PFinancial statements are the means by which economic entities report information about their financial position, their performance, and their cash flows (Zuca, 2017). The information presented in financial statements is utilized by diverse users, both internal and external, to make informed financial decisions regarding the company (Lan, 2012). Because of their importance for such decision making, financial statements must be prepared according to certain standards which focus on three key qualitative characteristics: the relevance of the information reported, the understandability of the information, and the timeliness of the information (“Making Financial Reports”, 2012). The standards followed by U.S. organizations are called General Accepted Accounting Principles, better known as GAAP (“About GAAP”, n.d.). According to Lan (2012), the most important financial statements reported by companies and most often used by decision makers are the income statement, the balance sheet, and the statement of cash flows. The purpose of this paper is to discuss the importance of each financial statement as an informational source to management, the internal users, for making informed financial decisions. Accordingly, there will be four sections to this paper. The first section will define the balance sheet and state its importance to managers for making decisions. The second section will define the income statement and state its importance to managers for making decisions. The third section will define the statement of cash flows and state its importance to managers for making decisions. Lastly, the fourth section will be the conclusion and will state the authors’ opinion on which financial statement is most important for making managerial decisions.
Balance Sheet
Definition
The balance sheet is considered to be the summary financial statement which presents all of the company’s assets, liabilities and equity at the end of the period. By applying the equation “assets = liabilities + equity”, the balance sheet provides information on the nature and amounts invested in the company’s resources (assets), its obligations to creditors (liabilities) and the ownership interest of the company’s resources (equity) (Lan, 2012; Marin & Lazar, 2016). Assets are listed on the balance sheet in order of liquidity, meaning that the most liquid asset (cash) is listed first. Assets are further separated into current assets, which are assets that can be converted into cash within one year, and long-term assets, which are assets with a useful life extending more than one year. Liabilities are separated into current liabilities, which are liabilities which must be paid within the next 12 months, and long-term liabilities, which are liabilities that are due in over 12 months (Arnow & Xakellis, 2001).
Importance to Managers for Decision Making
Managers can use the balance sheet in conjunction with financial ratios to evaluate the financial health of their company as well as for strategic management. One such ratio, the current ratio, measures the liquidity of the company. Liquidity is basically the ability of the company to pay its bills. The current ratio divides current assets by current liabilities as a measure of whether a company is able to meet its obligations for the next year. A resulting high ratio indicates a higher level of liquidity and the company’s ability to meet obligations (Arnow & Xakellis, 2001). Another ratio, the debt-to-equity ratio, is important for measuring the solvency of the company. Solvency is the company’s borrowing power and its ability to withstand an economic downturn. The debt-to-equity ratio determines solvency by dividing total liabilities by total equity. The higher the ratio suggests a weaker solvency and a higher financial risk (Arnow & Xakellis, 2001).
Income Statement
Definition
Whereas the balance sheet is the summary financial statement which gives a snapshot view of a company’s funds at the end of a period, the income statement is considered a flow statement which explains the changes that took place in the retained earnings account of the balance sheet (Hadzhikotev, 2013). By applying the equation of “revenue – expenses = income”, the income statement provides information regarding how much revenue was generated by the company, the expenses incurred by the company, and the resulting net profit or loss during the reporting period. The reporting period is always one year, which can be a company’s calendar year or fiscal year (Lan, 2012).
Importance to Managers for Decision Making
The income statement essentially measures the profitability of the company. Since companies will not survive over time without generating a profit, profitability is the primary goal of all business endeavors and the most important measure of success (Hofstrand, 2009). This makes the information reported in the income statement important to the company’s management. The income statement provides management with three important tools: the ability to see the company’s performance during the period, the ability to compare the performance of the business over multiple periods, and the ability to use the current period’s income statement for planning to determine how certain business decisions might affect profits (Sangl, 2009).
Although the income statement may show a business to be profitable, that does not necessarily mean that the business will not encounter a problem with cash flow. Whereas the income statement shows profitability, the next financial statement, the statement of cash flows, focuses on liquidity (Hofstrand, 2009).
Statement of Cash Flows
Definition
The statement of cash flows explains the changes that occurred in cash and cash equivalents for the period of the statement (Hadzhikotev, 2013). There are two methods allowed for its preparation: the indirect method, which reconciles net income on accrual basis to net income on a cash basis, and the direct method, which reports the operating cash receipts and disbursements which comprise net cash flows from operating activities (Petro & Gean, 2014).
The statement of cash flow contains three sections: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. The net change from these three sections will equal the change in a company's cash and cash equivalents reported during the period. Companies experience cash inflows when there are increases in the cash balance for the period and cash outflows when there are decreases in the cash balance (Hadzhikotev, 2013).
Importance to Managers for Decision Making
Management is concerned with the future operating results of their company, therefore, sufficient cash must be generated for the company’s continued existence. Measuring the cash inflows and outflows of a company can yield crucial information for management regarding a company’s short-term liquidity, long-term solvency, and overall operating performance (Hadzhikotev, 2013).
Conclusion
Although information found in the financial statements alone cannot provide a company’s management with all information needed to make crucial financial decisions, they can be of great benefit in their analysis. As was discussed, managers are able to use the balance sheet to make decisions which may affect the liquidity and solvency of the company. Managers are able to use the income statement to make decisions which may affect the profitability of the company. Managers can use the statement of cash flows to determine the company’s ability to meet obligations on time, its capacity for growth and its ability to sustain operations.
In the Authors’ opinion, the Statement of Cash Flows is the most important financial statement to managers for making financial decisions regarding their respective companies. A company’s ability to meet obligations and its capacity for profitability and growth depends on cash. According to Hadzhikotev (2013), a shortage of cash is the most critical factor that can determine the insolvency of a company. Cash is necessary for the operations and continued existence of any company. Cash is the medium through which a company is able to purchase inventory, pay employees, pay lenders, and pay dividends to stockholders.
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