Financial statements are official documents used by businesses and corporations. It is used to summarize their activities and provide full details about their assets, liabilities, and capital. They are prepared according to certain rules and standards, and they are used by various people who are interested in the business, such as owners, managers, investors, lenders, customers, regulators, and others. Financial statements have four main functions: to analyze profitability, assess earning capacity, determine financial position, and evaluate operational efficiency. In this blog post, we will explain what each function means and why it is important for the success of the business.
Financial statements are prepared for various purposes and users. Some of the main purposes and users are:
Financial statements are used to comply with legal requirements:
Businesses and organizations are required by law to prepare and present financial statements to comply with tax regulations, accounting standards, auditing rules, etc.
For example, public companies have to file their financial statements with regulatory bodies like SEBI(Securities and Exchange Board of India).
To communicate with stakeholders:
Businesses and organizations use financial statements to communicate with their stakeholders, such as owners, managers, investors, lenders, customers, suppliers, employees, etc. Financial statements provide information that helps stakeholders make informed decisions regarding resource allocation, business strategies, future income expectations, etc.
For example,
- Investors use financial statements to evaluate the performance and value of a company.
- Lenders use financial statements to assess the creditworthiness and risk exposure of a borrower.
- Customers use financial statements to judge the quality and reliability of a supplier.
To evaluate performance:
Businesses and organizations use financial statements to evaluate their own performance against their goals, objectives, budgets, plans, etc. Financial statements provide feedback that helps businesses and organizations identify their strengths and weaknesses, opportunities and threats, and areas for improvement and enhancement.
For example,
- Managers use financial statements to monitor and control the operations and activities of their departments
- Owners use financial statements to measure and reward the profitability and growth of their businesses; etc.
Functions of Financial Statement
Analyzing Profitability
One of the functions of financial statements is to analyze the profitability of the business. Profitability is the capacity of a commercial enterprise to generate profits from its operations. To measure profitability, we can use the income statement or the profit and loss statement. The income statement shows the revenue (money from selling goods or services), expenses (money spent on running the business), and net income or loss (revenue minus expenses) of the business for a certain period of time, such as a month, a quarter, or a year.
The income statement helps us answer questions like,
- How much revenue did the business earn in the period?
- How much did it cost to produce or deliver the goods or services?
- To analyze profitability more deeply, we can also use some ratios that compare different items on the income statement.
- How much did it spend on other expenses, such as salaries, rent, utilities, taxes, etc.?
- How much profit or loss did it make in the period?
For example:
- Gross income margin = gross income/ revenue
- Operating profit margin = operating profit/ revenue
- Net profit margin = net income/ revenue
Analyzing profitability is important because it tells us how well the business is using its resources to generate income. It also helps us compare the performance of the business with other businesses in the same industry or sector. A profitable business can attract more investors, customers, and lenders and can also reinvest its profits for future growth.
Assessing Earning Capacity
Another function of financial statements is to assess the earning capacity of the business. Earning capacity is the potential of the business to generate future income from its current and expected activities. To estimate earning capacity, we can use some indicators that show how much revenue or income the business can earn in the future based on its past or present performance. For example:
- Revenue trends: This shows how much the revenue of the business has grown or declined over time.
- Sales growth: This shows how much the sales volume or value of the business has increased or decreased over time.
- Overall financial performance: This shows how much net income or loss the business has made over time.
These indicators help us to answer questions like:
- How fast or slow is the business growing its revenue or sales?
- Consistency or variability of the business’s financial performance?
- How sustainable or risky is the business’s income generation?
To assess earning capacity more accurately, we can also use some projections or forecasts that show how much revenue or income the business expects to earn in the future based on its current plans and assumptions. For example:
- Budgets: These are plans that show how much revenue and expenses the business expects to have in a future period.
- Income statements: These are statements that show how much revenue and expenses the business expects to have in a future period based on its budget.
- Cash flow statements: These are statements that show how much cash inflows and outflows the business expects to have in a future period based on its budget.
These projections or forecasts help us answer questions like:
- How much revenue or income does the business expect to earn in the next month, quarter, or year?
- Are these expectations realistic or optimistic?
- How much cash does the business need or have to support its operations and investments?
Assessing earning capacity is important because it tells us how much value the business can create in the future from its current and expected activities. It also helps us evaluate the growth potential and risk exposure of the business. A high earning capacity can increase the value of the business and its shares, while a low earning capacity can decrease the value of the business and its shares.
Determining Financial Position
A third function of financial statements is to determine the financial position of the business. Financial position is the status of the business’s assets, liabilities, and equity at a specific point in time. To measure financial position, we can use the balance sheet or the statement of financial position. The balance sheet shows the assets (things that the business owns or has a right to), liabilities (things that the business owes or has to pay), and equity (the difference between assets and liabilities) of the business at a specific point in time, such as the end of a month, a quarter, or a year.
The balance sheet helps us to answer questions like, how much
- Money or other resources does the business have or can use?
- Debt or other obligations does the business have or has to pay?
- Money or other resources does the business owe to its owners or shareholders?
To determine financial position more precisely, we can also use some ratios that compare different items on the balance sheet.
For example:
- Current ratio = contemporary assets / contemporary liabilities
- Solvency ratio = overall assets / overall liabilities
- Debt-to-fairness ratio = overall debt / overall fairness
Determining the financial position is important because it tells us how strong or weak the business is financially. It also helps us assess the liquidity, solvency, and leverage of the business. A strong financial position can improve the creditworthiness and reputation of the business, while a weak financial position can impair the ability and confidence of the business to operate and grow.
Evaluating Operational Efficiency
The fourth function of financial statements is to evaluate the operational efficiency of the business. Operational efficiency is the ability of the business to use its resources effectively and productively to generate revenue and income. To measure operational efficiency, we can use some indicators that show how well the business is managing its assets, liabilities, and equity to generate revenue and income. For example:
- Accounts receivable turnover = revenue / average accounts receivable
- Accounts payable repayment period = average accounts payable / purchases
- Inventory turnover = cost of goods sold / average inventory
- Return on assets = net income / average total assets
- Return on equity = net income / average total equity
Evaluating operational efficiency is important because it tells us how well the business is using its resources to generate income. It also helps us to identify areas of improvement and enhancement in the business’s operations. A high operational efficiency can increase the profitability and growth of the business, while a low operational efficiency can decrease the profitability and growth of the business.
Conclusion
Financial statements are written records that show the financial activities and performance of a business or an organization. They have four main functions: to analyze profitability, to assess earning capacity, to determine financial position, and to evaluate operational efficiency. By understanding these functions, we can use financial statements effectively for making informed decisions regarding our business operations, strategies, and future prospects.