What Are Financial Statements?

Financial statements are organized accounting reports prepared according to specific accounting standards that provide a comprehensive picture of an entity's financial position and economic performance during a certain period. These statements represent the universal language of business that helps all stakeholders understand the company's financial condition and make informed investment and management decisions.

Financial statements are considered a fundamental communication tool between the company and various stakeholders, including current and potential investors, banks and lenders, suppliers, customers, employees, and government entities. Through these statements, one can assess the company's ability to generate profits, pay its obligations, and grow in the future.

Types of Financial Statements

The basic set of financial statements consists of six main statements, each providing different financial information that complements the others. Understanding each type of these statements is essential for obtaining a comprehensive understanding of the entity's financial position. Below is a detailed explanation of each type of basic financial statements:

1. Statement of Financial Position (Balance Sheet)

The statement of financial position shows the entity's financial position on a specific date, consisting of three main elements: assets (what the company owns), liabilities (what the company owes), and equity (owners' share). The statement of financial position is considered a "snapshot" of the financial position at a specific point in time. This statement must be balanced according to the basic accounting equation: Assets = Liabilities + Equity. The statement of financial position helps investors assess the company's financial strength and its ability to pay its debts.

2. Income Statement

The income statement shows revenues, expenses, and net profit or loss achieved by the entity during a specific period (usually a fiscal year). The income statement helps evaluate the basic operational performance and the company's ability to generate profits from its main operations. The income statement focuses on operational activities and excludes other comprehensive income items, making it useful for analyzing the company's basic operational performance.

3. Statement of Comprehensive Income

The statement of comprehensive income includes all items of the income statement plus other comprehensive income items such as revaluation differences, foreign currency differences, and unrealized gains and losses. The statement of comprehensive income provides a more complete picture of changes in equity resulting from transactions not related to owners. This statement is necessary for calculating comprehensive profitability ratios and comparing complete performance across different periods.

4. Statement of Changes in Equity

The statement of changes in equity shows the changes that occurred in equity during the financial period, including retained earnings, dividend distributions, issuance of new shares, and any other changes in capital. The statement of changes in equity begins with the opening balance and shows how equity was affected by profits or losses, transactions with owners, and other adjustments. The statement of changes in equity is important for understanding how shareholders' investment in the company grew or decreased.

5. Cash Flow Statement

The cash flow statement shows the movement of cash and short-term investments during the financial period, divided into three activities: operating, investing, and financing. The cash flow statement helps assess the company's ability to generate cash and manage liquidity. Operating activities include cash from main operations, investing activities relate to buying and selling long-term assets, and financing activities include transactions with shareholders and creditors. The cash flow statement is crucial for assessing earnings quality and financial sustainability.

6. Notes to Financial Statements

Notes to financial statements contain detailed information and clarifications about items included in the other four financial statements. These notes are necessary for understanding the accounting policies followed, important estimates, and risks facing the company.

Importance of Financial Statements

Financial statements occupy a central position in the world of business and investment, serving as the primary tool for financial communication between companies and all stakeholders. The importance of these statements goes beyond being mere accounting reports to become a strategic tool for making important financial and investment decisions. Financial statements serve a wide range of users, each relying on them for different and important purposes in their decision-making. Below are the main beneficiaries of financial statements and how they use them:

• For Investors and Shareholders: Financial statements help investors evaluate the company's financial performance and make informed investment decisions. By analyzing profitability, growth, and financial stability, investors can determine whether the company is worth investing in or not.

• For Management and Internal Decision Making: Financial statements are used as a management tool to evaluate performance and develop future strategies. They help management identify strengths and weaknesses, monitor cash flows, and plan budgets.

• For Banks and Lenders: Banks and financial institutions rely on financial statements to assess companies' creditworthiness before granting loans. These statements help determine the company's ability to repay debts and the level of financial risk.

• For Regulatory and Government Entities: Regulatory bodies such as the Securities and Exchange Commission use financial statements to monitor companies' compliance with accounting standards and financial laws, calculate due taxes, and ensure transparency in financial markets.

• For Suppliers and Customers: Suppliers use financial statements to assess the financial stability of their customers before granting flexible payment terms, while customers are interested in the financial stability of companies they deal with in long-term contracts.

• For Employees and Unions: Financial statements matter to employees because they reflect the company's stability and its ability to meet its obligations toward them, including salaries, bonuses, and retirement plans.

• For Comparative Performance Analysis: Financial statements allow useful comparisons between companies in the same sector and comparing the company's performance across different time periods to identify trends and improvement points.

• To Support Transparency and Accountability: Financial statements enhance transparency in financial markets and create an environment of accountability for management before shareholders, helping build trust and attract foreign investments.

How to Prepare Financial Statements Step by Step

Preparing financial statements is a systematic process that requires accuracy, attention to detail, and full compliance with local and international accounting standards. This process involves several sequential stages, each building on the previous stage to ensure accuracy and reliability of the financial information provided. This process must be carried out according to a specific timeline and under the supervision of qualified accountants to ensure compliance with standards and avoid errors. Below are the detailed steps for preparing financial statements:

1. Collect and Organize Financial Data

Start by collecting all documents and financial records for the accounting period, including invoices, receipts, bank statements, sale and purchase contracts, and payroll records. Make sure to organize these documents by date and transaction type to facilitate the review and audit process.

2. Review and Reconcile Accounts

Review all accounts in the general ledger and ensure the accuracy of balances. Perform necessary reconciliations such as bank reconciliation, accounts receivable and payable, and inventory. Ensure balances match supporting documents and make any necessary adjustments.

3. Prepare Trial Balance

Prepare the Trial Balance to ensure account balance and that the sum of the debit side equals the sum of the credit side. This step is necessary to ensure there are no errors in recording or posting before proceeding with financial statement preparation.

4. Make Adjusting Entries

Record all necessary adjusting entries such as depreciation, accrued expenses, prepaid revenues, and provisions. These entries are necessary to apply the accrual accounting principle and ensure all revenues and expenses are recorded in the appropriate period.

5. Prepare Adjusted Trial Balance

After making adjusting entries, prepare the Adjusted Trial Balance to ensure all adjustments have been recorded correctly and accounts are still balanced.

6. Prepare Comprehensive Income Statement

Start by preparing the income statement using revenue and expense data from the adjusted trial balance. Calculate net profit or loss, then add other comprehensive income items to prepare the complete comprehensive income statement.

7. Prepare Statement of Changes in Equity

Use net profit from the income statement and information about dividend distributions and capital changes to prepare the statement of changes in equity, which shows how equity evolved during the period.

8. Prepare Statement of Financial Position

Use final balances of assets, liabilities, and equity to prepare the statement of financial position. Ensure the statement is balanced according to the basic equation: Assets = Liabilities + Equity.

9. Prepare Cash Flow Statement

Collect cash flow information from operating, investing, and financing activities to prepare the cash flow statement. Either the direct or indirect method can be used according to accounting standards requirements.

10. Prepare Notes to Financial Statements

Write notes that explain accounting policies followed, important estimates, and additional details about financial statement items. These notes are an integral part of financial statements.

11. Final Review and Audit

Conduct a comprehensive review of all financial statements to ensure their accuracy, completeness, and compliance with accounting standards. External review by a certified auditor may be needed depending on company size and legal requirements.

12. Disclosure and Publication

After financial statements are approved by management and the board of directors, publish them according to legal and regulatory requirements, including submission to the Securities and Exchange Commission and other regulatory bodies.

With modern accounting software, many of these steps can be simplified and automated, saving time and reducing the likelihood of errors. Advanced programs provide sophisticated tools for automatically preparing financial statements according to local and international standards, ensuring accuracy and full compliance.

How to Analyze Financial Statements

Financial statement analysis is the process of examining and interpreting financial data to understand the company's financial performance and financial position and make informed decisions. Financial analysis relies on a set of specialized tools and techniques that help convert abstract numbers into useful and understandable information. This analysis is necessary for investors, lenders, and management to assess strengths and weaknesses, discover trends, and compare performance with industry standards. Below are the most important methods and tools for financial statement analysis:

Horizontal Analysis

Horizontal analysis compares financial data across multiple time periods to identify trends and changes in performance. The percentage change for each financial statement item is calculated compared to the base year, helping understand the growth or decline of revenues, expenses, and assets over time.

Vertical Analysis

Vertical analysis analyzes each item in the financial statement as a percentage of the total statement. In the income statement, each item is expressed as a percentage of total revenues, and in the statement of financial position as a percentage of total assets. This helps understand the cost structure and assets and liabilities of the company.

Financial Ratio Analysis

Financial ratio analysis is the most common and widely used financial analysis tool, including several categories:

Liquidity Ratios: Measure the company's ability to pay its short-term obligations, such as the current ratio (current assets ÷ current liabilities) and quick ratio. These ratios are important for assessing short-term financial stability.

Profitability Ratios: Measure the company's efficiency in generating profits, such as gross profit margin, net profit margin, and return on assets (ROA). These ratios help assess management's effectiveness in using resources.

Activity Ratios: Measure the company's efficiency in using its assets, such as inventory turnover ratio, accounts receivable turnover ratio, and asset turnover ratio. These ratios reveal the effectiveness of working capital management.

Leverage Ratios: Measure the company's dependence on debt, such as debt-to-equity ratio and interest coverage ratio. These ratios are important for assessing financial risk and sustainability.

Comparative Analysis

Involves comparing the company's performance with other companies in the same industry or with industry averages. This analysis helps understand the company's competitive position and identify areas that need improvement compared to competitors.

Cash Flow Analysis

Focuses on the cash flow statement to assess earnings quality and the company's ability to generate cash from its operations. Includes analyzing cash flows from operating, investing, and financing activities to understand sources and uses of cash.

Advanced Analysis

Includes using sophisticated analytical tools such as:

DuPont Analysis: Analyzes return on equity into its basic components (profit margin, asset turnover, and financial leverage) to understand sources of profitability.

Credit Analysis: Assesses credit risks and the company's ability to pay its debts, which is especially important for banks and lenders.

Fair Value Analysis: Uses ratios and multiples to estimate the company's true value and compare it to market value.

Using Technological Tools

Leveraging financial analysis software and big data tools to conduct more accurate and comprehensive analyses. Programs provide advanced analytical tools that help automatically produce reports and financial ratios, saving time and improving analysis accuracy.

Interpreting Results and Making Decisions

The most important step in financial analysis is correctly interpreting results in the context of the industry and general economic conditions. Analysis should lead to clear and actionable recommendations, whether they are investment, financing, or operational decisions, considering future risks and opportunities.

Frequently Asked Questions About Financial Statements

1. What is the difference between income statement and comprehensive income statement?

The income statement focuses on basic operating revenues and expenses to calculate net profit or loss from main operations. The comprehensive income statement includes everything in the income statement plus other comprehensive income items such as revaluation differences, foreign currency differences, and unrealized gains and losses from investments. The comprehensive income statement provides a more complete picture of changes in equity.

2. How often should companies prepare financial statements?

Companies prepare annual financial statements as a minimum, but publicly traded companies are required to prepare quarterly financial statements as well. Large companies may prepare monthly financial statements for internal use. Publicly traded companies must submit their financial reports to regulatory authorities within specified deadlines.

3. What accounting standards are required?

Companies apply International Financial Reporting Standards (IFRS) adopted by professional accounting bodies. These standards ensure compliance with international practices and enhance transparency and comparability with global companies. Standards are continuously updated to enhance compliance and transparency.

4. Can small companies simplify financial statement preparation?

Yes, there are simplified standards for small and medium enterprises that allow reducing disclosure requirements and accounting complexity. These standards help small companies comply with legal requirements without bearing excessive financial and administrative burdens. Modern accounting software significantly facilitates this process.

5. What is the importance of cash flow statement compared to income statement?

The cash flow statement shows actual cash movement, while the income statement may include revenues and expenses recorded accounting-wise but not yet converted to cash. Cash flows are important for assessing liquidity and ability to pay obligations, while the income statement focuses on profitability. Both are necessary for comprehensive understanding of financial performance.

6. How can investors use financial statements in decision making?

Investors use financial statements to evaluate profitability, growth, financial stability, and risks. They analyze financial ratios such as return on investment, liquidity ratios, and debt ratios. They also compare the company's performance with competitors and historical performance to make buy, sell, or hold decisions.

7. What are common mistakes in preparing financial statements?

Common mistakes include not properly applying the accrual principle, classification errors, not making necessary adjusting entries, depreciation calculation errors, and insufficient disclosure in notes. Also, not reviewing bank reconciliation and inventory valuation errors. Using advanced accounting software helps avoid these mistakes.

8. When does a company need an external auditor for its financial statements?

Publicly traded companies and large companies are legally required to appoint a certified external auditor. Banks also often require audited financial statements before granting loans. Even non-obligated companies may choose external auditing to enhance the credibility of their financial statements before investors and credit-granting entities.

Conclusion

Financial statements represent the backbone of any successful business activity, providing the necessary transparency for making sound financial decisions and building trust with investors and financial entities. Mastering the understanding and preparation of these statements according to adopted accounting standards is not just a legal obligation, but a strategic investment that contributes to business growth and long-term financial stability.