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Accounting is an important aspect in the field of business and commerce. It is defined as "the systematic recording, reporting, and analysis of financial transactions of a business" (Investorwords). The most important financial statements formulated in the accounting process include the balance sheet, the income statement, the statements of retained earnings and the statement of cash flows. These statements contain information regarding various financial transactions and the balances of the accounts of the items in relation to which transactions have taken place.
One of the chief functions of financial statements entails the provision of financial information to various persons associated with an organization, including investors, shareholders, creditors, debtors, business associates, managers, employees and owners. These persons are interested in determining the liquidity, profitability and solvency position as well as the value of the company. The value of the company is the measure of the worth of the company. It takes into account various factors such as market value of shares, value of owners' equity and the liquidity and profitability of the company.
Analyzing financial statements provides us with a correct valuation of the company as these include financial information that discloses the financial strengths and weaknesses of the company, the value of shareholders' equity as well as its liquidity, solvency and profitability.
Balance Sheet: A balance sheet can be defined as "a record of the financial situation of an institution on a particular date by listing its assets and the claims against those assets" (WordNet). In other words, a balance sheet is a financial statement that lists a company's assets and liabilities.
Example of Balance Sheet
December 31, 2010
Long term liabilities
One of the most important functions of a balance sheet is to provide information to the shareholders as well as creditors with respect to the amount that they have invested in the company or the amount that the company owes to them. Banks and other financing institutions can get an idea about the creditworthiness of the company by examining its assets. Since the balance sheet reveals the values of assets and liabilities, it provides us with a quite accurate idea of the valuation of a company.
Since a balance sheet shows the amount of owner's capital, it reveals what the firm is worth. An analysis of the balance sheet, thus, provides the owners with useful information to evaluate the future prospects of the company and guide them in decision making and in the formulation of business policies.
Income Statement: An income statement is "a document generated monthly and/or annually that reports the earnings of a company by stating all relevant income and all expenses that have been incurred to generate that income" (Entreprenuer.com). It is also referred to as a profit and loss statement.
Example of an Income Statement:
Income Statement of ABC Company Ltd. for the year 2010
By Interest received
To Interest paid
To Profit (transferred to Balance sheet)
By revealing the profit earned, or loss suffered by a company, an income statement allows owners and outsiders alike to make important decisions through its analysis, such as the profitability of the company, or reasons for losses.
The valuation of a company is based to a large extent upon its productivity and ability to earn profit. By investigating the values contained in the income statement of a company, users will obtain a clear cut idea with regard to the prosperity or otherwise of the business. It will demonstrate whether the activities of the company are proving to be favorable or not. Companies that earn larger amounts of profits will be valued higher than those with small amounts of gains or even losses.
Statement of Retained Earnings: "Financial statement showing the net income of a firm set aside as a reserve, paid out to the stockholders (shareholders), and consumed by the losses. It usually accompanies an income statement or statement of owners' equity" (Businessdictionary.com).
An illustration of a Statement of Retained Earnings is shown below.
Statement of Retained Earnings
XYZ Company Ltd.
Year ending December 31, 2010
Balance of Retained Earnings Dec 31, 2009
Dividend paid to shareholders
Balance of Retained Earnings Dec 31, 2010
Retained earnings of a company are basically the earnings that have been retained (as a reserve) by the company and not distributed to the shareholders in the form of dividends. Losses and other unforeseen contingencies are written off against these retained earnings. Furthermore, retained earnings are also used to pay dividends to shareholders, especially in case of losses or inadequate profits. Hence, retained earnings serve as a "backup" for the company and help it to meet its obligations in case of adverse conditions. Retained earnings are also used to for retention and reinvestment purposes, i.e. to fund activities related to expansion and development of the company.
The purpose of the statement of retained earnings is to show the values of profit earned (or loss incurred) during a year. The statement contains details regarding the net income for the year, the dividends paid to shareholders, the offset of losses, withdrawals by owners, investments made by owners and the balance remaining after the above adjustments.
In other words, the statement of retained earnings reveals the changes in retained earnings of the company. An examination of the statement reveals the profitability and solvency position of the company. If the retained earnings of the company are high and/or are increasing, one may infer that the company's profitability is good and the company is solvent as it has enough funds to hedge its activities against adverse situations. The value of such a company would be high. On the other hand, if a company's statement of retained earnings exhibit low or negative retained earnings (called retained losses) and if the measure of retained earnings is diminishing considerably every year, the valuation of such a company would be low.
Statement of Cash Flows: It is "a financial statement that reflects the inflow of revenue vs. the outflow of expenses resulting from operating, investing and financing activities during a specific time period" (Entrepreneur). A statement of cash flow or simply cash flow statement reveals only the cash coming into the business through revenues and cash going out of the business through expenses, without accounting for accrued revenues and expenses. Its purpose is not to provide insight into the profitability of the business, but the liquidity position of the company. An analysis of the statement illustrates the viability of the business and its ability to pay off short term expenses and debts (current liabilities).
Following is an example form of a Statement of Cash Flows
Statement of Cash Flows
For the Year Ended Dec 31 2008
Sources of Cash
From Operating Activities
Income for the year
Less: Adjustment for non-cash expenses
Net cash inflow from operating activities
From Investing Activities
Sale of investment
Less: Purchase of land
Net Cash outflow
From Financing Activities
Issue of capital stock
Less: Payment of bonds
Payment of dividends
Net cash inflow from financing activities
Opening cash on Dec 31, 2007
Add: Total cash inflow
Closing cash balance on Dec 31, 2008
A perusal and analysis of the statements of cash flow will reveal to creditors, investors, owners and management whether the company is solvent or not. The higher the liquidity and solvency of the company, greater will be its worth. Thus, the statement of cash flows is an important account that helps determine a company's value.
An important aspect of the analysis of financial statements and accounts of a company includes the formulation of accounting ratios in order to fully comprehend the liquidity, profitability and solvency of the company, and hence its value.
Accounting ratios of liquidity such as current ratio and quick ratio can be computed through the values of current assets and liabilities contained within the balance sheet. Similarly, for the calculation of profitability ratios, like net profit margin, return on equity, return on capital employed and return on assets, it is imperative to take into account the amounts included in the income statement, statement of retained earnings and balance sheet.
Other ratios including activity or efficiency ratios, debt ratios and market ratios also utilize the balance sheet, cash flow statement, income statement and statement of retained earnings in order to draw values for their computation. These statements contain values of various items in a concise and easy-to-find manner, thus allowing accounting ratios to be calculated easily. These ratios reveal the valuation of the company and since they are derived from the financial statements, one may conclude that these statements help to value a company.
Two principal methods used for market valuation of a company are Net Asset Value (NAV) method and Discounted Cash Flow (DCF) method. The first uses net value of all assets to determine the worth of the company, while the latter adjusts cash flows of the company for the time value of money. These methods use amounts contained in financial statements to compute the required values.
The above mentioned points clearly elucidate how the analysis of the financial statements of a company, including the balance sheet, income statement, statement of retained earnings and statement of cash flows provide us with a reasonable idea of the valuation of the company. Nonetheless, there are certain points that must be borne in mind in order to ensure that a correct and accurate valuation has been made. One must consider the errors and frauds that may plague the financial statements, such as unreasonable inflation of profits and concealment of material facts. It must be ensured that the company has a good internal control system and its accounts have been audited by external auditors. To get a better idea, financial statements of different years must be considered to ascertain trends in the activities of the business.
The value of a company depends greatly upon its creditworthiness, liquidity and solvency. Furthermore, the market valuation of a company is assessed through net asset value or discounted cash flows. The amounts required for these computations are contained within the financial statements of a company. Thus, with careful consideration and proper analysis, we may acquire a correct valuation of a company, through its financial statements of balance sheet, income statement, statement of retained earnings and statement of cash flows.