Financial statements, a powerful tool for decision making
There are no documents more powerful than financial statements for business analysis and decision-making.
However, as the founder of Sageworks, a major financial research firm, states in an interview with Forbes: "The information in the financial statements is massively underutilized." "Simply by sitting down and reviewing their financial statements with their accountant, business owners can develop a good framework for future decisions."
Obviously, we fully subscribe to that statement. The financial statements are the summary of all the monetary transactions of the company, the final product of the entire accounting process.
Potential investors, creditors, suppliers, business partners, managers, directors and even different government entities can make use of the financial statements, each for different purposes.
Let's dedicate this short post to present the 3 most important financial statements based on their nature and purpose..
The power of financial statements as an element for decision making depends on the expertise and ethics of the accounting team, find out how to choose the ideal accountant for your business.
Why are financial statements so important?
The main purpose of the financial statements is to inform.
Any analyst or stakeholder may review these reports and issue an analysis of the economic situation (liquidity, asset quality, sales) and financial situation (debts, profitability, risks, equity) of the business.
So, readers or users of financial statements use them to support different types of decisions, depending on who they are:
- Investors: The data will support investment decisions; they are more interested in the capability of the business to offer dividends.
- Creditors: They will use the financial statements to determine the company’s solvency and ability to pay its obligations.
- Suppliers and strategic partners: They will evaluate the financial statements to determine if the business is trustworthy and a candidate to commercial credit.
- Managers and Directors: They will extract data from the financial statements to: support operational, tactical and strategic decisions; align or formulate plans; define corrective actions; and use it as input for the budget process.
- Government: It will make use of the financial statements for tax purposes, to tax the company based on its assets or net income, as well as to issue some guarantee or certification of compliance.
As you can see, there are several purposes that exalt the importance of financial statements, depending on who reviews the information contained in them.
Now let's take a tour of the three most popular financial statements, their nature and specific purposes.
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The three most important financial statements
According to the portal specialized in financial tools Accountingtools.com, the three main financial statements have different purposes. So, let's define each of them based on their nature and specific goals.
The Income Statement
It is basically the first of the financial statements to be issued.
As its name indicates, it offers a view of business results for a given period of time, usually ranging from a quarter to a year. It starts with the gross income and then, it presents a breakdown of costs and expenses, and then it indicates the net income, whether a profit or net loss.
This is one of the most important accounting items for the business, although its value is subject to accrual accounting principles.
That is, the possible recognition of income and expenditure items that are not actual cash inflows or outflows for the reporting period. It is one of the reasons why your analysis and conclusions should be supplemented with the cash flow statement.
Going back to the income statement, it is one of the most relevant reports for potential investors, since it accounts for the ability of the business to generate profits and therefore, generate dividends.
Managers and the marketing, sales and administration teams will also pay special attention to it is a performance metric, since it accounts for the volume of sales and the nature of the different types of expenses.
The IRS and some state agencies will confront taxable income and deductible expenses.
When reviewed over various time periods, the income statement can also be used to analyze trends in revenue and results resulting from the company's operations.
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The Balance Sheet
Another of the most well-known and important financial statements. Unlike the income statement, the balance sheet does not cover a period of time but it is the representation of the company’s situation on a specific date.
The balance sheet is the snapshot of the company’s economic and financial situation.
We talk about economic situation in reference to the business’ assets and their distribution. How much the business keeps in in cash and cash equivalents, how much is held in inventories and accounts receivable; how much is the participation of fixed assets and how they are distributed.
However, the financial situation refers to the liability-equity confirmation. How indebted the business is, what its main debts are, what is the ratio of equity to debt.
On the balance sheet, the accounts are listed in "order of liquidity" and are broken down between:
- “Current" or circulating: those that in theory can be converted into cash in less than a year
- “Non-current" that theoretically would take more than a year to liquidate.
All of this information is used to issue conclusions about an entity's liquidity, financial position, and debt position. All this data constitutes the basis for reason analysis.
The Cash Flow Statement
The most underestimated or least popular of the financial statements at the level of small businesses, but not the least important.
The cash flow statement shows us the true ability of the business to generate cash flow from 3 different resource sources: Operations, investments or financing.
Like the income statement, the cash flow statement covers a period of time, it can range from a quarter to a year, but unlike the former, the latter reveals the true cash position of the company.
For instance, the income statement recognizes non-monetary expense items, such as depreciation of assets and amortization of intangibles; in the accounting process, these are recognized as expenses affecting profit, although you normally do not pay an invoice for it, they are not a true cash outflow.
On the other hand, the cash flow statement shows the nature of truly 'effective' receipts and disbursements of money, the ones that actually affect the cash account.
This information is very useful, as cash flows do not always match the sales, expenses and accounting profit shown in the income statement.
The healthy position would be to find cash provided (positive balance) at the operational level that is eventually being invested in business expansion and / or payment of debts.
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Financial statements as a tool in decision making – Conclusion
Finally, we must comment that the financial statements are not exempt from limitations, they show the past and generate a basis for the budget and projections, but they are not an absolute guarantee of what may happen in the future.
They do not reflect the intentions, goals and perspectives of managers for the coming periods; nor market threats or opportunities, like a business plan would.
The information contained therein depends on generally accepted accounting practices and principles such as IFRS and US GAAP, which may have minor discrepancies in procedures, classification, and recognition of accounts.
Furthermore, the accuracy of the financial statements to faithfully reflect the situation of the business depends on the ethics and professionalism of those in charge of accounting management and the faithful adherence and observance of the aforementioned procedures and standards.
That is why the accounting process of the business should not be in any hands. The professionalism and experience of GBS Group offers you advice and integral solutions.