. Financial Statements Once a set of financial statements are prepared they can be used for loan applications, fund-raising or to place a value on a business. But they are typically used for making business decisions that will affect operations. The numbers and calculations in the financial statements are also used to calculate ratios and make further analysis. Common figures derived are operating margins, debt-to-equity ratio, P/E, working capital and inventory turnover Purpose of financial statements by business entities The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions. Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities and equity are directly related to an organizations financial position. Reported income and expenses are directly related to an organizations financial performance. Financial statements are intended to be understandable by readers who have a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently. Financial statements may be used by users for different purposes: Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis is then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of managements annual report to the stockholders. Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings. Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and are prepared by professionals (financial analysts), thus providing them with the basis for making investment decisions. Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long-term bank loan or debentures) to finance expansion and other significant expenditures. Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company. Vendors who extend credit to a business require financial statements to assess the creditworthiness of the business. Media and the general public are also interested in financial statements for a variety of reasons. Financial ratio analysis groups the ratios into categories which tell us about different facets of a companys finances and operations. An overview of some of the categories of ratios is given below. * Leverage Ratios which show the extent that debt is used in a companys capital structure. * Liquidity Ratios which give a picture of a companys short term financial situation or solvency. * Operational Ratios which use turnover measures to show how efficient a company is in its operations and use of assets. * Profitability Ratios which use margin analysis and show the return on sales and capital employed. * Solvency Ratios which give a picture of a companys ability to generate cash flow and pay it financial obligations. Differences between the formats of financial statements for 3 different type of business- sole proprietorship, partnership and Limited company Government financial statements The rules for the recording, measurement and presentation of government financial statements may be different from those required for business and even for non-profit organizations. They may use either of two accounting methods: accrual accounting, or cash accounting, or a combination of the two (OCBOA). A complete set of chart of accounts is also used that is substantially different from the chart of a profit-oriented business Financial statements of non-profit organizations The financial statements of non-profit organizations that publish financial statements, such as charitable organizations and large voluntary associations, tend to be simpler than those of for-profit corporations. Often they consist of just a balance sheet and a statement of activities (listing income and expenses) similar to the Profit and Loss statement of a for-profit. Personal financial statements Personal financial statements may be required from persons applying for a personal loan or financial aid. Typically, a personal financial statement consists of a single form for reporting personally held assets and liabilities (debts), or personal sources of income and expenses, or both. The form to be filled out is determined by the organization supplying the loan or aid. Differences between Sole Proprietorship, Partnership Corporation I want to do this! Whats This? There are a number of different types of business organizations an individual or a group can form. However, three of the most common types of business organizations are sole proprietorships, partnerships and corporations. These three types of businesses are similar in some ways, but a number of differences are important to note. Formation A sole proprietorship or a partnership may be formed without filing any formal paperwork. The creators of a corporation, however, must file a document known as the articles of incorporation. Liability The owner(s) of a sole proprietorship or a partnership may be held liable for any business activity and/or obligation. Corporate shareholders, however, usually are liable only for the amount they invested. Record Keeping Corporations are required to keep strict records of meetings and other similar administrative activities, while a sole proprietorship or a partnership typically is not required to do so. Size A sole proprietorship can have only a single owner, but a partnership or a corporation may have any number of owners. Taxes The owner of a sole proprietorship is required only to report the business earnings on her tax return, while a corporation or a partnership must file a separate return for the business. BASIC FINANCIAL STATEMENT FORMAT PARTNERSHIP When preparing financial statements by hand the Income Statement would usually be prepared first because the net income or loss becomes part of the Statement of Partners Capital. The Statement of Partners Capital is usually prepared second because the ending partners capital balances become part of the Balance Sheet. Corporations are subject to income taxes but sole proprietorships and partnerships are not. Otherwise the income statements of each are identical. Income Statement (single-step format): HANSON RETAIL FOOD STORE Income Statement Year Ended December 31, 2006 Net Sales $262,000 Rent revenue 6,900 Interest revenue 1,400 Total Revenue 270,300 Expenses: Cost of Goods Sold $159,000 Salaries and wages 45,000 Advertising 12,400 Freight out 4,000 Depreciation 5,000 Taxes and licenses 3,000 Rent 6,300 Interest expense 350 Loss on sale of assets 250 Property taxes 2,000 Total expense 237,300 Net Income (loss) $ 33,000 ======== Owners equity statements of corporations are called Statement of Retained Earnings, those of sole proprietorships are called Statement of Capital and those of partnerships are called Statement of Partners Capital. Statement of Partners Capital: HANSEN RETAIL FOOD STORE Statement of Partners Capital Year Ended December 31, 2005 John Soo Mary Doe Totals Beginning balance $ 24,000 $ 33,000 $ 57,000 Net income (loss) 16,500 16,500 33,000 40,500 49,500 90,000 Withdrawals 500 1,500 2,000 Ending balance $ 40,000 $ 48,000 $ 88,000 =========== =========== ====== Balance Sheets of corporations have a Shareholders Equity section whereas sole proprietorships have an Owners Capital section and partnerships have a Partners Capital section. Otherwise the Balance Sheets would be identical. Balance Sheet: HANSEN RETAIL FOOD STORE Balance Sheet December 31, 2006 ASSETS Current Assets: Cash $ 3,000 Short-term investments/marketable securities 6,000 Accounts receivable, net 5,000 Inventory 10,000 Prepaid rent 2,000 Office supplies on hand 1,000 Total current assets 27,000 Long-Lived Assets: Long-term investments $ 10,000 Land 35,000 Building 86,000 Machinery equipment 50,000 Less accumulated depreciation ( 23,000) Patents 4,000 Total long-lived assets 162,000 Total Assets $189,000 ======== LIABILITIES Current Liabilities: Accounts payable $ 4,200 Notes payable 15,000 Interest payable 1,000 Wages payable 800 Total current liabilities 21,000 Long-Term Liabilities: Mortgage payable $ 30,000 Bonds payable 50,000 Total long-term liabilities 80,000 Total Liabilities 101,000 PARTNERS CAPITAL John Soo, Capital 40,000 Mary Doe, Captial 48,000 Total Partners Capital 88,000 Total Liabilities and Owners Equity $189,000 TASK 2 Last Year Current Ratio = C.A / C.L = 21 / 15 = 1.4 Acid Test = C.A / C.L = 15 / 15 = 0 Net Profit Margin = N.P / Sales =37/499 =0.07 Gross Profit Margin = G.P / Sales =99/499 =0.20 Return on Capital Employed = N.P / Equit + Debt = 17 / 75 = 0.23 Return on Ordinary Share holder fund = N.P after tax / Ordinary share holder equity = 17 / 14 = 1.2 Average Stock Turnover period = Avg Stock / CGS * 365 = 6 /400 X 365 =5.5 =6days Current Year Current Ratio = C.A / C.L = 11 / 11 = 0 Acid Test = C.A / C.L = 7 / 11 = 0.64 Net Profit Margin = N.P / Sales = 32 / 502 = 0. 06 Gross Profit Margin = G.P / Sales = 132 / 502 = 0.26 Return on Capital Employed = N.P / Equit + Debt = 5 / 79 = 0.06 Return on Ordinary Share holder fund = N.P after tax / Ordinary share holder equity = 5 / 14 = 0.36 Average Stock Turnover period = Avg Stock / CGS * 365 = 4 / 370365 =3.95 = 4 days