Financial Statements Include Which Of The Following Two

Financial statements are the bedrock of financial analysis, providing a structured overview of a company's financial performance and health. Understanding which statements are included and the information they convey is crucial for investors, creditors, managers, and other stakeholders to make informed decisions. While there are several supporting schedules and disclosures, the core financial statements fundamentally include two key documents: the balance sheet and the income statement. These two statements, when analyzed together and in conjunction with the statement of cash flows and statement of changes in equity, provide a comprehensive view of a company's financial status.

Delving into the Balance Sheet

The balance sheet, often referred to as the statement of financial position, is a snapshot of a company's assets, liabilities, and equity at a specific point in time. It adheres to the fundamental accounting equation:

Assets = Liabilities + Equity

This equation highlights that a company's assets are financed by either borrowing money (liabilities) or by raising capital from investors (equity).

Components of the Balance Sheet:

To fully grasp the information conveyed by the balance sheet, it's essential to understand its individual components: assets, liabilities, and equity.

• Assets: These represent what a company owns and can be tangible or intangible. Assets are typically categorized into current and non-current assets.

  • Current Assets: These are assets that are expected to be converted into cash or used up within one year or the company's operating cycle, whichever is longer. Examples include:

    • Cash and Cash Equivalents: This includes readily available cash balances and short-term, highly liquid investments that can be easily converted to cash.
    • Accounts Receivable: This represents the money owed to the company by its customers for goods or services sold on credit.
    • Inventory: This includes raw materials, work-in-progress, and finished goods held for sale.
    • Prepaid Expenses: These are expenses that have been paid in advance but not yet consumed, such as insurance premiums or rent.

  • Non-Current Assets: These are assets that are not expected to be converted into cash or used up within one year. Examples include:

    • Property, Plant, and Equipment (PP&E): This includes tangible assets such as land, buildings, machinery, and equipment used in the company's operations.
    • Intangible Assets: These are assets that lack physical substance but have economic value, such as patents, trademarks, and copyrights.
    • Long-Term Investments: This includes investments in other companies or securities that are held for more than one year.

• Liabilities: These represent what a company owes to others. Liabilities are also categorized into current and non-current.

  • Current Liabilities: These are obligations that are expected to be settled within one year. Examples include:

    • Accounts Payable: This represents the money owed to suppliers for goods or services purchased on credit.
    • Salaries Payable: This represents the salaries owed to employees but not yet paid.
    • Short-Term Debt: This includes short-term loans or lines of credit.
    • Accrued Expenses: These are expenses that have been incurred but not yet paid, such as utilities or interest.

  • Non-Current Liabilities: These are obligations that are not expected to be settled within one year. Examples include:

    • Long-Term Debt: This includes long-term loans or bonds payable.
    • Deferred Tax Liabilities: This represents the amount of income tax that is payable in the future.

• Equity: This represents the owners' stake in the company. It's the residual interest in the assets of the entity after deducting liabilities. The main components of equity are:

  • Common Stock: This represents the investment made by shareholders in exchange for ownership in the company.
  • Retained Earnings: This represents the accumulated profits of the company that have not been distributed to shareholders as dividends.
  • Additional Paid-in Capital: This represents the amount of money received from shareholders in excess of the par value of the stock.

Analyzing the Balance Sheet:

The balance sheet provides valuable insights into a company's financial health. Some key ratios and analyses derived from the balance sheet include:

• Liquidity Ratios: These ratios measure a company's ability to meet its short-term obligations. Examples include the current ratio (current assets/current liabilities) and the quick ratio ( (current assets - inventory) / current liabilities).
• Solvency Ratios: These ratios measure a company's ability to meet its long-term obligations. Examples include the debt-to-equity ratio (total debt/total equity) and the times interest earned ratio (EBIT/interest expense).
• Working Capital Management: Analyzing the components of current assets and current liabilities helps assess the efficiency of a company's working capital management.

Exploring the Income Statement

The income statement, also known as the profit and loss (P&L) statement, reports a company's financial performance over a specific period, typically a quarter or a year. It summarizes the revenues, expenses, gains, and losses that resulted in the company's net income or net loss.

Key Components of the Income Statement:

Understanding the key components of the income statement is crucial for interpreting its results. The typical structure of an income statement follows this format:

• Revenue: This represents the income generated from the company's primary business activities, such as sales of goods or services.
• Cost of Goods Sold (COGS): This represents the direct costs associated with producing the goods or services sold. This includes the cost of raw materials, labor, and manufacturing overhead.
• Gross Profit: This is calculated as revenue minus the cost of goods sold. It represents the profit a company makes before deducting operating expenses.
• Operating Expenses: These are the expenses incurred in running the business, such as salaries, rent, marketing, and research and development. Operating expenses are often divided into selling, general, and administrative (SG&A) expenses and research and development (R&D) expenses.
• Operating Income (EBIT): This is calculated as gross profit minus operating expenses. EBIT stands for Earnings Before Interest and Taxes and represents the profit a company makes from its core operations.
• Interest Expense: This represents the cost of borrowing money.
• Income Before Taxes (EBT): This is calculated as operating income minus interest expense.
• Income Tax Expense: This represents the amount of income tax owed to the government.
• Net Income: This is calculated as income before taxes minus income tax expense. Net income represents the company's profit after all expenses have been deducted. It is often referred to as the "bottom line."

Analyzing the Income Statement:

The income statement provides valuable insights into a company's profitability and performance. Some key ratios and analyses derived from the income statement include:

• Profitability Ratios: These ratios measure a company's ability to generate profits. Examples include gross profit margin (gross profit/revenue), operating profit margin (operating income/revenue), and net profit margin (net income/revenue).
• Earnings Per Share (EPS): This measures the amount of net income attributable to each share of common stock outstanding. It is calculated as (net income - preferred dividends) / weighted average number of common shares outstanding.
• Revenue Growth: Analyzing the trend in revenue over time provides insights into a company's sales performance and market share.
• Expense Analysis: Analyzing the components of operating expenses helps identify areas where the company can improve efficiency and reduce costs.
• Trend Analysis: Comparing income statements over multiple periods allows for the identification of trends in revenue, expenses, and profitability. This helps assess the company's performance over time and identify potential areas of concern.

The Interrelationship of the Balance Sheet and Income Statement

While the balance sheet and income statement provide different perspectives on a company's financial health, they are interconnected and provide a more complete picture when analyzed together. Here's how they relate:

• Net Income Impacts Retained Earnings: The net income from the income statement is added to the retained earnings account on the balance sheet. This increases the equity portion of the balance sheet. Conversely, a net loss decreases retained earnings.
• Depreciation Expense: Depreciation expense, which is reported on the income statement, reflects the decrease in the value of fixed assets (PP&E) over time. The accumulated depreciation, which is the total depreciation expense recognized to date, is reported as a contra-asset account on the balance sheet, reducing the book value of the related assets.
• Inventory and Cost of Goods Sold: The balance sheet reports the value of inventory at a specific point in time, while the income statement reports the cost of goods sold during a period. The flow of inventory from the balance sheet to the income statement is crucial for determining a company's profitability.
• Accounts Receivable and Revenue: The balance sheet reports the amount of money owed to the company by its customers (accounts receivable), while the income statement reports the revenue generated from sales. The relationship between accounts receivable and revenue can provide insights into a company's credit policies and collection efficiency.
• Debt and Interest Expense: The balance sheet reports the amount of debt a company has outstanding, while the income statement reports the interest expense incurred on that debt. The level of debt and the associated interest expense can significantly impact a company's profitability and financial risk.

Beyond the Balance Sheet and Income Statement: Other Important Financial Statements

While the balance sheet and income statement are core, understanding financial performance requires looking at two other key statements:

• Statement of Cash Flows: This statement reports the movement of cash both into and out of a company during a specific period. It categorizes cash flows into three activities: operating, investing, and financing.

  • Operating Activities: These relate to the normal day-to-day operations of the business, such as selling goods or services.
  • Investing Activities: These involve the purchase and sale of long-term assets, such as property, plant, and equipment (PP&E).
  • Financing Activities: These relate to how a company raises capital, such as issuing debt or equity.

  The statement of cash flows is crucial for assessing a company's liquidity and its ability to generate cash.

• Statement of Changes in Equity: This statement reports the changes in the equity accounts on the balance sheet during a specific period. This includes changes in common stock, retained earnings, and other equity components. This statement helps investors understand how a company's equity structure is evolving.

Conclusion

The balance sheet and the income statement are two fundamental financial statements that provide a comprehensive overview of a company's financial position and performance. The balance sheet offers a snapshot of a company's assets, liabilities, and equity at a specific point in time, while the income statement reports a company's financial performance over a period. By understanding the components of these statements and analyzing key ratios and trends, stakeholders can make informed decisions about investing in, lending to, or managing a company. However, a complete and thorough analysis also requires consideration of the statement of cash flows and the statement of changes in equity, offering a rounded view of a company’s financial health and prospects.