The aim of any business is to make profit and remain solvent. This will make a business to be in a position to pay its creditors, employees and to be able to perform its daily activities. Accounting, in this regard helps in preparation of financial statements that will aid various parties in a business (both the internal and external) to appraise the profitability and solvency of the business. The primary function of accounting is to come up with the company’s performance within a stated period of time e.g. a one-year period. This is then availed to the tax authorities, creditors and investors of the organization.These parties then come up with their findings regarding the firm based on these financial reports.
Types of financial statements
This financial statement shows the liabilities and assets in a company. In addition, it shows the owner’s equity. A balance sheet helps to make important management decisions. This is based on balance sheet analysis statement. The balance sheet analysis statement helps the company to raise funds for accounting purposes. Most lenders analyze balance sheet statement for the last three years and make their decision. Thus, balance sheet analysis is important because it helps the external parties like investors and the government to take their decisions accordingly (Itelsen, 2009).
Statement of cash flows
This is a statement that shows both cash inflows and cash outflows in a specified period within an organization. Cash out flows are the expenses incurred during processing of a product, while cash inflows are revenues made by a company within a certain period of time. The analysis of both the cash outflows and the inflows are important to a company simply because they are both essential for proper financial management.
Statement of owner’s equity (statement of retained earnings)
Retained earnings are influenced by incomes and dividends as it appears on the balance sheet. The changes in retained earnings are explained by the equity statements. The statement is of significance to the balance sheet in that the information from the income statement normally provides balance sheet with important items.
The equation below shows and describes equity statement for a sole proprietorship:
- Being equity + Investment – Withdrawals + Income = Ending equity.
For a corporation, the equation is as below:
- Stockholders’ equity = retained earnings + preferred stock+ premium on common stock + premium on preferred stock +common stock
Relationships Between the financial statements
A company’s financial statement is developed through the process of book keeping of the business firm. This is done as the firm records its financial transactions during an accounting period and this is the time that the financial statement begins to appear. Financial statements are developed by recording the transactions in both the general ledger and the accounting journal. The statements come along as the records are kept. The accounting equation is the common denominator between the different types of financial statements. It is derived from the financial statements (Weygandt, 2008).
The income statement and the accounting equation
The income statement is the statement of profit and loss. This means that it is important because it indicates whether an organization is making profit or losses. A negative net income shows that the organization is losing money while a positive net income means that the organization is gaining money. Usually, an income statement is developed from the accounting entries for the expenses and revenues. This is done throughout the entire accounting period. The accounting equation is as follows.
- Assets= Liabilities + Owner’s Equity.
In this equation owner’s equity consist of revenues and expenses. Revenues increase owner’s equity while expenses decrease owner’s equity.
The balance sheet and the accounting equation
Business organizations use balance sheets to show how much money the business is worth. A balance sheet is therefore used to show the net worth of a business firm. A balance sheet is an indicator of net worth while income statement indicates profitability. The items in a balance sheet are given in terms of book value. The accounting equation in the two sides should reflect the format of a balance sheet. This is because every asset has to be purchased with a liability.
Financial statements are of significance to employees, managers, and creditors. This is because they are used as indicators of the progress of the firm. They show whether the company is making losses or gaining. Additionally, a company should remain solvent. This is important because it enables the managers to meet day –to-day activities. This will enable them to meet their goals and to evaluate potential creditors and key suppliers. Investors use financial statement to determine if a business is worth of an investment while for creditors it helps them in determining creditworthiness. On the other hand employees use financial statements to determine the viability of a company (Weygandt, 2008).
Itelsen, T. (2009). Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports. New York: Career Pr. Inc.
Weygandt, J. (2008). Financial accounting (6th ed.). Hoboken: John Wiley & Sons.