Accountants play a vital role in issuing financial statements in accordance with accepted accounting principles. Accurate financial statements not only provide insights into financial performance during the fiscal year, but they are also often required by third parties, such as lenders and investors.
An annual comprehensive financial report includes several components, such as the income statement, the balance sheet, and the cash flow statement. In addition to these core financial statements, companies commonly issue notes describing the accepted accounting principles used and other important financial information.
In the accounting profession, different types of financial statements are issued. Compiled financial statements provide no assurance, while reviewed financial statements provide limited assurance. Audited financial statements offer reasonable assurance that the financial statements are free from material misstatements.
Each of these report types includes the core financial statements. In the following sections, we’ll break down the fundamentals of the three main reports in more detail.
Income Statement
The income statement, also known as a profit and loss statement, is a useful document that monitors the profitability of a business. It highlights the money your business earned and spent during the fiscal year.
Primary sources of revenue include sales from your core business function, while secondary sources of revenue might include bank interest and financial gains. There are two main sets of expenses: cost of goods sold and operating expenses. Cost of goods sold are expenses directly related to producing your primary source of revenue, while operating expenses are any other costs your business incurs.
Deciphering the Income Statement
There are a few figures on the income statement that aid in evaluation, including:
Gross Profit = Total Revenue – Cost of Goods Sold
Gross Profit Margin = (Gross Profit / Total Revenue) * 100
Operating Profit = Gross Profit – Operating Expenses
Net Profit = Total Revenue - Cost of Goods Sold – Operating Expenses + Other Income – Other Expenses
Balance Sheet
Another statement included in an annual report is a balance sheet. This document, also known as the statement of financial position, summarizes your business assets, liabilities, and equity. Assets are the items your business owns, while liabilities are what you owe. Equity is how much money is left over if you liquidate your assets and liabilities.
Assets and liabilities are further broken down between current and non-current. Current assets and liabilities are items expected to be received and paid within one year. Non-current assets and liabilities are items that aren’t expected to be received or paid within the next year.
The balance sheet gets its name because assets must equal liabilities plus equity. If assets do not equal liabilities plus equity, there is an error somewhere.
Analyzing the Balance Sheet
The balance sheet shows the overall financial health of your business. There are a few key metrics that you can calculate, including:
Current Ratio = Current Assets / Current Liabilities
Working Capital = Current Assets – Current Liabilities
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
The quick ratio is similar to the current ratio, with the exception of inventory. Inventory isn’t always a liquid asset and can’t easily be converted to cash at book value. As a result, the quick ratio can give more insights into the short-term liquidity of your company.
Cash Flow Statement
Annual reports will also include the cash flow statement. The cash flow statement shows movements in your cash accounts, reflecting the liquidity of your business during the previous fiscal year.
The cash flow statement is broken down into three main categories: cash flow from operations, cash flow from investing activities, and cash flow from financing activities. Cash flow from operations contains transactions from the main activities of your business, like revenue and expenses. This section will also contain changes in certain asset and liability accounts, like accounts receivable, inventory, and wages payable.
Cash flow from investing activities will show information related to the sale or purchase of assets and investment securities. Cash flow from financing activities will contain changes in your loan accounts, like lines of credit and other notes payable. Distributions or dividends paid to investors or shareholders will also be shown in cash flow from financing activities.
Reading the Cash Flow Statement
The cash flow statement is a crucial financial statement when it comes to understanding how cash is being used in a business. At the bottom of the statement, you will find a line item called net cash flow. An increase in net cash flow means that your business is retaining more cash, which could be due to more profitability.
On the contrary, a decrease in net cash flow could indicate your business is losing money or not effectively deploying funds. Net cash flow that stays the same doesn’t necessarily indicate poor performance, but it can highlight upcoming trouble if your reserves are low.
Summary
Annual reports for accountants include three main reports: the income statement, the balance sheet, and the statement of cash flow.
Compiled financials provide no assurance, reviewed financials provide limited assurance, and audited financials provide reasonable assurance.
The income statement shows a company’s profit or loss for a certain time period.
The balance sheet shows the overall financial health of a company.
The cash flow statement tracks cash transactions for a defined time period.
