Managers within the firm, as well as the firm’s owners and lenders, keep track of the firm’s performance by reviewing its financial statements – income statement, balance sheet, and statement of cash flows.
What is the purpose of the income statement?
Identify the major types of expenses that are shown on the typical income statement.
What is the purpose of the balance sheet?
Identify the major types of assets and the claims of creditors and owners shown on the typical balance sheet.
What are the three different accounts that comprise the owners’ equity (also known as stockholders’ equity) section on a typical corporate balance sheet?
What is a statement of cash flows? Describe the three standard sections contained in a statement of cash flows.
Sample Answer
Sample Answer
Purpose of the Income Statement
The income statement, also known as the profit and loss statement, serves to summarize a firm’s revenues and expenses over a specific period, typically a fiscal quarter or year. Its primary purpose is to provide stakeholders—such as management, investors, and lenders—with insights into the company’s profitability and operational efficiency. By detailing how much money the company earned (revenues) and how much it spent (expenses), the income statement helps assess whether the firm is generating profit or incurring losses during the reporting period.
Major Types of Expenses on the Income Statement
A typical income statement includes several major types of expenses, which can be broadly categorized as follows:
1. Cost of Goods Sold (COGS): This represents the direct costs associated with producing goods or services sold by the company, including raw materials and labor costs.
2. Operating Expenses: These are the costs required to run the company’s core business operations but are not directly tied to the production of goods. They generally include:
– Selling, General, and Administrative Expenses (SG&A): These are overhead costs, including salaries of non-production staff, advertising expenses, rent, and utilities.
– Depreciation and Amortization: This accounts for the reduction in value of tangible assets (depreciation) and intangible assets (amortization) over time.
3. Interest Expense: This expense arises from borrowing funds and is calculated based on interest rates applied to outstanding debt.
4. Taxes: This includes income taxes owed on the profits generated by the firm.
Purpose of the Balance Sheet
The balance sheet provides a snapshot of a company’s financial position at a specific point in time, detailing what the firm owns (assets), what it owes (liabilities), and the residual interest of the owners (equity). The primary purpose of the balance sheet is to give stakeholders an overview of the company’s financial health, enabling them to assess its liquidity, solvency, and capital structure.
Major Types of Assets and Claims on the Balance Sheet
A typical balance sheet includes two main sections: assets and liabilities/equity.
1. Major Types of Assets:
– Current Assets: These are assets expected to be converted into cash or consumed within one year, such as cash, accounts receivable, inventory, and short-term investments.
– Non-Current Assets: These assets are expected to last longer than one year and include property, plant, and equipment (PP&E), intangible assets (like patents), and long-term investments.
2. Claims of Creditors and Owners:
– Liabilities: These represent what the company owes to external parties. They are divided into:- Current Liabilities: Obligations due within one year, such as accounts payable and short-term debt.
– Long-Term Liabilities: Obligations not due for more than one year, such as long-term loans and bonds payable.
– Equity: This represents the owners’ claim on assets after all liabilities have been settled. It includes contributed capital and retained earnings.
Accounts Comprising Owners’ Equity
The owners’ equity section on a typical corporate balance sheet comprises three main accounts:
1. Common Stock: Represents the value of shares issued to shareholders at par value.
2. Preferred Stock: Represents shares that have preferential rights over common stock, particularly regarding dividends and asset distribution upon liquidation.
3. Retained Earnings: This account reflects cumulative profits that have been reinvested in the business rather than distributed as dividends to shareholders. It indicates how much profit has been retained for growth or other purposes.
Statement of Cash Flows
The statement of cash flows summarizes cash inflows and outflows over a specified period, providing insights into a company’s liquidity and cash management. It helps stakeholders understand how cash is generated and used in operations, investing activities, and financing activities.
The three standard sections contained in a statement of cash flows are:
1. Operating Activities: This section reflects cash transactions related to the core operations of the business. It includes cash received from customers, cash paid to suppliers and employees, interest payments, and tax payments.
2. Investing Activities: This section shows cash flows related to the acquisition or disposal of long-term assets. It includes purchases or sales of property, plant, equipment, and investments in other companies.
3. Financing Activities: This section details cash flows resulting from transactions with the firm’s owners and creditors. It includes cash received from issuing stock or borrowing funds, as well as cash paid for dividends and repayment of debt.
By examining these three components, stakeholders can gain a comprehensive understanding of how a company manages its cash resources.
