What Does a Financial Statement Include? Exploring 3 Key Components You Need to Know

In the first part, investors were introduced to financial statements as essential tools for analyzing a company's financial position and operational performance. Now, we will explore the details of each type of financial statement in greater depth to empower investors with the ability to make well-informed investment decisions. Broadly, financial statements are comprised of three main components:

1. Balance Sheet
2. Income Statement
3. Cash Flow Statement

1. Balance Sheet

The balance sheet presents an overview of a company’s financial position at a specific point in time, such as the end of the fiscal year. It consists of three main sections:

1.1 Assets

Assets represent what the company owns and can utilize to generate income or increase value. These are categorized into:

• Current Assets: Assets that can be converted into cash within one year, such as Cash and bank deposits, Trade receivables (amounts owed by customers) and Inventory
• Non-current Assets: Assets with a useful life exceeding one year, such as: Land, buildings, and equipment, Long-term investments and Intangible assets (e.g., patents or brands)

1.2 Liabilities

Liabilities represent financial obligations that the company must settle. These are divided into:

• Current Liabilities: Obligations due within one year, such as Trade payables (amounts owed to suppliers), Short-term loans
• Non-current Liabilities: Obligations with settlement periods longer than one year, such as Long-term loans, Bonds payable

1.3 Equity

Equity represents the residual interest in the company's assets after deducting liabilities. It includes:

• Share Capital: The capital registered during the incorporation process.
• Retained Earnings: Accumulated profits that are not distributed as dividends but are reinvested in the company or reserved for other purposes.

2. Income Statement

The income statement reports the company's revenues and expenses over a specified period, such as a quarter or year. The key components include:

2.1 Revenue

Revenue refers to the money earned from selling goods and services, categorized into:

• Operating Revenue: Core revenue from primary business activities, such as sales of goods.
• Non-operating Revenue: Revenue not derived from core activities, such as interest income.

2.2 Expenses

Expenses represent the costs incurred in conducting business operations, including:

• Cost of Goods Sold (COGS): Direct costs related to production.
• Operating Expenses: Other expenses, such as rent and salaries.
• Interest and Taxes: Costs for interest payments and income taxes.

2.3 Profit

Profit is the net result after deducting expenses from revenue, showcasing the company's profitability. Examples include:

• Gross Profit: Revenue after deducting COGS.
• Net Profit: Revenue after all expenses have been deducted.

3. Cash Flow Statement

The cash flow statement illustrates the inflow and outflow of cash within the company, divided into three sections:

3.1 Cash Flows from Operating Activities

This section highlights cash generated from core business operations, such as:

• Cash receipts from sales
• Payments to suppliers

3.2 Cash Flows from Investing Activities

This section shows cash used for investment purposes, such as:

• Purchase or sale of long-term assets
• Investments in other entities

3.3 Cash Flows from Financing Activities

This section reflects changes in the company’s capital structure, such as:

• Borrowing funds
• Paying dividends to shareholders

Interrelationship Among Financial Statements

Although the three financial statements provide distinct types of information, they are interconnected and collectively impact each other. To fully analyze a business, investors must grasp these interrelationships.

1. Relationship Between the Income Statement and Balance Sheet

Revenues and expenses in the income statement affect equity in the balance sheet:

• Net Profit from the income statement is recorded as Retained Earnings within the equity section of the balance sheet.
• If retained earnings increase, it indicates strong business performance and the ability to reinvest profits. Conversely, a decrease may result from losses or dividend distributions.

Uncollected revenues affect accounts receivable:

• Revenue from credit sales is recorded as Accounts Receivable in the balance sheet.
• When payments are collected, accounts receivable decrease, reflecting this change in the balance sheet.

2. Relationship Between the Income Statement and Cash Flow Statement

Net profit in the income statement serves as the starting point for operating cash flows:

• The cash flow statement begins calculating Operating Cash Flow using net profit from the income statement.
• Adjustments for non-cash items, such as depreciation, and changes in current assets and liabilities, are made to reflect actual cash flows.

Investment and costs influence profit and cash flows:

• COGS and operating expenses in the income statement impact operating cash flows. Effective cost control boosts cash flows.
• Investments in assets, such as machinery, are not immediately reflected in the income statement but appear under Investing Activities in the cash flow statement.

3. Relationship Between the Balance Sheet and Cash Flow Statement

Changes in the balance sheet are mirrored in the cash flow statement:

• Variations in Current Assets or Current Liabilities, such as increased trade receivables or decreased trade payables, are reflected in Operating Activities. Example: An increase in trade receivables implies reduced cash receipts, decreasing operating cash flows.
• Changes in Non-current Assets, like purchasing machinery or selling land, are shown under Investing Activities.

Financing activities affect both the balance sheet and cash flow statement:

• Issuing new shares increases equity in the balance sheet and is recorded under Financing Activities in the cash flow statement.
• Borrowing or repaying loans impacts liabilities in the balance sheet and is captured in the cash flow statement.

Key Takeaway

The interplay among the three types of financial statements is key to comprehensively understanding a business:

• The income statement demonstrates profitability.
• The balance sheet provides a snapshot of financial health at a given time.
• The cash flow statement reflects actual cash movements.

By analyzing these financial statements holistically, investors can gain a complete and precise understanding of a company's financial health and make more informed decisions.

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