We all know that four statements make up the set of financial statements. It is also well known that none of the statements alone can show a complete picture of the company's standing, and they must be seen in unison to make sense of all the aspects of a company's financial standing.
But suppose you have to look at only one statement (and no other statement at all); which one will you choose to understand the company's financial position?
It is a question that a lot of accountants debate upon. Here is our take on it.
Before we delve into the question, let us recap what these four statements are, just to be on the same page.
Financial statements are summarized records of an entity’s financial activities prepared under generally accepted accounting principles. It shows the entity's financial position, profitability, and growth potential. A set of financial statements comprises -
1. Balance sheet or Statement of financial position: It is a statement reflecting an entity’s assets, liabilities, and owner’s equity at any given time; in other words, the balance sheet provides details of the company's sources of funds and utilization. Balance sheet is based on a simple equation: ASSETS = LIABILITIES + OWNER’S EQUITY
2. Profit and Loss a/c or Income statement: It reflects the entity’s revenue, expenses, and profits/losses for a given period. It helps us understand the business's operations, including revenue from operations, cost of sales, non-operating expenses, and tax effect.
3. Cash flow statement: Statement highlighting cash generated or cash incurred by each of the following classes of business activities: Operating, Investing, and Financial, over a given time.
4. Statement of equity: It is a statement highlighting changes in owner’s equity over a given period. Change in equity may be due to numerous factors like- the issue of new shares, the dividend paid, profit/loss during the period, change in accounting policies, etc.
Now, let us return to our question, “Which is the most important financial statement?”
Most of us believe that the income statement is the most important financial statement as it shows the profit generated by the business. But do you think profit alone is the correct way to measure the performance of any business?
Let us try to understand this with an example. Entity A earns a net profit of $10,000, and Entity B earns a net profit of $8,000. By looking solely at the income statement, the opinion we derive will be Entity A is a better-performing entity. Now, if I add more information, the amount invested by Entity A is $100,000, and that for Entity B is $64,000. Do you still believe Entity A is better? Definitely not. Return for Entity A is 10% while it is 12.5% for Entity B, which implies entity B is a better performing entity.
The income statement does not show the return on investment, which is ideally a better way to understand the financial performance of any business. Then what is the answer to our question?
The most irritating answer we can get to our question is, "it depends!". Unfortunately, we have no choice but to give this irritating reply here - because that is the truth. But do not worry; we will not leave you with this cliffhanger. We will work together through a model to help us choose "the statement" from the set.
Let us dive in further and figure out which statement you should choose. To understand this, we will have to look at your different objectives for selecting the correct financial statement.
We all know that a business cannot operate without cash. The cash flow statement reports the movements of cash and its effect on an entity's cash position over time. Cash is vital to a business's survival, making this statement very important.
But why is the cash flow statement the most crucial statement?
Whenever we evaluate whether to grant credit or not, what is the first thought that comes to our mind? For every one of us, the answer to this question remains the same. “Whether I will be able to get my money back?”
The answer to this obvious question is derived from the cash flow statement, which makes it the most critical statement in the following cases - granting a loan to an entity, extending a credit facility to a supplier, vendor, or customer, or when we are investing for a long term in any business.
Now you must be wondering, how does the cash flow statement answer the question?
The statement of cash flows summarizes the inflows and outflows of cash (and cash equivalents) for a business over a period. To aid our understanding, these cash flows are divided into three categories: Operating, Investing, and Financing. Cash inflows and outflows falling within each category are added to provide a total for that category.
These totals are shown on the statement of cash flows and, when added together, reveal the net increase or decrease in cash (and cash equivalents) over the period. And when we know whether the entity can generate cash or not, we get a fair idea about the safety of our investment or credit granted.
But, if you are planning to acquire a company, the cash flow statement does not serve the purpose. In that case, the balance sheet becomes the most important financial statement.
How does the balance sheet serve our purpose?
The statement of financial position (Balance sheet) shows the various assets (including cash) and liabilities (including the shareholders’ equity) of the business at a particular point in time. It provides insights into how the business is financed and how the funds are deployed. The balance sheet shows the contribution made by owners and outside lenders. It also highlights the types of assets acquired.
The balance sheet gives a fair valuation of the business, which is the first step in acquiring the business. It helps in measuring the performance of a business. The effectiveness of a business in generating wealth can usefully be assessed against the amount of investment involved.
Thus, the relationship between the profit earned during a period and the value of the net assets invested can be helpful for many of us.
Does that mean the Income statement is not important?
Of course, not. The income statement would be the most important if you want to evaluate a business's performance or ascertain your tax liability.
The income statement (Profit and loss account) measures and reports how much profit a business has generated over time. It is, therefore, an immensely important financial statement for many users. It simply shows the total revenue generated during a particular reporting period and deducts the total expenses incurred in generating that revenue.
The difference between the total revenue and expenses will represent either profit (if revenue exceeds expenses) or loss (if expenses exceed revenue).
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In this blog, we tried to answer the age-old question about the most important financial statement in the context of the objective of perusing the statement. In an attempt to answer this question, we also took the opportunity to dig deeper into the aspects of the company that each statement brings out better than the other. The financial statements are not substitutes for one another; instead, they perform different functions.
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