Financial statements are important to all who have business
dealings with companies, and with those internal managers who need information to make decisions about
company operations. Investors, trade creditors and analysts need information to decide on the nature and
extent of investments they are going to make, or recommend to others. On the other hand, business managers
rely on such data to show the levels of performance they have achieved in their plan for increased profits
and reduced expense. Only such data, produced by accountants, can give a clear and concise picture of
essential financial information.
There are three fundamental financial documents: the balance
sheet, the income statement and the statement of cash flows. The balance sheet is a
status document in that it shows the existing condition of the enterprise at a particular point in time.
For example, the left part of the balance sheet shows the dollar value of all the assets used by the company
to develop its business, including the money used to pay salaries, provide credit, and support inventory.
The left side of the balance sheet also shows the dollar values of the fixed assets of the business, including
buildings and equipment. These assets, in total, represent the investment by the company in achieving
its overall economic activity of making sales, collecting rents, billing services, and so on.
The right side the balance sheet shows where the company
obtains the money to finance the business assets listed on the left side. Some of these liabilities are
provided by trade creditors who provide goods and services on credit, called accounts payable, or by services
provided and paid for later, called accruals, or by banks who provide money on a short term basis and
who take back notes. Some money is provided by mortgage holders and other long-term debt holders who have
special security rights to certain assets on the left hand side of the balance sheet.
On the right side of the balance sheet, in larger companies,
a whole category of long term financing is devoted to "securities." Securities are negotiable pieces of
paper that represent money the company has borrowed, called bonds, or money the company has received from
investors who will participate in the profits of the business, called stocks. The dollar amounts shown
for the these items are the amounts originally collected and are called "book values", which distinguishes
those values from the "market values" those securities may have in the financial marketplace.
There is one remaining item on the right hand side of the
balance sheet that deserves special attention: retained earnings. This is where all the net profits earned
by company and not returned to the shareholders in dividends is accounted for. This money represents the
money earned by the business and used to help finance its assets. This item is called "internally generated
Thus the balance sheet is a key financial document since
it shows the decisions made by management in the selection of assets to run its business and the financing
of those assets.
The income statement, on the other hand, is a running
record of the activities of the business in the current business period , showing such current items as
sales, expenses, taxes and profits. The income statement is widely used by outside financial decision
makers as the "bottom line" document for recommending loans and investments in that company, and by inside
managers who will be testing the efficacy of their budgets and other operating plans. The income statement
records sales and expense events as they occur and is, therefore, called an "accrual based system"
The third document, the statement of cash flows, is
an economic test of the other two. While accounting systems are "accrual based," the economic reality
is the ability to produce cash flow, and the viability of any enterprise is dependent on its ability to
meet its current financial obligations. Therefore, the ability to convert business activity to current
cash is vital. This document identifies the sources of cash and the uses of cash in a format required
by the Financial Accounting Standards Board (FASB) which identifies the cash produced from sales, the
cash used in the buying selling of assets, and cash borrowed or supplied by investors.