When it comes to understanding the financial health of a company, three essential documents play a crucial role: the balance sheet, income statement, and cash flow statement. These financial statements provide valuable insights into a company's performance, profitability, and liquidity. In this blog post, we'll break down these financial statements in simple terms, allowing even a layman to grasp their significance.
BALANCE SHEET:
Imagine the balance sheet as a snapshot of a company's financial position at a specific point in time, usually at the end of a quarter or year. It comprises three key sections: assets, liabilities, and shareholders' equity.
Assets: These represent what the company owns. It includes tangible assets like cash, inventory, buildings, and equipment, as well as intangible assets like patents and trademarks.
Liabilities: These reflect what the company owes to others. It includes short-term liabilities (e.g., accounts payable) and long-term liabilities (e.g., loans). Liabilities can also encompass obligations such as salaries payable and taxes owed.
Shareholders' Equity: This represents the residual interest in the company's assets after deducting liabilities. It reflects the shareholders' ownership in the business and can include items such as retained earnings and capital contributions.
The balance sheet follows a fundamental equation: Assets = Liabilities + Shareholders' Equity. By examining this equation, we can assess whether a company's assets are financed through liabilities or shareholders' equity.
An example balance sheet of an imaginary company is shown below:
INCOME STATEMENT:
An income statement, also known as a profit and loss statement, presents a summary of a company's revenues, expenses, gains, and losses over a given period, typically a quarter or year.
Revenues: These are the inflows of money from the sale of goods or services. It can include sales revenue, interest income, or any other income generated by the company.
Expenses: These are the costs incurred by a company while conducting its business operations. They include expenses such as salaries, rent, utilities, marketing costs, and more.
Gains and Losses: These arise from transactions that are not part of the core business operations. For example, gains or losses from the sale of assets or investments.
The income statement calculates the net income (or net loss) by subtracting the total expenses from the total revenues. Net income indicates the profitability of a company during the specified period. If revenues exceed expenses, the company generates a profit, whereas if expenses surpass revenues, it incurs a loss
An example income statement is as below:
CASH FLOW STATEMENT:
While the balance sheet and income statement provide valuable insights, they do not focus explicitly on cash. The cash flow statement fills this gap by detailing the cash inflows and outflows over a specific period, typically divided into three categories:
Operating Activities: These represent cash flows resulting from the core business operations, such as cash received from customers or payments made to suppliers.
Investing Activities: This category includes cash flows from buying or selling long-term assets, investments, or other business ventures.
Financing Activities: Cash flows associated with raising capital or repaying debts, including proceeds from issuing shares, loan repayments, or dividends paid to shareholders.
The cash flow statement helps assess a company's ability to generate cash, its liquidity position, and how it funds its operations and growth.
Here is how it looks for an imaginary company:
(One could get line items in cash flow statement from either income statement or balance sheet)
To get a good grasp of what is happening in a company, it is a good practice to start reading these financial statements. To comprehend how the company is performing, compare the financial statement with previous year and with pother competitors in its industry.
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