Why Financial Statements are important
The importance of accurate Financial Statements cannot be underestimated for any business operating in South Africa.
While you may already know that financial reporting is crucial (mainly because it is a legal requirement in South Africa and most countries), you may not understand how preparing them can help your business. Before we can delve into that, let's start by defining Financial Statements.
What are Financial Statements?
Financial statements are a collection of summary-level reports about an organisation's financial results, financial position, and cash flows.
There are several financial reports that a business owner needs to be aware of, they are:
- Income Statement
The Income Statement (also called the Profit & Loss, or Income & Expenditure Statement) records the business’ incoming revenue and outgoing expenditure, usually on a monthly basis. One of the most crucial bits of financial data you will find in an Income Statement is profit.
Expenses you might not consider a loss or expense also appear in the Income Statement. For instance, depreciation (the reduction in an asset’s value) is recorded on the Income Statement, as it is considered a loss to the business.
The structure of a typical Income Statement
The sales during the period are recorded here. This is the total value of sales made to customers.
Cost of sales
The direct costs of generating the recorded revenues go into "cost of sales". This would include the cost of raw materials, components, goods bought for resale and the direct labour costs of production.
The difference between revenue and cost of sales. A simple but very useful measure of how much profit is generated from every R1 of revenue before overheads and other expenses are taken into account. Is used to calculate the gross profit margin (%)
Operating costs and expenses that are not directly related to producing the goods or services are recorded here. These would include distribution costs (for example, transport) and the wide range of administrative expenses or overheads that a business incurs from time to time.
Operating profit records how much profit has been made in total from the trading activities of the business before any account is taken of how the business is financed.
Interest paid on bank and other borrowings, less interest income received on cash balances, is shown here.
Profit before tax
Calculated as operating profit less finance expenses
- Cash Flow Statement (CFS)
The cash flow statement measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses.
The structure of a CFS
The main components of the cash flow statement are:
- Cash from operating activities
- Cash from investing activities
- Cash from financing activities
- Disclosure of noncash activities is sometimes included when prepared under the Generally Accepted Accounting Principles, or GAAP
- Balance Sheet.
The Balance Sheet shows what the business owns (Assets), what it owes (Liabilities) and how much has been invested into it (Equity).
Using the Balance Sheet you can gauge
your liabilities, and hopefully find ways to reduce them over time. A business with a large ratio of liabilities to assets may be seen as risky as it funds its assets with debt rather than Equity.
A balance sheet can, therefore, be represented like this: Assets = liabilities + shareholders’ funds
The Benefits Of using financial statements
- Financial Statements allow you to manage debt
If there is one aspect of running a business owners should not ignore is debt management. Failure to manage debt can cripple the progress of any business regardless of its size or sector. While there may be many different ways of achieving this, it is almost impossible to manage debts effectively without preparing financial statements.
- Financial Statements allow you to identify trends
Regardless of what area of financial activity you are trying to track, only financial statements will help you identify those trends, both past and present, which will empower you to make sound financial decisions.
- Financial Statements make it easy for you to be 100% compliant.
As the information served up by financial statements has to be accurate and robust, this will help you remain 100% compliant – which is essential if you want your business to continue operating in South Africa.
When are Financial Statements mostly used?
Financial statements have a variety of uses to to decision makers and business owners.
They help to complete important tasks, such as:
- Maintaining Financial Records
Financial Statements are evidence of your company’s current and past financial health. In essence, it is recorded data. If circumstances, where evidence of your finances are required, during loan negotiations, filing tax returns or audits, having these financial records on file, can greatly reduce time wastage, admin work, stress and errors; errors caused by pouring over old and potential incorrectly recorded data.
- Making Management Decisions
By producing accurate and up-to-date reports on your business’ financial situation, you can make well-informed decisions about the direction you want your company to take. By looking at income, balance sheet and cash-flow statements, you can analyse financial data and make changes accordingly. For example, you may notice patterns of overspending, months where income dips, or a slow but evident decline in sales of a certain product. These changes may not be obvious, which means financial statements might be the only way of spotting them before they become a problem.
- Use for enticing investors
Some investors might be interested in your business, but they would need to assess the viability of your business before they can invest.
They will need to see empirical evidence that they will get their money back, make more money. Financial statements will allow you to showcase the success of your business and forecast for future profits, which may help convince investors.
- Use for Shareholders
If your company is listed then that means you have shareholders. They want results. They want to see the company do well, as this will increase the value of their stake in the business.
They use financial statements from time to time to to make informed decisions about their equity investments. Some of the metrics mostly used by shareholders include profitability ratios, liquidity ratios, debt ratios, efficiency ratios, and price ratios.
- 5. Use for Government
Governmental policies pertaining to corporates depend heavily on financial statements. This is because these statements depict how companies are functioning in general. The government can use this information to decide taxation and regulatory policies.
However, as public entities are more likely to generate their own revenue and have debtors, creditors, loans, they are also required to prepare financial statements. They use Generally Recognised Accounting Practice as their accounting framework, which is similar to the accounting frameworks used in the private sector.
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