Financial Statements Explained

The financial statements of a company are the diagnostic reports of its health. It is therefore vital to understand these statements.

The three main statements are:

- Profit & Loss Statement or Income Statement
- Balance Sheet
- Statement of Cash Flows

Let us imagine that the PQR Company was started in January 2010 with a capital of $ 75,000 and had a cash balance of $33,000 at Dec. 31, 2010. Since it was a new company it made all its purchases in cash. Its financial year is from January to December each year. At Dec. 31, 2010 the following statements were generated - all values being in dollars.

Income Statement (basic) as at Dec. 31, 2010 – PQR Company

Sales 70,000
Cost of Sales (48,000)
_______

Gross Profit 22,000

Admin Exp. (19,000)
_______

Net Profit 3,000
_______

Just looking at the profit does not give the full diagnosis of the company’s operation and where the money is tied. The Balance Sheet and the Statement of Cash Flows also need to be examined to ascertain the status of the company.

Balance Sheet at Dec. 31, 2010 – PQR Company

Assets
Current Assets:
Cash & Bank 33,000
Accounts Receivable 45,000
______
Total Assets 78,000
======

Liabilities
Current Liabilities:
Accounts Payable 0.00
_______

Total Liabilities 0.00
_______

Equity

Capital /Investment 75,000
Retained Earnings 3,000
______
Total Equity 78,000
______

Total Liabilities + Equity 78,000
======


Statement of Cash Flows

This statement shows how the money has been utilized. The PQR Company had the following Statement of Cash Flows at the end of 2010

Cash from Operating Activities

Net Income 3,000
Decrease/ (Increase) in accounts receivable (45,000)
Increase / (Decrease) in accounts payable 0.00 ______

Net (decrease) in Cash & Equivalents (42,000)

Cash Available at the beginning of the year 75,000
_______

Cash at the end of the period 33,000
=======


The above report shows the movement of the cash generated . In 2010 the business was started with $75,000 and the business netted a profit of $ 3,000. Therefore there should have been 78,000 at the end of 2010 out of which 45,000 was accounts receivable ( pending collection from customers) and 33,000 was available in the bank.


Business Health and Liquidity

The following ratios indicate the health and the liquidity of the company:

- Working Capital:
Current Assets (from Balance Sheet) (-) Current Liabilities ( Balance Sheet) The company has a positive working capital.

- The company has enough liquid assets to cover its liabilities.

- Return on investment Net Income (ref. Income Statement) / Equity ( ref. Balance Sheet) was 4% in 2010 .

- Liabilities / Equity (ref. Balance Sheet) , shows that the operations were funded from the capital invested without any borrowings.

- About 64% of the sale is on credit which would need to be reduced or strictly monitored if doubtful or bad debts are to be avoided and also to release the tied-up cash inorder to enhance the working capital.

- The company purchased against cash from suppliers (ref. Income Statement & Balance Sheet) probably because it was a new company and therefore in subsequent years must attempt to have some credit from its suppliers which would help maintain a healthy working capital for the business when the cash requirements are bound to increase.

- The current net profit margin to sales (ref. Income Statement) is only about 4%. This margin is on the lower side and must be attempted to be improved.

- The company has some funds in the bank which could be used in investment or money earning activities.


The figures in the three statements mentioned above are broadly categorized for ease of understanding. In actual practice there would be other asset, liability and expense accounts but the methods to scrutinize the reports would be similar. Also in subsequent years the figures would be mentioned in comparison with the previous year’s figures which would point out the improvements made or lack thereof.