Financial Statements are accounting reports that summarize a business’s activities over a period. Essentially, they give business investors, lenders, and creditors an idea of its financial health. We have various types of Financial Statements: The Statement of Financial Position (Balance sheet), The Income Statement, the Cashflow Statement, and the Statement of Change in Equity.
The Statement of Financial Position or Balance Sheet
A Balance Sheet is a financial statement that reports a Company’s assets, liabilities, and shareholder equity. It provides a snapshot of a company’s finances. What a business owns is equal to what a business owes. A business owns assets and owes liabilities to third parties, but it also owes equity to those who own the business. For a company listed on a stock exchange, that would be the shareholders. As suggested by its name, a Balance Sheet abides by the equation below:
Assets = Liabilities + Equity
I know you might be wondering how this relates to the Financial Statement. The answer to that is the equal sign (=). The equal sign tells us that assets always have to balance with their Liabilities and Equity. When we pick a business and look at this accounting equation at a single point in time, we are looking at a Balance Sheet.
Let us take a look at equity. Equity denotes the value left over after liabilities have been removed. Recall the accounting equation; If you take your Assets and subtract your Liabilities, you are left with equity, which is the portion of the Company that the investors and owners own. Owners equity can be divided into two: Capital Contribution and Retained Earnings.
Capital Contribution and Retained Earnings
Capital Contribution is the money invested into a business by its owners in exchange for a share of the equity. This makes you a shareholder and part of the business. Contributed capital increases if investors (either existing or new ones) make additional contributions and decreases if the Company repurchases any of its outstanding stock.
Retained Earnings are accumulated profits for future use. Profit is a Company’s financial benefit when its revenues are greater than its expenses. And a business’s accumulated profits for future use are called its retained earnings. This is left over after we add up all the Company’s profit and remove what has been withdrawn by the owners. Retained earnings are made up of opening retained earnings, which is last year’s retained earnings carried forward into the start of this year, plus current year profits, which is the difference between revenue and expenses, minus current year withdrawals. The profit distributions to the business owners or shareholders are called Dividends.
In conclusion, the balance sheet is an essential tool used by executives, investors, analysts, and regulators to understand the current financial health of a business. It is generally used alongside the two other types of financial statements: the income statement and the cash flow statement. The balance sheet can help users answer questions such as whether the Company has a positive net worth, has enough cash and short-term assets to cover its obligations, and is highly indebted relative to its peers.
In my next post, I will discuss the other Financial Statements: Income Statements and Cashflow Statements.
Written by Tutty Tero