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Introduction to Company Financial Statements

Meaning Of Financial Statements

Financial statements are formal records of the financial activities and position of a business, person, or other entity. They provide a summary of the financial performance and financial position of an enterprise at a particular point in time or over a specific period.

In the context of a company, financial statements are prepared primarily for reporting to the owners (shareholders), creditors, government agencies, and other stakeholders. They are prepared based on the accounting records maintained by the company.

The main components of a company's financial statements as per Schedule III of the Companies Act, 2013, in India are:

  1. Balance Sheet: A statement of the financial position of the entity at a specific point in time, showing its assets, liabilities, and equity. It follows the fundamental accounting equation: Assets = Liabilities + Equity.
  2. Statement of Profit and Loss (or Income Statement): A statement that shows the financial performance of the entity over a specific period (e.g., a financial year), detailing revenues, expenses, and the resulting profit or loss.
  3. Cash Flow Statement: A statement that shows the inflows and outflows of cash and cash equivalents during a specific period, classified into operating, investing, and financing activities.
  4. Statement of Changes in Equity: A statement that shows the changes in the equity of the entity between the beginning and the end of the reporting period, including contributions from and distributions to owners, and the profit or loss for the period.
  5. Notes to Accounts: These provide additional information, explanations, and details about the items presented in the Balance Sheet, Statement of Profit and Loss, Cash Flow Statement, and Statement of Changes in Equity. They also include a summary of significant accounting policies.

These statements together provide a comprehensive view of a company's financial health, performance, and liquidity.


Nature Of Financial Statements

Financial statements have certain characteristics that define their nature:

1. Based on Accounting Concepts and Conventions

Financial statements are prepared based on fundamental accounting concepts (like Going Concern, Accrual, Business Entity, Money Measurement, etc.) and accounting conventions (like Conservatism, Consistency, Full Disclosure, Materiality, etc.). These concepts and conventions provide the framework for recording transactions and preparing statements.

2. Recorded Facts

Financial statements are based on recorded facts, such as the cash received or paid, the cost of assets, amounts due from debtors, etc. These are verifiable transactions documented in the books of accounts.

3. Accounting Concepts

Certain accounting concepts influence the preparation of financial statements. For instance, depreciation is calculated based on the concept of matching costs with revenues, and provisions are made based on the conservatism convention.

4. Accounting Conventions

Conventions guide the application of accounting principles. For example, the convention of conservatism suggests providing for all known losses but not anticipating profits. The convention of consistency requires using the same accounting methods from one period to another unless a change is justified.

5. Personal Judgements

Despite being based on principles and facts, financial statements involve personal judgments made by the accountants or management. Examples include estimating the useful life of an asset for depreciation, assessing the likelihood of recovering debts, or choosing among acceptable inventory valuation methods (like FIFO or Weighted Average). These judgments can affect the reported financial results and position.

In essence, financial statements are not merely a collection of raw data but are prepared using a structured framework (concepts and conventions) applied to recorded facts, often involving estimates and judgments.


Objectives Of Financial Statements

The primary objective of financial statements is to provide financial information about an entity that is useful to a wide range of users in making economic decisions. More specifically, the objectives include:

1. To Provide Information about Financial Position

The Balance Sheet provides information about the entity's assets (resources controlled), liabilities (obligations), and equity (owners' stake) at a specific point in time. This helps users understand the entity's financial structure, liquidity, and solvency.

2. To Provide Information about Financial Performance

The Statement of Profit and Loss shows the entity's revenues earned and expenses incurred over a period, leading to the net profit or loss. This helps users assess the entity's profitability, operational efficiency, and earning capacity.

3. To Provide Information about Cash Flows

The Cash Flow Statement shows how the entity generated and used cash during a period. This information is crucial for assessing the entity's ability to generate cash, meet its financial obligations, pay dividends, and fund its investing and financing activities.

4. To Assist in Assessing Future Prospects

By analysing past financial performance and position, users can make informed judgments about the entity's potential for future profitability and cash generation.

5. To Aid in Decision Making

Financial statements provide data that helps various users make economic decisions, such as:

6. To Provide Information about Changes in Equity

The Statement of Changes in Equity explains how the owners' stake in the business has changed during the period.

In summary, financial statements aim to provide a fair presentation of the financial results and position of the entity, useful for a wide range of users making diverse economic decisions.


Uses And Importance Of Financial Statements

Financial statements are vital for various stakeholders for different purposes:

For Investors

Investors use financial statements to evaluate the profitability, stability, and growth prospects of a company. They assess the risk and return potential before making investment decisions (buying/selling shares). Key metrics derived from financial statements include Earnings Per Share (EPS), Return on Equity (ROE), Dividend Payout Ratio, etc.

For Creditors and Lenders

Banks and other lenders analyse financial statements to assess the company's creditworthiness, ability to repay debt (both principal and interest), and the security available. They look at ratios like Debt-to-Equity Ratio, Interest Coverage Ratio, and liquidity ratios.

For Management

Management uses financial statements for internal decision-making, planning, controlling operations, evaluating performance of different segments, and formulating strategies. They help in budgeting, cost control, and identifying areas for improvement.

For Employees

Employees are interested in the stability and profitability of the company as it affects their job security, remuneration, bonuses, and retirement benefits. They can assess the company's ability to meet its obligations.

For Customers

Customers, especially those with long-term contracts or dependence on a supplier, may use financial statements to assess the company's ability to continue as a going concern and fulfil its commitments.

For Government and Regulatory Bodies

Governments use financial statements for taxation purposes (calculating income tax, GST, etc.) and for formulating economic policies. Regulatory bodies like SEBI, MCA, and RBI use them to ensure compliance with laws and regulations and to protect the interests of investors and the public.

For Researchers and Analysts

Academicians, researchers, and financial analysts use financial statements for research, industry analysis, forecasting, and making recommendations.

For Public

The public may be interested in information about the company's performance, contribution to the economy, environmental practices, and social responsibility.

In summary, financial statements are a crucial source of information for informed decision-making by a wide range of users, both internal and external to the company.


Limitations Of Financial Statements

Despite their importance, financial statements have certain limitations that users should be aware of:

1. Based on Historical Costs

Many assets are recorded at their historical cost (original purchase price) rather than their current market value. In periods of significant inflation, historical costs may not reflect the true value of the assets or the current cost of replacing them. This limits the relevance of the Balance Sheet in showing current economic values.

2. Influence of Personal Judgment

The preparation of financial statements involves estimations and personal judgments (e.g., useful life of assets, provision for doubtful debts, inventory valuation method). Different judgments can lead to different financial results, even for the same underlying transactions. This can introduce subjectivity.

3. Only Provide Interim Reports

Financial statements are prepared for specific periods (e.g., annually, quarterly). They do not reflect the continuous flow of transactions. The financial position shown in the Balance Sheet is as on a particular date, which may not be representative of the position throughout the period.

4. Do Not Reflect Current Market Value of Assets

Except for certain investments, most assets (like land, building, machinery) are shown at depreciated historical cost. Their realisable or replacement values in the market may be significantly different.

5. Ignore Non-Monetary Factors

Financial statements only record transactions that can be measured in monetary terms. Important qualitative factors like the quality of management, employee morale, brand reputation, customer loyalty, technological advancements, and market conditions are not directly reflected in the statements, although they significantly impact the company's performance and prospects.

6. Possibility of Window Dressing

Management may sometimes manipulate accounting policies or apply creative accounting techniques within the legal framework to present a more favourable financial picture than the reality. This is known as window dressing and can mislead users.

7. Not Suitable for Forecasting (on their own)

While past performance is an indicator, financial statements alone are insufficient for making accurate predictions about the future. External factors, industry trends, and management decisions are equally, if not more, important for forecasting.

8. Lack of Comparability

Comparing the financial statements of different companies can be challenging due to differences in accounting policies adopted (e.g., depreciation methods, inventory valuation), size, nature of business, and reporting periods.

Therefore, while financial statements are essential, they should be analysed with caution, considering their inherent limitations and supplementing the information with other relevant data and analysis.