What are Financial Statements? How is it Important for a Business?

Effective financial management is crucial for the success and sustainability of any business. But how can a company’s leadership group, investors, and other stakeholders comprehend and analyse its finances? This is where financial statements come into the picture.

Financial statements provide a complete overview of a company's financial data. They offer valuable insights into its financial health and performance, allowing the management team and investors to make well-informed decisions.

It becomes necessary to delve deep into the intricacies of financial statements, exploring what is a financial statement, the types of financial statements, and how they can help various stakeholders involved in a business.

Financial statements are documents that reflect financial data and performance during a given period. They represent a formal record of an organisation's business activities and financial transactions. Investors, company board members, and other stakeholders rely on financial statements to assess the company’s financial strength and gain insights into its current and future success. Shareholders utilise these statements to evaluate the status of their investments in a business.

The financial statements for Indian businesses usually comprise three components – the balance sheet, the income statement, and the cash flow statement. Each serves a specific purpose in providing a comprehensive overview of the company's financial performance.

1. Balance Sheet

   A balance sheet discloses a company's assets, liabilities, and shareholders' equity. It is a glimpse into a company's financial position at a specific time period. In simpler words, a company’s balance sheet displays the residual amount after liquidating (selling) all its assets and settling debts. Lenders and investors rely on the balance sheet to evaluate the company's liquidity, solvency, and overall financial health.

2. Income Statement

   The income statement summarises a company's revenues and expenses during a specific period. It indicates whether the company has incurred a net loss or profit during an accounting period. Investors and stakeholders can analyse the company’s income statement to assess its ability to generate profits and manage working capital.

3. Cash Flow Statement

   A company’s cash flow statement tracks the inflow and outflow of cash during a specific period. It indicates how much cash flows into a business and how it is being used to generate profits. Positive cash flow indicates profits, whereas negative cash flow reflects losses. Business owners, financial analysts, and investors can analyse the cash flow statement to assess the company’s ability to generate sustained profits and maintain operational liquidity.

4. Statement of Shareholders’ Equity

   It tracks how much profit is kept in the business after paying dividends. Starting with the opening balance, it adds net income and subtracts dividends. The closing balance shows how much has been reinvested, helping long-term investors assess the company’s growth and reserve strategy.

5. Statement of Retained Earnings

   The statement of retained earnings specifically focuses on how profits are retained in the business. It starts with the opening retained earnings, adds net income for the period, and subtracts dividends paid. The closing retained earnings figure reflects the company’s ability to reinvest profits back into operations or reserves.

6. Notes to the Financial Statements

   These explanatory details support and clarify the figures presented in the primary financial statements. They may include accounting policies, breakdowns of specific line items, contingent liabilities, asset valuations and related-party transactions. This, in turn, helps interpret the financials correctly and identify any hidden risks or assumptions.

The importance of financial statements for Indian companies in many ways. Listed below are a few aspects that depict how these documents shape a company's strategic direction:

• Ensures Regulatory Compliance

  When it comes to global finances and Indian businesses, financial statements play a crucial role in complying with legal and regulatory requirements. They contribute to increased transparency and accountability, ensuring the company adheres to prescribed norms and guidelines. As per the Securities and Exchange Board of India (SEBI) guidelines, all listed companies must release annual financial statements on their websites.

• Facilitate Research and Financial Analysis

  The financial statements of companies facilitate research and financial analysis along with credit evaluation of an entity. Investors, lenders, and other stakeholders can analyse these statements to gauge a company’s profitability, liquidity, solvency, and overall financial performance to make well-informed investment or lending decisions.

  Furthermore, financial statements facilitate comparability among various companies using standardised accounting principles and can provide credit solutions. For example, investors can compare the balance sheets of different companies to analyse their financial standings and make informed investment decisions.

• Helps the Government in Policymaking

  Financial statements aid the government in formulating taxation and regulatory policies based on the companies’ operational and financial performances. Government authorities can assess and levy taxes on businesses according to their income and asset levels reflected in their financial statements.

• Calculation of Financial Ratios

  Financial ratios, such as the Price-to-Earnings (P/E) ratio, Earnings Per Share (EPS), Debt-to-Equity (D/E) ratio, etc., help financial analysts and investors accomplish a comprehensive picture of a company’s financial health. Financial statements contain several values, including annual profits, shareholders’ equity, etc., that are essential for calculating these ratios.

Listed below are the different ways financial statements help in making informed decisions:

• Strategic Business Planning

  Financial statements provide insights into revenue patterns, cost structure, profitability and resource allocation. Business owners and leadership teams use this information to assess what is working, what is underperforming and where to allocate resources.

• Investment and Funding Decisions

  They help lenders, investors, and financial institutions evaluate risk and potential return. Profitability, liquidity and solvency ratios drawn from these statements help determine creditworthiness, valuation and suitability for equity infusion. Businesses also use them to decide the best time and method for raising capital.

Financial statements have key limitations. They are based on historical data and may not reflect current conditions or future performance. Intangible assets like brand value and employee skill are often excluded. Differences in accounting policies affect comparability. These statements also typically use historical cost accounting and may not reflect inflation-adjusted values. This can distort asset values and reduce the accuracy of financial analysis.

Below is a guide to reading financial statements effectively:

1. Start with the Income Statement

   This tells you whether the company is profitable over a specific period. Check revenue trends, gross margin and net income for key performance signals.

2. Review the Balance Sheet

   Look at assets, liabilities and equity to assess the financial position. It shows what the company owns, owes and how much shareholders have invested.

3. Examine the Cash Flow Statement

   Focus on cash from operating activities to understand if the business generates real cash or only paper profits. Pay attention to any large changes in investing or financing activities.

4. Read the Notes to Financial Statements

   These notes explain accounting methods, breakdowns and hidden details. They provide essential context to the numbers shown in the main statements.

5. Analyse Key Ratios

   Use ratios like current ratio, debt-to-equity and return on equity to draw insights. They simplify large datasets and help with performance comparisons across time or competitors.

Each financial statement serves a specific purpose. But they are interlinked to present a full financial picture. The net income from the income statement feeds into the cash flow statement and the retained earnings section of the balance sheet. The cash flow statement, in turn, reflects how income and balance sheet changes affect liquidity. These connections ensure that financial performance, resource position and cash movements are aligned.

Financial statements are essential tools that provide valuable insights into a company’s financial health and global financial management. They facilitate research, analysis, and comparability among various companies and help investors and lenders make well-informed investment or lending decisions.

Financial statements also aid the government in formulating taxation and regulatory policies based on companies' operational and financial performances. Furthermore, by understanding the importance of financial statements, businesses can build a robust foundation for long-term growth and expansion.