Purpose of financial statements: The best guide
Do you know what financial statements are? What is the purpose of financial statements?
You've probably heard of the balance sheet, income statement, statement of cash flow, or statement of retained earnings. These documents provide information on a company's financial position and performance. They are very important for closing your accounting year and they will be used to establish a financial diagnosis and report of your company.
With the information gathered in financial statements, your company will be able to make informed business decisions and get the facts straight on your numbers.
In this article, we will explain what are financial statements, their purpose as well as their main types. And lastly what the limitations of financial statements are.
What are financial statements?
By definition, a financial statement is an accounting document that provides information about the financial position of a business. This information may relate to the state of its financial structure, the composition of its assets, the evaluation of its financial performance, and the measurement of its profitability.
The financial statements summarize in a clear and structured way the events that have affected a company throughout its existence as well as the transactions it has carried out with third parties.
The financial statements allow any reader of accounts:
- to conduct precise analyzes, in particular in the context of business takeovers, company valuations, mergers, demergers, or partial contributions of assets;
- to carry out comparisons in the time (the financial statements of the same company each year);
- to make comparisons in space (the financial statements of a company are compared to those of a competitor);
- to make decisions (the management teams of a company use them as a support, a real tool for decision-making).
The financial statements are addressed to all interested: partners, shareholders, managers, employees, bankers, investors, businesses, and anyone interested in it.
Which companies must prepare financial statements?
In principle, all commercial, craft, industrial or liberal companies must prepare financial statements. However, the scope of the obligations differs according to the nature of the activity (industrial and commercial profits - BIC, non-commercial profits - BNC or agricultural profits - BA) and the size of the company (micro-company, small company, or enterprise normal size).
What is the purpose of financial statements?
Financial statements are a structured financial representation of events affecting a company’s business and the transactions carried out by it. The purpose of financial statements is to provide information on the financial position, financial performance, and cash flow of a business, information useful to a variety of users for making business decisions.
The purposes of financial statements are based on the needs of their users, and take into account the limitations of financial statements as a medium of information, the nature of government operations, and legislative oversight.
In particular, the purposes of financial statements in the public sector should consist of providing information in preparation for the decision-making process and demonstrating how the entity carries out its mandate relating to the resources entrusted to it by:
- providing information on sources, distribution, and the use of financial resources;
- providing information on how the entity has funded its activities and met its cash flow requirements;
- providing useful information for the assessment of the capacity of the entity to finance its activities and honor its liabilities and commitments;
- providing information on the financial position of the entity and its evolution;
- providing comprehensive information useful for the assessment of the financial performance of the entity in terms of cost of service, efficiency, and achievements.
To meet these purposes, the financial statements provide information on:
- net assets / equity,
- the products,
- cash flows.
Types of financial statements
There are three main types of financial statements:
- the balance sheet,
- the income statement,
- the cash flow statement.
It is necessary to fully understand and master these terms of statement to ensure good management of your business and to be effective with your accounting software.
The balance sheet
The balance sheet is a photo of the financial situation of your business at some point in its life. The balance sheet gives you a photograph of the heritage of a company.
It compares, on the one hand, what it owns (its assets are classified in decreasing order of liquidity: fixed assets, inventories, trade receivables, cash, and financial investments).
And, on the other hand, what it owes (its liabilities are classified also in order of liquidity: capital, legal and statutory reserves, retained earnings or deficit, provisions, regulated provisions, financial debts, supplier debts, tax and social debts, and bank overdrafts). A balance sheet must always be balanced: the total amount of assets must equal the total amount of liabilities.
The balance sheet gives information on the financial situation of a company at a specific time. It makes it possible to study its financial structure and solvency. As part of these studies, it is generally reworked (certain account items are subject to reclassification) to arrive at a functional assessment.
As with the income statement, many financial ratios are calculated from a balance sheet. There are also three possible presentations for a balance sheet:
- The summary balance sheet,
- The basic balance sheet,
- The developed balance sheet.
|THE BALANCE SHEET|
(what you own)
(what you owe)
The income statement
The purpose of the income statement is to make it possible to measure the profitability generated by a company during a period called the accounting year. The income statement only includes data from the financial year relating to previous years.
The income statement puts in opposition, on the one hand, all the operations which have been calculated in the creation of wealth for a company (these are the revenues: turnover, subsidies, operating income, income from the sale of fixed assets).
And, on the other hand, those which had the effect of destroying wealth (these are the expenses: purchases and consumption of materials, external charges, taxes and duties, personnel charges, financial charges, and exceptional charges). The differential represents the net profit.
The income statement generally highlights several sub-results to identify the financial performance of the company at different levels:
- On the operational level (activity carried out by the company): it is the operating outcome,
- On the financial plan (policies for investing surpluses and financing): this is the financial outcome,
- In the non-current area (non-current events): this is the exceptional outcome.
In addition, the income statement serves as a support for the calculation of numerous financial ratios.
There are different methods of presentation of the income statement depending on the framework to which the company falls. The standard chart of accounts (COA), for example, provides three presentations:
- The abridged income statement,
- The basic income statement,
- The developed income statement.
|THE INCOME STATEMENT|
(what you spend)
(what you earn)
In other words, the income statement calculates the balances of your revenues accounts minus the balance of your expenses accounts to generate the net profit, also called Profit or Loss.
The income statement tells you how you spent the money you earned, and whether you managed to save some of it to meet your long-term goals.
The cash flow statement
The cash flow statement is a descriptive note which supplements the statistical information appearing in the balance sheet and the income statement. It allows a good reading of the annual accounts by providing additional appropriate information.
In general, the cash flow statement only contains information relating to operations, items, or significant variations (so as not to overwhelm the reading of this financial statement). The purpose of the cash flow statement is to provide useful elements for a good understanding and decision-making process.
Once again, depending on the size of the company, it can be:
- Exempt from drawing up a cash flow statement,
- Required to write a complete cash flow statement (the basic cash flow statement),
- Authorized to produce a simplified cash flow statement or even a cash flow statement abbreviated.
👉 Tip: When you use a cash flow statement, the ideal is to opt for the simplified VAT regime (filing of an annual declaration followed by quarterly installments). The declaration is drawn up at the end of the accounting year when the unpaid debts are recorded in the accounts.
In some cases, the income statement and balance sheet do not necessarily reflect what happened during the year since not all transactions are necessarily paid.
Limitations of financial statements
In the field of financial accounting, it remains impossible to know the margin generated by the sale of a product or the cost of the product. In the same way, as for expenses, income is categorized by nature. In addition, the financial results obtained relate to all of the activities carried out during an accounting year.
The other limitations imputable to financial statements relate to the very boundaries of the principles governing the discipline. These do not allow:
- To process operations whose results vary randomly,
- To record currency fluctuations,
- To update the value of transactions.
In conclusion, the financial statements include 3 main types: the balance sheet, the income statement, and the cash flow statement. Now that you have a global picture of what is going on within your business, you have several options available to you. Financial statements will help you in your entrepreneurial choices.