The Purpose of the Four Financial Statements

The four financial statements give individuals and organizations a window to "peer through to see what is inside the organization and how it is operating". It is hard to pay debt obligations or expenses effectively, grow, or invest if finances are not fully understood. Even if an individual or organization are not seeking to "get rich" it is still important to understand the financial pulse of the organization. The four financial statements that individuals or investors need to gain a better understanding of an organization’s business health are the income statement, balance sheet, statement of retained earnings, and statement of cash flows.

To address the financial statements, we must begin with the chart of accounts. The chart of accounts are the building blocks of the financial statements. It is absolutely critical that management keep a keen eye on developments in the chart of accounts. Placing limits and controls within the accounts can be the difference between profit and loss, cash flow, or credit rating issues. The chart of accounts essentially keeps a running tab of all the accounts (asset, liability, and equity) along with their account numbers.

Income Statement. The income statement provides information about profitability for a particular period for a company. The formula to determine, Net Income, is

                                                     Net Income = Revenues - Expenses

The income statement is a bit straightforward since it only contains the two accounts, revenues and expenses only. Subtracting the expenses from revenues leaves the amount of income remaining, or net income. Another term that is commonly used for net income is profit. Either an organization are operating in gains/profit (+) or at a loss (-). In order for the organization to remain in operations and sustainable, the revenues need to be consistently greater than expenses. A loss here, a loss there leaves room for recovery. But not very many individuals and organizations can sustain operating at a loss. If or when there are two consecutive periods of losses, management should review their strategic and financial strategies and make necessary adjustments to get the lagging performance objectives (sales, profit margin, etc.) back on track.

The key to ensuring an individual or organization uses the income statement as a competitive advantage is to focus on achieving total contribution where total revenues equal total expenses, preferably as early in the fiscal year as possible. Another way of thinking of it is finding the point, in dollars and units, at which costs equal revenue (Jay Heizer, 2017, p. 318). This is called break-even analysis!

Balance Sheet. The balance sheet provides information about assets the company has as well as liabilities the company owes (Tracie Miller-Nobles, 2018, p. 19). It also allows decision makers to determine their opinion about the financial position of the company.

Assets = Liabilities + (Owner's/Stockholder's) Equity

If you like taking photos, you can relate to the balance sheet by thinking of it as a still photo or ‘moment captured in time’ of the organization's overall business health.

The importance of the balance sheet is ensured both sides of the accounting equation are equal. One side will show exactly how much an individual or organization owns or has claims of assets, while the other shows the amount of leverage (or lack of) the individual or organization are using to support operations or performance...from period-to-period. If the balances are not equal, then there is an error that must be fixed. Overstating or understating values can lead to undesirable consequences, competitively and legally.

The key to ensuring an individual or organization uses the balance sheet as a competitive advantage is to focus on achieving low overall debt and cost of debt while increasing their assets and equity accounts. This leads to great financial statistics, favorable lending rates, and good credit rating!

Statement of Retained Earnings. The statement of retained earnings informs users about much of the earnings were kept and reinvested in the company (p. 19). The importance of the statement of retained earnings is to determine exactly how much the organization are keeping or retaining, from period-to-period.

Retained Earnings, Beginning + Net Income (Loss) for the period – Dividends for the period = Retained Earnings, Ending (Tracie Miller-Nobles, 2018, p. 19)

Knowing how much is being kept and reinvested back into the business matters. The most recent earnings figure should be equal to or greater than the last period. The key to ensuring an individual or organization using the statement of retained earnings as a competitive advantage is to focus on holding the previous period’s amount steady thereby increasing the amount each period on a consistent basis.

A separate financial strategy that could be executed is keeping the previous period’s earnings (in dollars) equal to or greater than previous period’s expenses can be beneficial and lead to more paid-in capital from current and prospective investors. As we are aware, investors love to see returns! This displays good management decisions and can lead to great financial statistics, favorable lending rates, and improved brand reputation!

Statement of Cash Flows. The statement of cash flows reports on an organization's cash receipts and cash payments for a period of time (p. 19). This allows people, like you and I, to view where management are spending cash. Cash are spent, generally, in three areas: financing activities, investing activities, and operating activities.

Operating activities involves cash payments and receipts for expenses. Investing activities involves the purchase and sale of land and equipment for cash. Financing activities involve cash contributions by investors and cash dividends paid to the investors. If there is a need to see precisely where the money is spent or invested, evaluating the cash flow statement can help in making business and financial decisions.

The performing organization or investor can evaluate business performance of the performing organization at any time period, if they possess accurate and reliable financial statements. Audited financial statements are the preferred method for evaluation and analysis. Use of the generally accepted accounting principles (GAAP) in the audited financial statements are as equally important. A high return on assets (ROA) are what we all seek, whether that be personal or business finance! We want to make money off of the assets we’ve invested into. Investors or learners can view public organizations and their business’ performance by viewing their financial statements using their ticker symbol on the Securities and Exchange Commission’s online platform.

In summary, a financial manager’s number one priority is to ensure he or she uses the statements as a competitive advantage as opposed to a competitive disadvantage. It is wise to use the financial statements to be proactive relative to the market, instead of reactive. In other words, stay ahead of the market instead of behind the market. When you’re ‘ahead’ of the market, you have time to make adjustments. When you are ‘behind’ the market the hole gets bigger, deeper, and longer to climb out of. Attention to detail on these statements can save in terms of time, effort, and money!

References

Jay Heizer, B. R. (2017). Operations Management: Sustainability and Supply Chain Management, 12th Edition. Pearson.

Tracie Miller-Nobles, B. M. (2018). Financial & Managerial Accounting, 6th Edition. Pearson Education.

U.S. Securities and Exchange Commission. (2024, April 2). Retrieved from www.sec.gov

---

Meet Nikia Smith, the Project Management Consultant driving success at Business and Wealth Generations. With over a decade of advisory expertise, Nikia orchestrates strategy and operations, spearheading growth and innovation. Beyond his professional endeavors, Nikia actively participates in his community, having served on the Board of Directors at the Project Management Institute Florida Suncoast Chapter in different roles for several years. Recognized for his contributions, he received the PMI Florida Suncoast Chapter Award in 2018 for significantly boosting membership and retention and was also selected to attend the 2019 PMI North America Leadership Institute Meeting in Philadelphia. Nikia holds a bachelor’s degree in management and organizational leadership with a focus on Project Management, alongside several business certificates from St. Petersburg College. He is also certified in CAPM and PMP by the prestigious Project Management Institute. For collaboration opportunities, reach out to Nikia at info@thebusinesswg.com.