Question

What is purpose of each of the financial statement below; support your answer with example

Income statement
Returned Earning statement
Balance sheet
Cash flow statement

Answer 1

1) Income Statement

The income statement, also called the profit and loss statement, is a report that shows the income, expenses, and resulting profits or losses of a company during a specific time period, especially, for a year. The income statement is the first financial statement prepared during the accounting cycle because the net income or loss must be calculated and carried over to the balance sheet statement before other financial statements can be prepared.
The income statement calculates the net income of a company by subtracting total expenses from total income. This calculation shows investors and creditors the overall profitability of the company as well as how efficiently the company is  generating profits from total revenues.

There are several different types of income statements that are created for different reasons. For example, the year-end statement that is prepared annually for stockholders and potential investors. Interim financial statements are prepared for management to check the status of operations during the year. Management also typically prepares departmental statements that break down revenue and expense numbers by business segment.

The purpose of the income statement is to show the reader how much profit or loss an organization generated during a reporting period. This information becomes more valuable when income statements from several consecutive periods are grouped together, so that trends in the different revenue and expense line items can be viewed.
The income statement contains several subtotals that can assist in determining how a profit or loss was generated.The gross profit is derived by netting revenues and the cost of goods sold together, and provides an indicator of the ability of a business to set price points that customers will accept, and to maintain the cost of the goods and services that it provides. The other subtotal is the operating profit, which is the gross profit minus all operating expenses (such as selling and administrative expenses). This subtotal reveals the ability of a firm to generate a profit before the effects of financing activities are factored into the final profit figure.

There are two different groups of people who use this financial statement: internal users and external users.
Internal users like company management and the board of directors use this statement to analyze the business as a whole and make decisions on how it is run. For example, they use performance numbers to decide whether they should open new branch, close a department, or increase production of a product.
External users are like investors, creditors & competitors. Investors want to know how profitable a company is and whether it will grow and become more profitable in the future. They are mainly concerned with whether or not investing their money is the company will yield them a positive return.
Creditors are more concerned with a company’s cash flow and if they are generating enough income to pay back their loans.
Competitors use P&L to gauge how well other companies are doing in their space and whether or not they should enter new markets and try to compete with other companies.

Example of the Income statement of Amazon co. :

Source: amazon.com

In the above statement , we can see how the operating income, net income & corresponding earnings per share of the co. increased every year from 2015 to 2017.

2) Retained Earning Statement

Retained Earnings (RE) are the portion of a business’s profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. Normally, these funds are used for working capital and fixed asset purchases (capital expenditures) or allotted for paying off debt obligations.

Retained Earnings are reported on the balance sheet under the shareholder’s equity section at the end of each accounting period.
The statement of retained earnings reconciles changes in the retained earnings account during a reporting period. Typically, an account “Retained earnings” has a credit balance. If this is a debit balance, the company has a loss, which is also indicated in the equity capital section of the balance sheet, reducing its value.
The statement begins with the beginning balance in the retained earnings account, and then adds or subtracts such items as profits and dividend payments to arrive at the ending retained earnings balance.

The RE formula is as follows:

RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends

Statement of retained earnings links the income statement to the balance sheet, showing how the period’s income statement profits either transfer to the balance sheet as retained earnings or shareholders as dividends.

Generally accepted accounting principles require that RE report be compiled whenever a balance sheet and income statement are presented. Public companies must publish their statement of retained earnings along with other financial statements quarterly and the end of each year to allow shareholders to make informed decisions.

RE statement helps shareholders and investors to evaluate the operations of the firm and predict future growth. This is important in decision making, whether to hold, buy, or sell company shares. They can also see the percentage of net income that is paid in dividends, which helps them to decide whether the company will be a good source of dividend income or if the prices of its shares will grow in the future.

Example :-

Company ABC
Statement of Retained Earnings
For the year ending December, 31st, 2019

Begining Balance in $ ml.
Retained Earnings on January, 1, 2019 3256,14
Net Ncome for fiscal year 2019 2689.55
Total 5945.69
Dividends declared & paid on 2019
Dividends paid on preferred stocks (56.89)
Dividends paid on common stocks (215.63)
Total Dividends Deducted (272.52)
Ending Balance Retained Earnings December, 31, 2019 5673.17

3) Balance Sheet

A balance sheet is a statement of the financial position of a business that lists the assets, liabilities, and owner's equity at a particular point in time.
The balance sheet displays the company’s total assets, and how these assets are financed, through either debt or equity. It can also be referred to as a statement of net worth.
This statement is used to analyze a company’s financial position. An analyst can use the balance sheet to calculate a lot of financial ratios (like current ratio, quick ratio, total debt/equity ratio etc.) that help determine how well a company is performing, how liquid or solvent a company is, and how efficient it is.

Important purposes include:

1. Liquidity – Comparing a company’s current assets to its current liabilities provides a picture of liquidity. Current assets should be greater than current liabilities so the company can cover its short-term obligations. The Current Ratio and Quick Ratio are examples of liquidity financial metrics.
2. Leverage – Looking at how a company is financed indicates how much leverage it has, which in turn indicates how much financial risk the company is taking. Comparing debt to equity and debt to total capital are common ways of assessing leverage on the balance sheet.
3. Efficiency – By using the income statement in connection with the balance sheet it’s possible to assess how efficiently a company uses its assets. For example, dividing revenue into fixed assets produces the Asset Turnover Ratio to indicate how efficiently the company turns assets into revenue. Additionally, the working capital cycle shows how well a company manages its cash in the short term.
4. Rates of Return – The balance sheet can be used to evaluate how well a company generates returns. For example, dividing net income into shareholders’ equity produces Return on Equity (ROE), and dividing net income into total assets produces Return on Assets (ROA), and dividing net income into debt plus equity results in Return on Invested Capital (ROIC).
5. Generally, investors and creditors look at the balance sheet of the company to understand how effectively a company will use its resources and how much it can give in return.
   While applying for a business loan, a company has to submit a balance sheet to the bank.
6. A potential acquirer of a business examines a balance sheet to see if there are any assets that could potentially be stripped away without harming the underlying business. For example, the acquirer can compare the reported inventory balance to sales to calculate an inventory turnover level, which can indicate the presence of excess inventory.
   Company’s balance sheet analysis can detect business expansion and future expenses.

Example :-

Balance Sheet of XYZ Ltd. as at 31st December, 2019

ASSETS	$	LIABILITIES	$
Current Assets:		Current Liabilities:
Cash in Bank	$18,500.00	Accounts Payable	$4,800.00
Petty Cash	$500.00	Wages Payable	$14,300.00
Net Cash	$19,000.00	Office Rent	—
Inventory	$25,400.00	Utilities	$430.00
Accounts Receivable	$5,300.00	Federal Income Tax Payable	$2,600.00
Prepaid Insurance	$5,500.00	Overdrafts	—
Total Current Assets	$55,200.00	Customer Deposits	$900.00
		Pension Payable	$720.00
Fixed Assets:		Union Dues Payable	—
Land	$150,000.00	Medical Payable	$1,200.00
Buildings	$330,000.00	Sales Tax Payable
Less Depreciation	$50,000.00	Total Current Liabilities	$24,950.00
Net Land & Buildings	$430,000.00
		Long-Term Liabilities:
Equipment	$68,000.00	Long-Term Loans	$40,000.00
Less Depreciation	$35,000.00	Mortgage	$155,000.00
Net Equipment	$33,000.00	Total Long-Term Liabilities	$195,000.00
		TOTAL LIABILITIES	$219,950.00
		Owners' Equity:
		Common Stock	$120,000.00
		Owner - Draws	$50,000.00
		Retained Earnings	$128,250.00
		Total Owners' Equity:	$298,250.00
TOTAL ASSETS	$518,200.00	LIABILITIES AND EQUITY	$518,200.00

4) Cash Flow Statement

The purpose of the cash flow statement is to identify the major cash flows occurring during the same period of time as the company's income statement and between the related balance sheets.
The cash flow report is important because it informs the concerned parties about the business cash position. For a business to be successful, it must have sufficient cash to pay its expenses, bank loans, taxes and to purchase new assets. A cash flow report determines whether a business has enough cash to do this. Having cash is a key requirement for a business to stay solvent. When a business has no longer enough cash to pay its dues, it is often declared bankrupt.
The CF statement is important for analyzing the liquidity and long term solvency of a company.
The major cash flows are presented in one of these classifications:

• Operating activities
• Investing activities
• Financing activities

The net change from these three classifications also explains the major reasons for the change in the company's cash and cash equivalents between two balance sheet dates.
The cash flow statement is required to disclose other information, including the amount of interest paid, the amount of income taxes paid, and any significant investing and financing activities which did not require the use of cash.

The cash flow statement uses cash basis accounting instead of accrual basis accounting which is used for the balance sheet and income statement by most companies. For example large entities like Nike and Microsoft will often have a significant amount of non-cash transactions, sometimes even billions of dollars in revenue that is simply owed to them but hasn’t been received in cash yet. In these situations, an Income or B/S statement is not always sufficient, and a cash flow report is valuable to many users, such as banks and shareholders.

Exanple :-