Tuesday, August 28, 2007

The 3 Critical Financial Statements

There are three vital statements for understanding the condition of a business or entity: (1) the Profit and Loss Statement, (2) the Balance Sheet and (3) the Sources and Uses Statement. Each of them provides a different perspective of how an entity is operating. Combined, they show examiners the health of the business. Each statement reflects a different perspective on the business’ financial operations.

The first statement, the Profit and Loss, can also be called the Income Statement. It documents the amount of money coming into the entity (the income) and the money going out of the entity (the expenses). The difference between what comes in and what goes out is the Net Income, if there is more money coming in than going out. If not, there is a Net Loss. The statement covers a specific period, which is shown in the heading of the statement. Note that it tells us nothing about what has happened for any date that is not included by the statement dates. Think of it as a snapshot for the specific time period. Some common snapshot periods are monthly, quarterly and yearly ones.

The second statement, the Balance Sheet, covers the condition of the business from the time it began until the ending date on the statement. The Balance Sheet reveals three important business characteristics: (1) it summarizes the assets owned by the entity (e.g., buildings, bank accounts, inventory, etc.); (2) the entity liabilities (e.g., loans, outstanding bills, etc.); and (3) the business owners’ equity. The statement is arranged in what is called the ‘accounting equation’, which indicates total Assets will equal the sum of Liabilities and Equity. Balance Sheets are commonly issued at the same frequency as the Profit and Loss and usually reflect the business on the last day of the Profit and Loss period.

Finally, the Sources and Uses Statement reveals how the business received and used funds during the statement period. It shows how much money was provided by business operations and how much was provided by loans or capital received by the entity. The statement also summarizes how the funds were used by the entity. It demonstrates if the company is healthy, headed for trouble, or just bouncing along. Like the Profit and Loss, this statement covers only the period shown in the statement heading. It says nothing about any period not included in the statement. Again, the statement usually covers the same period as the Profit and Loss.

Taking these three statements together, there is a present picture of the business. From the Profit and Loss, comes how well it did during the period, a short-term perspective. From the Balance Sheet it is seen how the entity is accumulating assets or liabilities, from a long-term perspective. Finally, the Sources and Uses statement demonstrates where and how efficiently the entity resources were used during the period. All three perspectives are important to the entity overview.

To an investor or owner the statements answer three questions about the entity. Did the entity make a profit? Did the entity increase the owners’ equity? And finally, were entity assets used efficiently? From the overviews in these three statements, further questions might be formulated in specific areas.

Michael Russell

Your Independent guide to Accounting

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