What are financial statements?

What are financial statements?

They are a set of documents that captures the financial health of the business for a specific period (year, quarter, month etc.) They are therefore an important tool to help executives and directors make sound decisions. For example, financial statements for a corporation are usually prepared by Chartered Professional Accountants (CPA) with help from the company's management and are approved by the board of directors. They are presented during or before the annual meeting of shareholders just like public corporations.

Several levels of government require financial statements. They must also comply with a set of rules called International Financial Reporting Standards (IFRS). Therefore, they are fairly consistent and make it easier to compare financial statements for different businesses.

Helpful tip: Several non-profit organizations (NPO) must also produce their financial statements.

What information is included in financial statements?

Financial statements are a combination of documents. Some are mandatory, and others depend on the legal structure of the business (corporation or other). Here is an overview of the main elements: 

Balance sheet or statement of financial position 

This document includes:

• Assets such as bank balances, stocks, accounts receivable, investments
• Liabilities (accounts payable and debt) 
• Shareholders' equity on the exact date the fiscal year ends (assets minus liabilities)

It’s essentially a snapshot of what the business owns and what it owes. This data allows you to assess the financial strength of the business and its ability to absorb potential losses. It also shows how the money earned during the year was used. 

Income statement

This section includes revenues, expenses and profits (or losses). It also helps understand how expenses are broken down and allows for comparisons between different periods (two years for example). It helps understand and explain the profitability and growth (or lack thereof) of the business. Budgets for the coming years are based on this information.

Cash flow statement (or financial position of the business)

This document provides information on the various activities of the organization, financing it receives from lenders and its investments. It documents cash flow (source and use of the funds)

Statement of retained earnings (or changes in shareholders' equity)

This section shows what the owners retain in the business.

Notes

They include important information to help the reader understand the document, such as the accounting methods used or major transactions that took place. 

External auditor’s report 

It provides the conclusions of an independent expert on the financial statements. An audit is often required by law or requested by business partners or by the business. 

What is the purpose of the financial statements?

These documents are important to help:

• Business owners and leaders make more informed business decisions
• Financial institutions and other lenders assess the business’s ability to repay
• Passive or potential investors obtain an objective snapshot of the situation (Those investors are one of the sources of financing for businesses.)
• Different levels of government calculate tax payable
• Business owners and potential buyers evaluate what the business is worth

How to read and analyze financial statements.

Here is some specific information included in financial statements that you should focus on and what this information means:

Profitability

Is the sales price of the products or services high enough to cover the expenses of the business? This will help you determine whether the cost is appropriate.

Collection of accounts receivable

The financial statements should prove that revenues are increasing faster than accounts receivable. To calculate this rate, you need to divide the accounts receivable by the daily revenues.

A high rate should be a hint that the business may eventually have trouble getting paid.

Cash flow

The acid test ratio shows whether the business can fulfill its immediate obligations without selling shares and does not include prepaid fees. To calculate this ratio add the cash on hand to the accounts receivable and the short term investments. Then divide the result by the short-term liabilities.

The result will show whether the business will have trouble meeting its commitments. If necessary, there are ways to optimize your business’s cash flow.

Inventory

The turnover rate of inventory is additional information available in the financial statements. To calculate it, divide the average value of the inventory (or the value of the current period) by the cost of goods sold.

In certain sectors, such as perishable goods, a repeatedly low turnover rate is abnormal. It might mean loss of inventory. Inversely, a high turnover rate is a good sign. It means the business is selling its products quickly and earning more money.

Taxation

It makes sense that a business with lower taxes will have higher earnings. However, it is unlikely that the business will be able to reduce its taxes every year.  

Keep in mind that you will have a more accurate picture of the situation if you evaluate growth before taxes. It is also the best indicator of manager performance.

Self-generated funds

They are earnings plus depreciation expense (cost without cash outflows) after investments in working capital (amount earmarked for everyday expenses). 

They should exceed the earnings. Otherwise, it might be a symptom of an upcoming downturn.

Depreciation

Depreciation is a way to account for the wear and tear of some equipment. A high depreciation expense can lower profits and vice-versa. 

Earnings per share (public corporations)

This ratio indicates the amount of earnings compared to the number of shares of the business. In other words, it is the amount that would be received for each share if the business distributed all its profits. As a general rule, this information is already included in the financial statements of public corporations. Compare this number to previous fiscal years to assess the growth of the business. It can also be used to evaluate the business in relation to its competitors.

Book value per share (public corporations)

It is an interesting ratio for future investors. It will indicate if the share price is undervalued- or overvalued. To calculate it, subtract the value of preferred shares from the shareholders’ equity. Then divide the result by the number of outstanding shares.

If the share price is below its book value, it may be undervalued. This may indicate good growth prospects, making the shares a good buy. 

Understanding the financial statements is key to understanding the business. It will be easier to make an informed decision and pursue business opportunities. Your advisor can help you understand them better so you can manage the accounting of your business or choose your investments. Feel free to make an appointment with our experts for personalized support. We’re here to answer your questions.