Introduction
Documenting corporate operations is essential for internal use and compliance. Accounting cannot be accomplished without taking into account three primary financial statement components: the balance sheet (BS), income statement (IS), and cash flow statement (CF). A financial statement is a document issued to the public (for publicly traded firms) that declares the firm’s economic competence, situation, and direction as of its inception. A balance sheet is a financial record that depicts a company’s financial status at the end of an operational cycle. It enables people like the editor to determine a company’s equity and debt. It can also help entities such as banks qualify for credit or loans. An income statement summarizes the financial results of a company’s sales and operations. The statement of cash flows is a document that illustrates the amount of cash flowing in and cashed out during a specific period. A cash flow statement depicts the change in money over some time. This statement contains cash from operating, investing, and financing activities. These three together give complete accounting information on an entity’s continuous operations as of a specific period. This essay will concentrate on three key documents: the income statement, the balance sheet, and the cash flow statement.
Synthesizing the interrelationship of BS, IS, and CF
BS, IS, and CF collectively presents a company’s health. BS presents key indicators in understanding what a company has by presenting its liabilities and equity (Tauringana et al., 2014). By scrutinizing the BS, one can infer the major components of the business, its properties, equipment, investments made, receivables, debts, and investments from shareholders, among others. As a supplement to the information presented by the BS, IS explains in detail how the company earns from its operations. It dictates the determination of the company’s operating efficiency and profitability. To examine the overall financial position of a company, one can review the flow of cash that the company maintains. CF presents the actual inflow and outflow of cash as an effect of the company’s operation. It also offers the company’s capability to wither short-term and long-term risks by providing a baseline for a healthy cash flow.
The usefulness of a Balance Sheet
A balance sheet summarizes liabilities, assets, and shareholders’ equity. Such data can be used to calculate the rate of return and better comprehend the firm’s capital structure. It also gives data that can be used to assess a company’s risk and predict future cash flow opportunities. A balance sheet contains information that can be used to determine a firm’s liquidity solvency. A firm’s liquidity is defined as its capacity to service short-term liabilities with assets that are readily changeable to cash. Cash is a company’s most liquid asset (Kieso et al., 2019). Inventory, for example, is a liquid asset, although it is less liquid than other assets such as securities in the short-term money market. They can be turned to cash more quickly than inventory. Knowing the firm’s liquidity state will allow you to manage its ability to satisfy its current needs. Because of the nature of their operation, some companies have surplus liquidity. They can use the additional liquidity to optimize shareholder profits. In other circumstances, certain businesses have limited liquidity. To avoid short-term financial troubles, they require good liquidity management.
A balance sheet helps a firm measure its solvency. A firm can meet the required long-term financial obligations of a firm. A solvency ratio shows the possibility of long-term survival of the firm. It evaluates the health of a firm on a long-term basis. Long-term investors and creditors in a firm are mostly interested in the solvency ratios (Anderson, 1981). It proves that the firm can service its credit, pay interest, and afford the principal upon debt maturity. Business owners also benefit from the solvency ratios since they can identify a downtrend and act effectively to avoid bankruptcy (Kieso et al., 2019). An increase in the solvency ratio shows a firm’s likelihood of going bankrupt. Solvency ratio increases with an increase in debt financing. A firm should maintain a certain level of solvency ratio. Comparing these ratios with other firms in the same industry and the industry average is important.
A firm’s liquidity, as well as solvency, indicates the firm’s financial flexibility. Such flexibility is the ability of the firm to take effective actions that can change the amounts and cash flow timing in response to any unexpected demands or opportunities. It is time to adjust cash flows when the liquidity and solvency ratios are unpleasant. One can manage this by increasing debt or paying them off. With a high solvency ratio, it is important to plan on paying off some debts. A good month of sales can generate extra cash that can be used to pay debts instead of venturing into new investments. On the other hand, a firm with a low solvency ratio should take advantage and seek debt financing for the firm’s growth. Although low ratios are desirable, it sometimes indicates a firm’s unwillingness to venture into new initiatives.
Elements of the Balance Sheet
The significant elements of a balance sheet are liabilities, assets, and equity. An asset is a potential financial future benefit acquired from past events. Things such as cash, inventory, and buildings are the firm’s assets. Assets are also subdivided into several categories. First is the capital assets (Kieso et al., 2019). Such assets’ life exceeds one year. They are tangible and are necessary for the ongoing firm’s activities. The second is current assets. These are highly liquid assets and can be converted into cash within one operating cycle. Cash is one of the readily available current assets. The third type of asset is property, plant as well as equipment. These assets are long-lived and used in daily business operations. They include; land, buildings, machinery, and many others.
The other main element of a balance sheet is liabilities. It is the amount owed by a business. Just like assets, liabilities are classified as long-term and short-term. Short-term liabilities can be set off through the liquidation of short-term assets. They include; accounts payables, in advance collections, and any other liability whose settlement can be done within one operating cycle (Kieso et al., 2019). Long-term liability is the other form of liability. Their maturity takes more than one business operating cycle. Some of the long-term liabilities include bonds, deferred tax liability, and note payables. Long-term liabilities arise from financial situations such as bonds and leases or ordinary firm operations such as income tax and pension.
Equity is the final element in a balance sheet. It shows the difference between the firm’s total assets and total liabilities. It can be owner’s equity or shareholders’ equity. It comprises capital stock, excess paid capital, treasury stock, retained earnings, minority interests, and other inclusive incomes. A company’s equity is also known as its book value. If the company is a sole proprietorship, the phrase owner’s equity is suitable, whereas stockholders equity is appropriate for a corporation. The three essential components of a balance sheet are critical in determining a company’s financial situation at any given time.
Income Statement
An income statement describes a company’s management performance as shown in its profitability (or lack thereof) during a specific period. It lists the historical income and expenses that contributed to the current profit or loss and suggests how to improve the outcomes (Penman, 2009). Unlike a balance sheet, which is a “still snapshot” taken at a specific time, an income statement is a “movie” that portrays what transpired over a month, quarter, or year. It is based on a basic accounting equation (Income = Revenue – Expenses) and displays how the owner’s equity changes for the better or worse. It, along with the balance sheet and cash flow statement, constitutes the basic financial information needed to manage a business.
The usefulness of the Statement of Cash Flows
A cash flow statement is just as useful as other firm reports. The major cash flow statement’s purpose is to show the cash received, and the firm paid within an operating cycle. From a cash flow, one can tell how cash has affected business operations at a given period, identify investing and operating transactions, and tell if the cash has increased or decreased over a period (Kieso et al., 2019). Such reports are crucial to investors and creditors in telling how the firm is doing with its most liquid asset. A cash flow is categorized into operating, financing activities, and investing. A cash flow statement is vital in long-term and short-term planning.
Conclusion
In summary, BS, IS, and CF may have technical relationships within and among each other. Still, considering qualitative and strategic regard to the information, it implies lies upon the decision maker. Future decision-makers must fully accept and understand that these three financial statement components are not just a summary of everything. It serves as a precedent and baseline for every future business direction an organization will take. A balance sheet, income statement and cash flow statement are significant in business reporting. The balance sheet shows a firm’s financial position in one business operation cycle. It provides crucial information for assessing a firm’s liquidity, solvency, and financial flexibility. An income statement summarizes the financial results of a company’s sales and operations. A cash flow statement depicts the change in money over some time. This statement contains cash from operating, investing, and financing activities.
References
Anderson, R. (1981). The usefulness of accounting and other information disclosed in corporate annual reports to institutional investors in Australia. Accounting and Business Research, 11(44), 259-265.
Kieso, D. E., Weygandt, J. J., Warfield, T. D., Wiecek, I. M., & McConomy, B. J. (2019). Intermediate Accounting, Volume 2. John Wiley & Sons.
Penman, S. H. (2009). Accounting for intangible assets: There is also an income statement. Abacus, 45(3), 358-371.
Tauringana, V., & Mangena, M. (2014). Board structure and supplementary commentary on the primary financial statements. Journal of Applied Accounting Research.
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