Financial statements are records of a business's financial health and activity.
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The objective of financial statements is to provide accurate financial information to both internal and external users. If you are running a business or thinking about buying a business, it is crucial to understand how to interpret financial statements.
Internal users of financial statements include management and employees. Managers need detailed financial statements to make decisions and certain employees, like members of a union, use financial statements to bargain for compensation and benefits.
External users of financial statements include investors, creditors, and the government.
One of the most important sources of information about a business for shareholders and potential investors are the annual and quarterly reports issued by publicly traded companies, which contain a number of financial statements as required by the SEC. Private companies may also issue financial statements especially designed for potential investors.
Creditors, such as banks, also use financial statements to help determine the financial health of the company that is applying for a loan. Businesses must keep detailed financial records to help pay taxes so the government is another big user of financial statements.
There are four basic types of financial statements: balance sheet (also referred to as "statement of financial position/condition"), income statement (also referred to as "profit and loss statement"), statement of retained earnings, and statement of cash flows.
The balance sheet reports the company's assets, liabilities, and owner's equity at a given point of time. The income statement reports the company's income, expenses, and profits over a period of time. The statement of retained earnings reports and explains changes in retained earnings over a period to time. The statement of cash flow reports the inflow, outflow, and movement of cash in the company over a period of time.
In order for financial statements to be useful to users, they must be understandable and consistent. The larger and more complex a company is, the more notes you could expect to accompany the financial statements.
Notes are an integral part of financial statements. Accountants who prepare financial statements much also follow accounting conventions, rules, and regulations. In the United States, accounting guidelines are set by the Financial Accounting Standards Board (FASB).
When using a business's financial statements, there are three attributes you should be aware of:
- Businesses tend to minimize taxes by minimizing the reporting of profits (by minimizing the reporting of income and maximizing the reporting of expenditure). As a result, statements tend to be tax oriented.
- An important accounting convention is conservatism. This means when an accountant is unsure which value to use, they will use the most conservative. As a result, financial statements tend to be biased towards conservatism.
- Financial statements tend to be historical in nature. This means some assets may be quoted at a historical value instead of current market value.