Assets are tangible or intangible items a business owns or controls the business uses these items to produce value, and the items have economic value. While tangible assets are physical, non-tangible assets are rights that enable a business to compete effectively. Assets can also be current or non-current. Current assets yield value to a business over a short period, usually within a single financial year. Non-current assets, on the other hand, can yield economic value to a firm for more than a single financial year. Liabilities comprise the obligation of a business to sacrifice future economic benefits to other business entities; past business events and transactions cause these obligations, and settling them requires a business to yield future economic benefits through, for instance, providing services, or using some of its assets.
The assets a business possesses give rise to various claims these claims result from the approach the business used to fund its assets. The owners of a business can contribute the funds used to purchase the assets. Still, the business can incur liabilities to acquire certain assets. For instance, a business entity can borrow money from a financial institution and use it to acquire plant and machinery. The difference between the business owners claim on the assets and the claims resulting from liabilities comprises equity. For example, if plant and machinery valued at $10,000 is the only asset a business owns, and the owners contributed $6,000 towards the machines purchase while creditors provided the remaining funds, the equity in that business is $10,000 - $4,000 = $6,000. In some instances, equity can be the same as net assets because net assets are total assets less the liabilities arising from those assets.
The three basic financial statements of a business are the income statement, the statement of financial position and the cash flow statement. The income statement reports information on the income, expenses and profit of a business enterprise over a given period. For a business to perform its core mandate, it has to undertake certain operating activities. Take the case of an apparel retailer. Stocking apparel stores requires the retailer to, among others, source for apparel supplies, hire store attendants to organize apparel in the store and help customers shop. Operating activities generate revenue and cause a business to incur expenses. If a business is to operate profitably, the revenue from operations should pay all the operating expenses. In cases where the revenue falls short of the operating expenses, business makes a loss.
The statement of financial position reports the assets, liabilities and owners equity of a business over a given period. Businesses require assets for their operations. For instance, a retail establishment needs furniture and fittings to operate effectively. In the course of business operations, obligations to sacrifice future economic benefits, and hence liabilities, arise; a business might, among others, borrow funds to finance short-term cash flow needs, or receive payment for goods or services it has not delivered yet. The statement of financial position shows how changes in assets and liabilities over a given period affected a business entitys financial standing. Ideally, all liabilities and the owners equity should have the same value as the total assets. If total liabilities and owners equity exceed assets, a business might not be financially sound.
The cash flow statement presents information on cash flows a business earned from its operating, financing and investing activities. Cash flow from operating activities includes the revenue from operations and the operating expenses a business incurs over a given period, while cash flow from investing activities comprises the cash a business spends on, and earns from, the acquisition and disposal of assets. Financing activities, on the other hand, entail the procurement and payment of funds; cash flows from such activities include, among others, receipts of the proceeds of commercial loans, and retirement of notes payable. The cash flow statement helps in generating a picture of the cash position of a business something that the income statement cannot do well. Some items included in computing the net income do not reflect the true cash position of a business. For instance, depreciation is included as an operating expense when computing the net income, yet, in practical terms depreciation does not entail a cash flow.
One needs to know the period covered by financial statements before they can make a valid analysis of a business entitys condition. Financial statements can cover a quarter, half, or full financial year. When comparing financial statements, it is important to ensure the periods one is comparing are consistent. For instance, one cannot derive a valid estimate of sales growth from comparing the turnover reported in an end-year income statement to the turnover indicated in the income statement for the subsequent quarterly period. A good estimate of sales growth requires a comparison of the turnover in two or more full-year, quarter-year, or half-year periods.
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