Understanding how changes in a company's revenue, operating assets and liabilities impact changes in cash flow will help business managers:
- Understand how business decisions and market events affects cash flow, profits and financial position of a business
- Analyze financial performance of business units
- Improve business planning and evaluate forecasts of sales, expenses and income
The guts of an annual financial report are the following three primary financial statements:
- Statement of Comprehensive Income - also called the Income Statement, this is the summary of a company’s sales revenue and expenses for the year (the profit-making activities of the business) and it reports the company’s final profit or net income for the year. A publicly owned business corporation must report earnings per share in its income statement. A non-public company does not have to report earnings per share, but it is useful information to its shareholders.
- Balance Sheet – also called the Statement of Financial Position, this is a summary of the company’s assets, liabilities, and owners’ equity at the close of business on the last day of the income statement period. To understand a balance sheet you need to understand the differences between the basic types of assets used by a business (inventory versus property, plant and equipment, for instance), and the difference between operating liabilities (mainly accounts payable and accrued expenses) versus debt on which the business pays interest. Also, you should know the difference between the two different sources of owners’ equity – capital invested by the owners in the business versus profit earned but not distributed to owners, which is called retained earnings.
- Statement of Cash Flows – also called the cash flow statement. Profit generates cash flow but the amount of cash flow from profit during the year generally is not equal to net income for the year. This third financial statement starts with a section summarizing cash flow from profit for the year, which is an extremely important number. The statement also reports other sources of cash for the year and what the company did with its available cash during the year. The cash flow statement exposes the financial strategy of the company.
In short, the three financial statements revolve around the three financial imperatives of every business – to make profit, to remain in healthy financial condition, and to make good use of cash flow. The three financial statements usually fit on three pages of an annual financial report, one statement on each page.
This sub-section draws predominantly from John A. Tracy, "How to Read a Financial Report", 6th Edition, 2004 John WIley & Sons, Inc.
Those who are interested in understanding this area better may refer to this publication.
The first part of the attachment illustrates the interlocking nature of financial statements; with the objective to show connections between accounts from the income statement to balance sheet items, in turn these translations impact on operating cash flows in cash flow statements. The second part builds on those connections between the financial statements to forecast operating cash flow impacts from business scenarios of growth and decline. It then reviews key financial ratios that may be used to measure the company's financial situation, achievements and pinpoint potential red flags, introduces the concept of economic profit (or EVA as trademarked by Stern Stewart) and closes with a basic principles of management accounting.