Question

Please define the relationship between the balance sheet, income statement, and the statement of cash flows. Demonstrate your understanding of these financial statements and their limitations by selecting four ratios that you think are important in evaluating the strength of an organization’s financial position.

Answer 1

Balance sheet, Income statement, and the statement of cash flows are the basic financial statements. The income statement measures the earnings of an entity's operations over a given period of time. The Income statement is used to measure profitability, creditworthiness, and investment value of an entity. The cash flow statement shows company's cash inflows, cash outflows, and the net change in cash from it's operating, financing, and investing activities during the accounting period, in a manner that reconciles the beginning and ending cash balances. The statement helps interested parties determine if an entity needs external financing or if it is generating sufficient positive cash flows to meet it's obligations and pay dividends. A balance sheet is a financial statement that reports a company's assets, liabilities and shareholders' equity. It shows the financial position of a company at a point of time.

The 3 financial statements are all linked and dependent on each other.

• The net income in the income statement is added to the retained earnings line in the balance sheet, which alters the amount of equity listed on the balance sheet.
• The net income figure also appears in the cash flows from operating activities section of the statement of cash flows.
• Changes in various line items in the balance sheet roll forward into the cash flow line items listed on the statement of cash flows.
• The ending cash balance in the balance sheet also appears in the statement of cash flows.
• The purchase, sale, or other disposition of assets appears on both the balance sheet (as an asset reduction) and the income statement (as a gain or loss, if any).

Limitations of the financial statements

• Most asset accounts of a nonfinancial nature are reported at historical cost. While Historical cost measures are considered reliable , they are also considered less relevant than fair value.
• Financial statements incorporate the use of numerous estimates and professional judgements.
• The statement of cash flows omits non cash transactions such as exchange of stock for property.

Important Ratios that helps to evaluate the strength of an organization's financial position are,

1. Debt- Equity Ratio= Total Debt/ Equity (Shows the ability of the company to pay it,s debts)

2. Current Ratio = Current Assets/ Current Liabilitues ( to check Liquidity)

3. Earnings per share = Earnings/ Number of shares outstanding.

4. Long term debt to equity ratio= (Total debt- Current liabilities)/ Equity

5. Debt to Total Asset Ratio= Total debt/ Total Assets

6. Interest Coverage(Times Interest Earned) Ratio= EBIT/ Interest expense