What is Financial Statement? Types: Profit and Loss Account, Balance Sheet, Cash Flow Statement

What is Financial Statement?

A financial statement is a document that summarizes the financial transactions of a business or an individual over a specific period. It typically includes information on assets, liabilities, revenues, expenses, gains, and losses, and provides an overview of the financial health of the entity.

The three main types of financial statements are the income statement (also known as the profit and loss statement), the balance sheet, and the cash flow statement.

Financial statements are important for analyzing the performance of a business and making informed financial decisions. They are also used by investors, lenders, and other stakeholders to evaluate the financial health and profitability of a company.

The primary aim of investing money in a business is to earn profits. An organisation needs to periodically evaluate the profits earned and losses incurred and the financial standing of the organisation on a given date.

The primary aim of investing money in a business is to earn profits. An organisation needs to periodically evaluate profits earned and losses incurred and the financial standing of the organisation on a given date. In addition, different users of accounting information have different requirements.

These requirements can be fulfilled by preparing final accounts also called financial statements, which provide profit earned and the losses suffered by a business. A financial statement is an official record of all financial transactions of an organisation for a particular period of time. It reflects financial position (or financial health) and performance of the organisation.

As per this section, a company’s financial statement must include a balance sheet for the concerned financial year, statement of disclosure pertaining equity changes, cash flow statement, profit and loss account in the case of profitable organisations or income and expenditure account in the case of non-profit organisations such as, charitable trusts, hospitals, educational institutions.

However, in the case of one person company, small company and dormant company, there is no requirement to include cash flow statement.

A business owner would be interested in knowing whether his/her business is running at a profit or incurring loss, the actual financial position of the business, etc. The main aim of Financial Statements is to inform the owner about the progress of his/her business and the financial position at the right time and in the right manner.

Types of Financial Statements

There are mainly three types of Financial Statements in an organisation.

Profit and Loss Account

Profit and loss account is prepared so as to ascertain the net profit earned and net loss suffered by a business over a given accounting period. Therefore, this statement depicts the financial position of a company.

In other words, the profit and loss account is a statement that shows expenditures, revenues and net income of an organisation. The company’s profit and loss account is a brief description of company’s revenue, expenses and net profit (or net loss) for any particular period of time.

It may be produced on a monthly, quarterly, half annually or annual basis. In most cases, it is produced on an annual basis along with other financial statements. It is the statement which reflects company’s financial performance to its investors, management and other interested parties. In simple words, the profit and loss account is the explanation of company’s profitability over a particular period of time.

Let us now discuss the components of the profit and loss account which are given as follows:

• Revenue: Revenue is the total amount of money received by a business entity after selling its products or services. Generally, revenue is also known as sales revenue or net sales and it can be calculated by deducting sales return, discounts and allowances from total sales.It is recorded at the top of the income statement and because of this it is also known as ‘top line’.
  
  
• Cost of goods sold (COGS): COGS includes all direct costs involved in the process of production. For example, raw material, labour, factory overheads, depreciation on plant and machinery, etc.
  
  
• Gross profit or gross loss: It is the difference between the revenue received and cost of goods sold for a particular period of time.
  
  
• Operating expenses: Operating expenses are the amount of expenses that a business entity has to bear in day-to-day business operations. For example, amortisation of intangible assets, advertising and sales expenses, research and development, rent of building, etc.
  
  
• Administrative expenses: Administrative expenses are those expenses which are not directly related with the process of production and these expenses are related to management and supporting activities of a business organisation.
  
  For example, depreciation on corporate office building, salary of top level managers, legal charges, functional cost of HR department, functional cost of IT department, functional cost of finance department, etc.
  
  
• Operating income: Operating income can be calculated by deducting operating and administrative expenses from gross profit. It is also known as earnings before interest and taxes (EBIT).
  
  
• Other income: Other income is the income which is non-operational in nature and is not generated on the basis of core operations of a business. For example, rent received from the in-house canteen contractor of a factory.
  
  
• Other expenses: Other expenses are those expenses which are not related to the core operations of a business enterprise and these expenses do not contribute anything to the process of production. For example, income tax paid to the government, interest paid for borrowings, etc.
  
  
• Net profit or net loss: It can be calculated by deducting all expenses from revenue. It is recorded at the end of income statement and because of this it is also known as ‘bottom line’.
  
  Net profit/loss is also known as ‘accounting profit/loss’ because there are many non-cash transactions such as amortisation, depreciation, etc. are included under it.

All above items appear in debit or credit side of ‘profit and loss account’. The items that appear on the debit side of the Profit and Loss Account are as follows:

• Expenses incurred in a business: This is divided into two parts:
  
  
  • Direct expenses: These are recorded in income statement.
    
    
  • Indirect expenses: These are recorded on the debit side. Indirect expenses are further categorised as follows:
    
    
• Selling expenses: These include all expenses relating to sales such as carriage outwards, travelling expenses, advertising, distribution costs, etc.
  
  
  • Office expenses: These include all expenses incurred on running an office such as office salaries, rent, tax, postage, stationery etc.
    
    
  • Maintenance expenses: These include all expenses related to the maintenance of assets such as repairs and renewals, depreciation, etc.
    
    
  • Financial expenses: These include all expenses related interest paid on loan, discount allowed, etc.

The items that appear on the credit side of the profit and loss account are as follows:

• Gross profit
  
  
• Other gains and incomes of the business such as interest received, rent received, discounts earned and commission earned.

The format of a Profit and Loss Account is as follows:

Profit and Loss Account

Company Name_____________

Profit and loss statement for the year ended March 31, 20XX

Particulars	Amount
Revenue/ Net sales
(-) Cost of Goods Sales
= Gross Profit
Other incomes
(-) Operating expenses
(-) Administrative expenses
(-) Distribution costs
(-) Other expenses
= Operating income/Earnings before Interest and Tax (EBIT)
(-) Interest paid
=Profit before tax (PBT)
(-) Income tax
= Net profit

Let us understand the preparation of a Profit and Loss Account with the help of the following illustrations:

Illustration

Prepare the profit and loss account from the following particulars of ABC Limited for the year ending March 31, 2017:

Particulars	Amount(₹)
Net Sales	75000
Administrative expenses	4000
Interest received	1200
Profit on sale of old machinery	1400
Operating expenses	14000
Income tax paid	0.00
Cost of goods sales	34000
Distribution costs	4800
Other expenses	1900
Interest paid	1700

Solution: The required profit and loss account is shown in the following table:

Profit and Loss Account

ABC Limited

Profit and loss statement for the year ended March 31, 2017

Particulars		Amount in ₹
Revenue from operations / Net sales		75000
(-) Cost of Goods Sales		34000
= Gross Profit		41000
Other incomes
Interest received		1200
Profit on sale of old machinery	1400	2600
(-) Operating expenses		14000
(-) Administrative expenses		4000
(-) Distribution costs		4800
(-) Other expenses		1900
= Operating income/ Earnings before Interest and Tax (EBIT)		18900
(-) Interest paid		1700
=Profit before tax (PBT)		17200
(-) Income tax		0.00
= Net profit		17200

Balance Sheet

In simple words, a balance sheet refers to a statement that summarises and presents the financial position of an organisation on any given date. It shows the assets and liabilities of an organisation. The main aim of preparing a balance sheet is to determine the exact financial position of a company.

In a balance sheet, the debit balances are reflected by the assets and the liabilities are reflected by the credit balances. A number of steps are involved in preparing a balance sheet. The first step is transferring all nominal accounts in the trial balance to the trading and profit and loss account.

Next, the personal accounts of customers are grouped under the heading of sundry debtors, the entities from whom the amounts of sold goods and services are due. Similarly, we need to group all balances of the suppliers under the single heading of sundry creditors, the entity to whom the organisation owes money or payment. In the end, the real and personal accounts are grouped as assets and liabilities and are arranged in a proper way. The resultant statement obtained is called the balance sheet.

The American Institute of Certified Public Accountants defines balance sheet as, “A tabular statement of summary of balances (debits and credits) carried forward after an actual constructive closing of books of account and kept according to the principles of accounting.”

In the balance sheet, assets are represented on the right side and liabilities are shown on the left side. It is also known as the statement of sources of funds and application of funds. The financial position of the organisation includes its economic resources (assets), economic obligations (liabilities), and owner’s equity. As discussed in previous chapters, a balance sheet is the detailed summary of the basic accounting equation:

Assets = Liabilities + Owner’s Equity

The pro forma of the balance sheet is shown in the following table:

The proforma of the balance sheet in reverse order of liquidity is shown in the following table:

Part I — Balance Sheet

Name of the Company…………………….

Balance Sheet as at ………………………

(Rupees in…………)

Particulars 1		Note No 2	Figures as at the end of current reporting period 3	Figures as at the end of the previous reporting period 4
I. Equity and Liabilities (1) Shareholders’ funds (a) Share capital (b) Reserves and surplus (c) Money received against share warrants (2) Share application money pending allotment (3) Non-current liabilities (a) Long-term borrowings (b) Deferred tax liabilities (Net) (c) Other Long term liabilities (d) Long-term provisions (4) Current liabilities (a) Short-term borrowings (b) Trade payables (c) Other current liabilities (d) Short-term provisions
	Total
II. Assets Non-current assets (1) (a) Fixed assets (i) Tangible assets (ii) Intangible assets (iii) Capital work-in-progress (iv) Intangible assets under development (b) Non-current investments (c) Deferred tax assets (net) (d) Long-term loans and advances (e) Other non-current assets
(2) Current assets (a) Current investments (b) Inventories (c) Trade receivables (d) Cash and cash equivalents (e) Short-term loans and advances (f) Other current assets
	Total

Illustration

Prepare the profit and loss account and the balance sheet from the following particulars of Rajan Associates on 31st March, 2017:

Particulars	Amount ₹
Net Sales	249000
Administrative expenses	12000
Interest received	3400
Profit on sale of old machinery	2200
Gain on government bonds	3500
Operating expenses	48000
Income tax paid	8800
Cost of goods sales	134000
Distribution costs	14600
Other expenses	3800
Interest paid	6200
Bills Receivable	16200
Creditors	23300
Machinery	52700
Plant	55600
Cash in Hand	22000
Net Debtors	40000
Drawings	6500
Capital	80000
Bills Payable	5000
Loan	9000

Solution:

Statement of Profit and Loss

Rajan Associates

Profit and loss statement for the year ended March 31, 2017

Particulars	Amount in ₹
Revenue from operations / Net sales	294000
(-) Cost of Goods Sales	134000
= Gross Profit	160000
Other incomes Interest received 3400 Profit on sale of old machinery 2200 Gain on government bonds 3500	9100
(-) Operating expenses	48000
(-) Administrative expenses	12000
(-) Distribution costs	14600
(-) Other expenses	3800
= Operating income/ Earnings before Interest and Tax (EBIT)	90700
(-) Interest paid	6200
=Profit before tax (PBT)	84500
(-) Income tax	8800
= Net profit	75700

Balance Sheet

Rajan Associates

Balance sheet for the year ended March 31, 2017

S. No.	Particulars	Amount in ₹
	Capital Share capital Add: Net profit Less: Drawings	80000 75700 6500
		149200
	Liabilities Loan Bills Payable Creditors	9000 5000 23300
		37300
	Total	186500
	ASSETS Plant Machinery Bills Receivable Debtors Cash in Hand	55600 52700 16200 40000 22000
	Total	186500

Cash Flow Statement

Cash flow statement is one of the most significant financial statements that are issued by any organisation. Cash flow statement measures the actual cash generated by the organisation within a particular period of time.

Under this statement, the word ‘cash flow’ refers to the amount of cash that comes into or goes out from the organisation. Cash flows of any organisation are categorised into, cash inflow and cash outflow.

Cash inflow refers to the total amount of cash that comes into the organisation through various activities. For example, cash received on behalf of sales, cash received from the sale of assets, loan received, issue of debentures, issue of shares, interest received, dividend received, etc.

On the other hand, cash outflow refers to the total amount of cash that goes out from the organisation through various activities. For example, cash purchase of raw material, purchase of assets, redemption of debentures, cash payment for wages, income tax payment, repayment of loan, interest paid, dividend paid, etc.

The cash inflows and outflows of any organisation can further be classified into three activities. These activities are operating activities, investing activities and financing activities.

• Operating activities are those activities which are related to core business operations of the business and it includes all those activities which are related to the revenue generation of the organisation.
  
  For example, cash sale of goods, payment made to the supplier, commission, cash payment of salaries, etc.
  
  
• Investing activities are those activities which are related to the purchase or sale of long-term investments and assets. For example, cash purchase of plant and machinery, old machinery sold for cash, investment in government bonds, etc.
  
  
• Financing activities are those activities which are related to the financial transactions of a business and these activities provide the overview of cash used in business financing.
  
  For example, loan received, issue of shares, payment of dividend, repayment of loan, issue of debentures, etc.

---

Relationship between Income Statement and Balance Sheet

The profit and loss account reflects the financial performance of the company by analysing the overall profitability of the entity. It shows how much amount of gain or loss has taken place during a particular time period.

On the other hand, a balance sheet reflects the financial health of an entity by providing a pathway to ratio analysis. In other words, balance sheet shows owes (liabilities) and owns (assets) of the entity.

However, both the financial health and financial performance are interrelated via equity investment in the balance sheet and net profit on the profit and loss account. The connection between the balance sheet and profit and loss account can also be determined with changes in the equity of the entity.

For example, suppose ABC Enterprise has owners’ equity of ₹1 crore at the year ending March 31, 2016 and ₹1.25 crore for the year ending March 31, 2017.

During this time period the owner did not brought in any new investment and nor he withdrew anything for personal use. So in this case we can say that the company’s owner equity has been raised by ₹25 lakh due to retained earnings or net profit.

Let us now discuss some important terms related to financial statements:

• Opening stock or opening inventory can be defined as per their nature (i.e. raw material, work-in-progress and finished goods). In the case of raw material opening, stock means the inventory of raw material that is unused at the beginning of the accounting period.
  
  Work-in-progress opening stock is the inventory of semi-finished goods at the beginning of the accounting year. In the case of finished goods, opening stock is the inventory of unsold finished goods at the beginning of the accounting period.
  
  
• Closing stock or ending inventory is the amount of inventory lies with the organisation at the end of the accounting period. It may be in the form of raw material, work-in-progress or finished goods. At the end of the accounting year this closing stock became opening stock in the following accounting year.
  
  
• Purchase can be defined as the overall cost of inventory, asset or an item, that is possessed by an organisation to carry out its various operations. In simple words, purchase is a transaction that means exchange of money with goods or services.
  
  
• Sales can be defined as the transfer of ownership of a particular asset, item good or service to the buyer, for a certain amount of money.
  
  
• Direct expenses are those expenses which are directly related to core operations of the entity. Generally, direct expenses involve costs related to the purchase of raw material and conversion of raw material into finished goods. For example, raw material, labour, factory overheads, etc.
  
  
• Indirect expenses are required to ensure smooth running of an organisation and these expenses not directly related to the core revenue generating operations of the entity. For example, stationary bills, telephone charges, printing of brochures, legal fees, professional services, etc.
  
  
• Income is the sum of money that an organisation receives from selling of goods and services. In accounting terms, it can be explained as a surplus of revenue over expenditure for a given time frame.