Elizabeth Girardy Prof. Andrew Moore ECB 117 A12/13/2017 The Importance of Financial StatementsFinancial statements are like a story told about the financial state of a company. Each are important on their own like a chapter in a book, but together they tell the complete story. In this paper I will discuss three financial statements and their purposes. I will also discuss the relationship between them and how they depend on each other. The three statements in this essay are the balance sheet, income statement, and statement of cash flows. All three financial statements use information found in the basic accounting equation. This equation is assets = liabilities + equity (Wild, 15). To give a brief overview of why each statement is important, the balance sheet is like a snapshot of the entire equation. It is important to an organization because it shows what their resources are and what they owe at a specific point in time (citation). The income statement looks at revenues and expenses, and contributes to the equity section of the balance sheet. It is helpful to the organization because it shows what expenses were needed to generate the revenues during one period (Citation). The statement of cash flows analyses the change in the cash account from one balance sheet to another. It shows an organization where is cash is being used and where it is being brought in (citation). Together, the three work together to provide useful information that the company uses to make decisions and that lenders and investors use to decide whether or not they will invest in the company. The balance sheet is the clearest expression of the accounting equation in that it shows all the accounts on either side of the equation. In other words, the balance sheet is supposed to show the balanced equation. It captures one moment in time like a photograph. To elaborate on the form and how it helps the company, the balance sheet includes the assets of a company on one side and liabilities and equity on the other just like the equation. Assets are what the company owns (Wild,15). Balance sheet asset accounts are those such as the cash account, accounts receivable, prepaid expenses, land, buildings, and equipment. This side of the equation shows the company’s resources. To make things more organized, the assets section is split into current assets and long term assets. All these are arranged in order of liquidity. Current assets can be converted to cash within the company’s operating cycle. Long Term assets take longer than the company’s operating cycle to be converted to cash. This method of organization is helpful to the company, because it helps them to see how quickly they can liquidize their assets (citation). On the other side of the equation, liabilities and equity have to equal assets. The liabilities accounts show what the company owes. These are accounts such as accounts payable, wages payable, and unearned revenues. It is also separated into current and long term categories. For liabilities, this categorization helps the company to see which liabilities must be paid within each operating cycle (citation). Equity is what is owned by the stockholders (citation). One of the numbers on the balance sheet called retained earnings comes from another statement not discussed in this paper called the statement of retained earnings. This number reflects the net income or loss, minus dividends paid and shows what would be left if the company paid all their liabilities and liquidized their assets (SEC Emblem). Overall, the balance statement is helpful to the owners of the organization, because it shows their resources against what they owe at a given point in time (citation). This information is also helpful to investors and lenders who need this information to assess whether or not investing in a certain company is a good idea. Looking at the balance sheet they can see the company’s assets and liabilities and from that create ratios that tell them whether the company has a disproportionate number of liabilities and whether or not their investment will be worthwhile to them (citation). This should show the importance of the balance sheet to companies and investors. While the balance shows the accounts in the accounting equation, it is not sufficient to tell the company everything about its financial health. The information from the balance sheet is supplemented by other statements such as the income statement. The income statement uses information from the expanded accounting equation. This equation is assets = liabilities + common stock + revenues – expenses- dividends (Wild). The number that the income statement tries to find is the net income. As stated earlier, the net income is used in the statement of retained earnings, which is found in equity section of the balance sheet. Simply put, the net income is revenues minus expenses. While the balance sheet is like a photograph representing one moment in time, the income statement reflects a period of time. It records the revenues made in one period and the expenses used to make those revenues in the same period (Citation). This is helpful to the company to track which expenses were incurred to make revenues. Further categories on the income statement provide more detail about the revenues and expenses. If we look at a merchandiser, the income statement will also show the gross margin. This is helpful for the company to know because they can see the expenses of the goods that were sold for revenue (citation). Two types of incomes statements are the multi step income statement and the single step income statement. Both are useful for different things. This number represents the revenue brought in from sales minus, the cost of the items that were sold. The multi-step income statement shows expenses in two categories. These categories are operating expenses and non-operating expenses (investopedia). The purpose of this is so that it is obvious which expenses go towards operating the business and which do not. Both of these categories of expenses subtracted from revenues equal the net income or the net loss. The single step does not use these categories and shows more of an overview of the expenses. They still display the same net income or loss irrespective how many specific categories the expenses are broken into. A net income indicates that the company is making more money than it is spending. A net loss indicates that company is spending more than it bringing in. The income statement is important so that the company knows that it is making a profit rather than a loss. Anything alarming in regards to this will show up on it. Income statements can also be reviewed together to detect undesirable trends, such as an overall trend of a net loss (Citations). It makes it easier to see how to correct these trends because all the expenses incurred appear clearly labeled on the income statement next to the revenues. For this reason, this statement is important to potential lenders and investors. Clearly, if the company is losing money they may be hesitant to lend money they may not get back. For this reason, the company wants the income statement to display a net income, and to take measures to correct their financial issues if they see a net loss. The income statement shows the financial health of the company in regards to the revenues and expenses, however net income does not tell the company if it’s inflow of cash is sustainable. For that, another financial statement is required. The statement of cash flows tells the story of the cash account. As the name implies, it exists to make clear where cash is being used and brought in or how cash is flowing. In other words, it contains the reason for the change in the cash account between one balance sheet and the one before it. The company uses it to show that it is making cash in a way that it can be sustainable. The company’s income statement may show a net income, but that does not mean is not bringing enough cash in from sales to cover their expenses (citation). If it is the case that the company is using more cash than it is bringing in, the statement of cash flows will reveal this problem, but the income statement will not. It is also helpful because it shows specifically where a company is spending its cash and where it is bringing in cash through its different categories. To give a clearer indication of what these are, the statement of cash flows is separated into three categories: operating, investing, and financing activities. Operating activities are those that have to do with the net income. It starts with the income statement and makes adjustments so that only the accounts having to do with cash (or cash equivalents) are considered in the net income number, then it deals with the current asset and liability accounts on the balance sheet. Because it deals with current accounts, it helps the organization see a small picture of how it is doing financially (investopedia). The next two categories deal with long-term accounts and how the company will be doing in the long run (citation). The second category deals with cash involved in investing activities. Basically, these are changes in buying or selling long term assets. Any kinds of long term assets that purchased represent cash flowing out while selling these assets represent cash flowing in (citation). The third category is financial activities. This involves the cash brought in from stocks and cash paid for dividends (citation). If these categories added together equal a positive number it indicate that cash is flowing into the company. Because the statement of cash flows is split up into activities, it makes it easy to see where cash is being used and where it is being brought in. This indicates why it is important that the statement of cash flows is separated into multiple categories. Similar to the way that the balance sheet must balance, the statement of cash flows must also balance. The three categories added together should equal the amount of cash the company has which is indicated on the balance sheet. To summarize, the statement of cash flows can tell a company if they are bringing in enough money to cover their expenses. If they are not, this information would not appear in the income statement or balance sheet. Knowing whether or not you will be able to cover your expenses is essential information, making the statement of cash flows important to a company. Although the statement of cash flows balances like the balance sheet, it records a period of time like the income statement. It requires information from two balance sheets for this reason because it analyses the differences between them. In fact, the statement of cash flows uses both the balance sheet and the income statement. All three statements together tell a story that the statements cannot tell individually. The story that they are telling is the tale of the organization’s finances. The balance sheet shows the totals of all of a company’s accounts. The income statement provides the number that represents revenues minus expenses which is the net income or loss. This is factored into retained earnings, which appears in the equity section of the balance sheet. Therefore, to have a Balance sheet that balances the income statement must be correct making it dependant on the income statement. Additionally, the two reveal different things about the company’s financial well being. While the balance sheet shows the amounts in every account at a specific point in time, the income statement shows how revenues were earned in a certain period of time. Both the balance sheet and the income statement must be correct to make a statement of cash flows. The cash flow statement adjusts the net income (or loss) to reflect only the accounts that have to do with cash in that period. Then it observes the changes in the accounts on the balance sheet and records the flow of the cash into or out of those accounts. In this way the statement of cash flows provides the organization with information about how cash is being used and where cash is flowing in or out. The balance sheet and the statement of cash flows cannot exist without the income statement. They are like a family that works together. While I did not about ratios in this paper, I will note that the way that investors, lenders, and organizations are able to analyse the data in the financial statements is through ratios (investopedia). An organization uses this information to make responsible future choices concerning their finances, while investors use it to decide if the organization is worth investing in. They are helpful to everything involving the company’s financial decisions. In a sense, all the financial statements take the same information that is in the accounting equation and look at it in different ways. These different ways of seeing the information are helpful to business owners to assess how their organizations are doing and if they are making a profit. The balance sheet shows the resources that the company owns and the things that the company owes so that they can be compared against each other. It shows all the assets and liabilities, then takes information from the income statement (via the statement of retained earnings) to show what is owned by the stockholders. The income statement shows what expenses the company had to incur to make the revenues in the same period. From the income statement a company can see if it is making more than it is spending. The statement of cash flows examines at the cash account shown in the balance sheet and sees what caused the difference in the amount from a different balance sheet. It offers more information It looks at all accounts having to do with cash and accounts for the differences between them in different periods. In these different ways, the three statements show how the company is doing financially and if they are making profits that would attract lenders and investors. If the company is in trouble and needs to sort itself out, the financial statements will show that too. All three are necessary to the company because they show its financial health.