What Are the Components of a Financial Statement?

Financial statements consist of three different statements: income statement, balance sheet and cash flow statement. All three are necessary to provide an accurate overview of the financial stability and viability of a business. At the least, firms prepare annual financial statements, and most businesses compile them monthly or quarterly as well.

1.Income Statement
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The income statement details income sources and expenses and shows the net income. The first section of the statement lists all income of the business. This usually breaks down into categories to show sources of income, which add up to a total income figure. The next section shows a total of all expenses associated with the business. For instance, most businesses will have salary and administration expense, utilities, lease or mortgage expense and taxes. The final category shows net income, derived by subtracting total expenses from total income.

2.Balance Sheet
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The balance sheet of a business reveals its net worth. This is the difference between all assets and all liabilities. Some businesses are generic in this statement and simply list generalized categories of assets and liabilities, with the asset category being first on the statement. Larger businesses break down the asset and liability categories into current and non-current or short-term and long-term. Current or short-term applies to assets easily converted to cash, and liabilities that are due within 12 months. Non-current or long-term apply to assets not easily converted to cash, and liabilities not due within 12 months. Assets minus liabilities equal the company's net worth.

3.Cash Flow Statement

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The cash flow statement shows the cash that flows in and out of the business. This is actual cash and does not include credit, loans, payables or receivables not yet received or paid out. Cash inflows list first followed by cash outflows. The difference between the two should correspond to the bank account balances of the business.

4. Notes to the Financial Statements These are additional notes and information added to the end of the financial statements to supplement the reader with more information. Notes to Financial Statements help the computation of specific items in the financial statements as well as provide a more comprehensive assessment of a company's financial condition. Notes to Financial Statements can

include information on debt, going concern, accounts, contingent liabilities, or contextual information explaining the financial numbers (e.g. to indicate a lawsuit). The information contained within the notes not only supplement financial statement information, but they clarify line-items that are part of the financial statements. For example, if a company lists a loss on a fixed asset impairment in their income statement, Notes to Financial Statements could serve to corroborate the reason for the impairment by providing specific information relative to how the asset became impaired. Notes to the Financial Statements are also used to explain the method of accounting used to prepare the financial statements (all publicly traded companies are required to use accrual basis accounting for financial reporting purposes as mandated by the SEC), and they provide valuations for how particular accounts have been represented.

Components Of Cash Flow Statement:

Cash flow statements record the amounts of cash and cash equivalents entering and leaving a company. The CFS allows investors to understand how a company's operations are running, where its money is coming from, and how it is being spent. The Structure of the CFS The cash flow statement is distinct from the income statement and balance sheet because it does not include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash is not the same as net income, which, on the income statement and balance sheet, includes cash sales and sales made on credit. Cash flow is determined by looking at three components by which cash enters and leaves a company: core operations, investing and financing. Operations Measuring the cash inflows and outflows caused by core business operations, the operations component of cash flow reflects how much cash is generated from a company's products or services. Generally, changes made in cash, accounts receivable, depreciation, inventory and accounts payable are reflected in cash from operations. Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in revenue, expenses and credit transactions (appearing on

the balance sheet and income statement) resulting from transactions that occur from one period to the next. These adjustments are made because non-cash items are calculated into net income (income statement) and total assets and liabilities (balance sheet). So, because not all transactions involve actual cash items, many items have to be re-evaluated when calculating cash flow from operations. For example, depreciation is not really a cash expense; it is an amount that is deducted from the total value of an asset that has previously been accounted for. That is why it is added back into net sales for calculating cash flow. The only time income from an asset is accounted for in CFS calculations is when the asset is sold. Changes in accounts receivable on the balance sheet from one accounting period to the next must also be reflected in cash flow. If accounts receivable decreases, this implies that more cash has entered the company from customers paying off their credit accounts - the amount by which AR has decreased is then added to net sales. If accounts receivable increase from one accounting period to the next, the amount of the increase must be deducted from net sales because, although the amounts represented in AR are revenue, they are not cash. An increase in inventory, on the other hand, signals that a company has spent more money to purchase more raw materials. If the inventory was paid with cash, the increase in the value of inventory is deducted from net sales. A decrease in inventory would be added to net sales. If inventory was purchased on credit, an increase in accounts payable would occur on the balance sheet, and the amount of the increase from one year to the other would be added to net sales. The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has been paid off, then the difference in the value owed from one year to the next has to be subtracted from net income. If there is an amount that is still owed, then any differences will have to be added to net earnings. Investing Changes in equipment, assets or investments relate to cash from investing. Usually cash changes from investing are a "cash out" item, because cash is used to buy new equipment, buildings or short-term assets such as marketable securities. However, when a company divests of an asset, the transaction is considered "cash in" for calculating cash from investing. Financing Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from financing are "cash in" when capital is raised, and they're "cash out" when dividends are paid. Thus, if a company issues a bond to the public, the company receives cash financing; however, when interest is paid to bondholders, the company is reducing its cash.

Theory Of Working Management

Capital

Working capital management is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the interrelationship that exists between them. The term current assets refer to those assets which in the ordinary course of business can be, or will be, converted into cash within one year without undergoing a diminution in value and without disrupting the operations of the firm. The major current assets are cash, marketable securities, accounts receivable and inventory. Current liabilities are those liabilities which are intended, at their inception, to be paid in the ordinary course of business, with in a year, out of the current assets or earnings of the concern. The basics current liabilities are accounts payable, bills payable, bank overdraft, and outstanding expenses. The goal of working capital management is to manage the firms current assets and liabilities in such a way that a satisfactory level of working capital is maintained. This is so because if the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy.

Sources of Finance
Finance is essential for a businesss operation, development and expansion. Finance is the core limiting factor for most businesses and therefore it is crucial for businesses to manage their financial resources properly. Finance is available to a business from a variety of sources both internal and external. It is also crucial for businesses to choose the most appropriate source of finance for its several needs as different sources have its own benefits and costs. Sources of financed can be classified based on a number of factors. They can be classified as Internal and External, Short-term and Long-term or Equity and Debt. It would be uncomplicated to classify the sources as internal and external.

2.1 Internal sources of finance

Internal sources of finance are the funds readily available within the organisation. Internal sources of finance consist of: Personal savings Retained profits Working capital Sale of fixed assets

2.1.1 Personal savings

This is the amount of personal money an owner, partner or shareholder of a business has at his disposal to do whatever he wants. When a business seeks to borrow the personal money of a shareholder, partner or owner for a businesss financial needs the source of finance is known as personal savings.

2.1.2 Retained profits

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Retained profits are the undistributed profits of a company. Not all the profits made by a company are distributed as dividends to its shareholders. The remainder of the profits after all payments are made for a trading year is known as retained profits. This remainder of finance is saved by the business as a back-up in times of financial needs and maybe used later for a companys development or expansion. Retained profits are a very valuable no-cost source of finance.

2.1.3 Working capital

Working capital refers to the sum of money that a business uses for its daily activities. Working capital is the difference of current assets and current liabilities (i.e. Working capital = Current assets Current liabilities). Proper working capital management is also vital as it is also a source of finance for a business. Current assets Current assets are also known as cash equivalents because they are easily convertible to cash. Current assets consist of Stock, Debtors, Prepayments, Bank and Cash. These assets are used up, sold or keep changing in the short run. Stock this refers to the stock of goods available to the business for sale at a given time. It is very important to maintain the right amount of stock of goods for a business. If stock levels are too high it means that too much of money is being held up in the form of stock and if stock levels are too low the business will lose possible opportunities of higher sales. Debtors are a businesss customers owing money to the business having been bought the businesss goods or service on credit. If a business has cashflow problems it can maintain a low level of debtors by encouraging the debtors to pay as early as possible.
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Prepayments these are the expenses paid in advance. The payment being made even before the expense occurs is a prepayment.

Bank and Cash Bank is the cash held in banks and cash is money held by the business in the form of cash. Having too much of money in the form of cash is also not good for a business since it can use that money to invest and earn a return but however a business should have healthy current ratio (current assets : current liabilities) of 2:1. Current liabilities Current liabilities are short-term debts that are in immediate need of settlement. Some examples of current liabilities are creditors, accruals, proposed dividends and tax owing. These obligations have to be paid within a year. Creditors also known as trade creditors are suppliers from whom the business purchased goods on credit. Paying the creditors as late as possible will ease cash flow requirements for a business. Accruals are the expenses owed by the business. Dividends proposed are the dividends payable for the year that is not yet paid. Tax owing is the sum of money owing as tax.

2.1.4 Sale of fixed assets

Fixed assets are the assets a company that do not get consumed in the process of production. Some examples of fixed assets are land and building, machinery, vehicles, fixtures and fittings and equipment. Sometimes where the fixed asset is a surplus and is abandoned, it can be sold to raise finance in demanding times for the business. Otherwise businesses may choose to stop offering certain products and sell its fixed
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assets to raise finance. Selling fixed assets reduces the production capacity of a business affecting a businesss return.

2.2 External sources of finance

Sources of finance that are not internal sources of finance are external sources of finance. External sources of finance are from sources that are outside the business. External sources of finance can either be: Ownership capital or Non-ownership capital

2.2.1 Ownership capital

Ownership capital is the money invested in the business by the owners themselves. It can be the capital funding by owners and partners or it can also be share bought by the shareholders of a company. There are mainly two main types of shares. They are: Ordinary shares Preference shares

2.2.1.1 Ordinary shares

Ordinary shares also known as equity shares are a unit of investment in a company. Ordinary shareholders have the privilege of receiving a part of company profits via dividends which is based on the value of shares held by the shareholder and the profit made for the year

by the company. They also have the right to vote at general meetings of the company. Companies can issue ordinary shares in order to raise finance for long-term financial needs.

2.2.1.2 Preference shares

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Preference shares are another type of shares. Preference shareholders receive a fixed rate of dividends before the ordinary shareholders are paid. Preference shareholders do not have the right to vote at general meetings of the company. Preference shares are also an ownership capital source of finance. There are several types of preference shares. Some of them are Cumulative preference share, Redeemable preference share, Participating preference share and Convertible preference share. Cumulative preference shares if a company is in a loss making situation and is unable to pay dividends for one year then the dividend for that year will be paid the next year along with next years dividends. Redeemable preference shares these preference shares can be bought back by the company at a later date. Normally the date of redemption is usually agreed. Participating preference shares give the benefit of additional dividends to its shareholders above the fixed rate of dividends they receive. The additional dividend is usually paid in proportion to ordinary dividends declared. Convertible preference shares convertible preference shareholders have the option of converting their preference shares to ordinary shares.

2.2.2 Non-ownership capital

Unlike ownership capital, non-ownership capital does not allow the lender to participate in profit-sharing or to influence how the business is run. The main obligations of non-ownership capital are to pay back the borrowed sum of money and interest. Different types of non-ownership capital:
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2.2.2.1 Debentures
Debentures are issued in order to raise debt capital. Debenture holders are not owners but long-term creditors of the company.

Debentures Bank overdraft Loan Hire-purchase Lease Grant Venture capital Factoring Invoice discounting

Debenture holders receive a fixed rate of interest annually whether the company makes a profit or loss. Debentures are issued only for a time period and thus the company must pay the amount back to the debenture holders at the end of the agreed period. Debentures can be secured, unsecured, fixed or floating. Secured debentures are debentures that are secured against an asset. They are also called mortgage debentures. Unsecured debentures these debentures do not have an asset as collateral. Fixed debentures have a fixed rate of interest. Floating debentures do not have fixed rate of interest and are not tied to any specific asset. Bearer debentures these debentures are easily transferable.
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Registered debentures are not easily transferable and legal procedures have to be followed in case of a transfer. Convertible debentures can be converted to stock at the end of the debenture repayment date.

2.2.2.2 Bank overdraft

Bank overdraft is a short term credit facility provided by banks for its current account holders. This facility allows businesses to withdraw more money than their bank account balances hold. Interest has to be paid on the amount overdrawn. Bank overdraft is the ideal source of finance for short-term cashflow problems.

2.2.2.3 Loan

Loans are amounts of money borrowed from banks or other financial institutions for large and long-term business projects such as the development or expansion of the business. However loans can be substituted by other alternative sources of finance which are more suitable.

2.2.2.4 Hire purchase

Hire purchase allows a business to use an asset without paying the full amount to purchase the asset. The hire purchase firm buys the asset on behalf of the business and gives the business the sole usage of the asset. The business on its part must pay monthly payments to the hire purchase firm amounting to the total value of the asset and charges of the hire purchase firm. At the end of the payment period the business has the option of purchasing the asset for a nominal value.

2.2.2.5 Lease
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In a lease the leasing company buys the asset on behalf of the business and the asset is then provided for the business to its use. Unlike a hire purchase the ownership of the asset remains with the leasing company. The business pays a rent throughout the leasing period. The leasing firm is known as the lessor and the customer as lessee. Leasing is

of two types, namely Finance lease and Operating lease. Finance Lease this is where the lessees monthly payments add up to at least 90% of the total value of the asset. Operating Lease this lease does not run for the full life of the asset and the lessee is not liable for the full value of the asset. The residual risk is taken up by the lessor.

2.2.2.6 Grant

Grants are funding given to businesses for programs or services that benefit the community or public at large. Grants can be given by the government or private firms. For example a grant may be given to open a new factory where unemployment is high.

2.2.2.7 Venture capital

Venture capital is the capital that is contributed at the initial stages of an uncertain business. The chance of failure of the business is great while there is also a possibility of providing higher than average return for the investor. The investor expects to have some influence over the business.

2.2.2.8 Factoring
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This is where the factoring company pays a proportion of the sales invoice of the business within a short time-frame to the business. The remainder of the money is paid to the business when the factoring company receives the money from the businesss debtor. The remainder of the money will be paid only after deducting the factoring companys service charges. Some factoring companies even offer to maintain the sales ledger of the business. Factoring is of two types: Recourse factoring and Non-recourse factoring. Recourse factoring In this type of factoring the client company is liable for bad debts. Non-recourse factoring is where the factor takes responsibility for the payment of the debtors. The client company is not liable if debtors do not pay back. Non-recourse factoring is usually more expensive because of the high risks experienced by the factor.

2.2.2.9 Invoice discounting

In invoice discounting the client company send out a copy of the invoice to the invoice discounting firm. The client then receives a portion of the invoice value. In contrast to factoring, the client company collects the money from its debtors. Once the payment is received it is deposited in a bank account controlled by the invoice discounter. The invoice discounter will then pay the remainder of the invoice less any charges to the client.
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3.0 The financial costs of the different sources of finance

Personal savings have low costs since they are provided by an owner, partner or shareholder. The owner may charge a rate of interest for the loan provided. Retained profits have opportunity cost, that is the money could have been used elsewhere for some other purpose. Otherwise there arent any other costs for this source of finance. Working capital they do not have any costs other than opportunity cost. Sale of assets by selling fixed assets it uses then the firms production capacity will diminish. If it sells unused or abandoned fixed assets then only the potential production capacity reduces. Sometimes firms will have to stop offering certain products or services in order to sell its asset and raise finance. The asset may cost much more than what it sold for if it wants to replace it. Ordinary and Preference shares dividends has to be paid out of profits to shareholders as a return for their investment in the business. There are administrative costs occurring from issuing shares like stock exchange listing fee, printing and distribution fee and advertising fee. Debentures have to be paid a fixed or floating interest depending on the type of debenture that is issued. Bank overdraft interest is a little higher than for bank loans and interest is calculated on a daily basis. Loans Interest is usually fixed for short term loans, and long-term loans usually have a variable rate of interest. Interest rates are lower than for bank overdrafts. Hire-purchase the business ends up paying more than the original value of the asset for its purchase. Lease the ownership of the asset remains with the leasing company even after the business pays more than 90% of the assets value but
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however some leasing firms provide the option of purchase of the asset a nominal value. Grants are free and have no financial costs. Venture capital the venture capitalist will have some influence over the business and the business will have to share profits with the investor. The investor will want the capital back at a later date. Factoring Factors charge a rate of interest of about 1.5% to 3% of the invoice value as finance charges. Interest is calculated on a daily basis. Credit management and administrative fee are also charged and ranges from about 0.75% to 2.5% of turnover. Invoice discounting Invoice discounting also charges a rate of interest of about the same but its credit management and administrative charges are lower than a factors because only finance is provided and sales ledger is not maintained by an invoice discounting firm.
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4.0 Advantages and Disadvantages of the different

sources of finance 4.1 Personal savings

Advantages The owner would not want collateral to lend money to the business. There is no paperwork required. The money need not necessarily be paid back to the owner on time. Can be interest free or carry a lower rate of interest since the owner provides the loan. Disadvantages Personal savings is not an option where very large amounts of funds are required. Since it is an informal agreement, if the owner demands the money back in a short notice it might cause cashflow problems for the business.

4.2 Retained profits

Advantages They need not be paid back since it is the organisations own savings. There are no interest payments to be made on the usage of retained profits.

Page | 13 The companys debt capital does not increase and thus gearing

ratio is maintained. There are no costs raising the finance such as issuing costs for ordinary shares. The plans of what is to be done with the money need not be revealed to outsiders because they are not involved and therefore privacy can be maintained. Disadvantages There maybe opportunity costs involved. Retained profits are not available for starting up businesses or for those businesses that have been making losses for a long period.

4.3 Working capital

Advantages Since it is an internal source of finance there are no costs involved. No repayment is needed. External parties cannot influence business decisions. Will not increase debt capital of the firm so gearing ratio is maintained. Disadvantages Opportunity costs are involved. Is not suitable for long term investments. Working capital cannot raise large amounts of funds. Total risk is undertaken by the company.
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 Using working capital as a source of finance will affect the current

ratio of the business

4.4 Sale of assets

Advantages Funds are again raised by the business itself and therefore need not be paid back. No interest payments are required. Large amounts of finance can be raised depending on the fixed asset sold. Would be the ideal source of finance if it was for an asset replacement. Disadvantages If the asset is sold then the business would lose opportunities to generate income from it. If the business wants to buy a similar asset later on it may cost more than it was sold for. If the asset is sold and the money is spent without return then the business is broke. The asset may be able to generate more income than the purpose it was sold for.

4.5 Ordinary share issue

Advantages The amount need not be paid back it is a permanent source of capital. Able to raise large amounts of finance.

Page | 15 If the company follows a rational dividend policy it can create huge

reserves for its development program. The dividends need to be paid only if the company makes a profit. No collateral is required for issuing shares. It will help reduce gearing ratio Disadvantages Issuing shares is time consuming. It incurs issuing costs. There are legal and regulatory issues to comply with when issuing shares. Possible chances of takeover where an investor buys more than 50% of the total issued shares value. Groups of equity shareholders holding majority of shares can manipulate the control and management of the company. May result in over-capitalisation where dividend per share falls. Once issued the shares may not be bought back and therefore the capital structure cannot be changed.

4.6 Preference share issue

Advantages

 Have no voting rights and thus the management can retain control

over the affairs of the company. Preference shareholders need not be paid if the company makes a loss.
Page | 16 Even if the company makes large profits preference shareholders

need to be paid only a fixed rate of interest. Has other benefits similar to ordinary share issue such as no repayment required, large amounts of capital can be raised, permanent source of capital and no collateral required. Redeemable preference shares can be redeemed. Disadvantages Even if the company makes a very small profit it will have to pay the fixed rate of dividend to its preference shareholders. Preference shares are usually cumulative and thus twice the amount must be paid the following year if dividends are not paid on the year they need to be paid. Taxable income is not reduced by preference dividends unlike debentures where interest paid reduces taxable income. Have other drawbacks similar to ordinary share issues such as the cost, time consumption and legal requirements.

4.7 Debentures

Advantages Debenture holders do not have rights to vote at the companys general meetings. Tax benefits debenture interests are treated as expenses and charged against profits in the profit and loss account. Debentures can be redeemed when the company has surplus funds. Disadvantages
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Debenture interests have to be paid regardless the company makes a profit or loss. The money borrowed has to be paid back on an agreed date.

4.8 Bank overdraft

Advantages No security is needed for a bank overdraft. Ideal for short-term cashflow deficits. Easy and quick to arrange. Interest is only paid when overdrawn and on the exact amount needed Since overdraft is a short term debt it is not included in calculating the firms gearing ratio. Disadvantages There is a limit to the amount that can be overdrawn. Interest has to be paid on an overdraft that is calculated on a daily basis and sometimes the bank charges an overdraft facility fee too.

 Overdrafts are meant to cover only short-term financing and are not a permanent or long-term source of finance Interest is calculated on a variable rate and therefore it is difficult to calculate the cost of borrowings. Overdrafts can be recalled by the bank at any time if not stated in the agreement.

4.9 Loans
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Advantages Large amounts can be borrowed. Suitable for long-term investments. The lender has no say on how the money is spent. Need not be paid back for a fixed time period and banks do not withdraw at a short notice. Interest rates are lower than for bank overdrafts and are set in advance. Disadvantages Collateral is needed. The amount borrowed has to be repaid at the agreed date. Interest is charged. Loans will affect a companys gearing ratio.

4.10 Hire purchase

Advantages The business gains use of the asset before paying the assets value in full. The payment is made in affordable instalments. Hire purchase instalments are taxable expenditures. At the end of the payments ownership of the asset is transferred to the company.
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asset. Disadvantages Ownership remains with the lender until the last payment is made. The asset will cost the company more than the original value. If payments are not made on time the lender has the right to repossess the asset. If the asset is required to be replaced due to breakdown or because it is out-dated in which case the payment may still have to be made and the asset replaced.

4.11 Lease

Advantages The amount in full need not be paid in order to start using the asset. The total cost and the lease period is pre-determined and thus helps with budgeting cashflow.

 In an operating lease, payments are made only for the usage

duration of the asset. Lease is inflation friendly where the agreed rate is paid even after five years when other costs increase due to inflation. It is easier to obtain a lease than a commercial loan. Disadvantages The ownership of the asset remains with the lessor even after payments but however in a finance lease the option is provided to buy the asset at a nominal value. the asset. Lease cannot be terminated whenever at lessees will.

Page | 20 In a finance lease the lessee ends up paying more than the value of

4.12 Grants

Advantages Grants do not have to be paid back. There are no costs involved in obtaining a grant. Disadvantages Grants are given on certain restrictions and laws imposed by the government. Not all organisations are eligible for grants. Grants are given freely and therefore are very competitive because lots of firms try for the same source of fund.

4.13 Venture capital

Advantages Venture capitalists invest large sums of money in the business. They may also bring a lot of experience and expertise along with the money.

Page | 21 Since they become owners by investing in the business they have

equal interests in the businesss success. Venture capitalists are only periodical investors wanting to exit the business at some stage. Disadvantages The profits will be shared with the investor. Acquiring venture capitals is a lengthy and complex process where a business plan and financial projections must be submitted to the potential venture capitalist As an owner of the business the venture capitalist may want to influence the strategic decisions and take control of the business.

4.14 Factoring

Advantages A large proportion of money is received within a short time-frame. The sales ledger of the business can be outsourced to the factor. The money collections from debtors are undertaken by the factoring

company. Helps a business to have a smooth cashflow operation. Non-recourse factoring protects the client company from bad debts. Disadvantages The business has to pay interests and fees for the factor for its services. The cost will be a reduction on the companys profit margin.
Page | 22 Lack of privacy since the sales ledger is maintained by the factor.

Costumers would not like factoring companies collecting debts from them.

4.15 Invoice discounting

Advantages The client company receives the money in a short period. There is some amount of privacy since the sales ledger is maintained by the client company and only some invoices are submitted for immediate cash. Less costly than factoring since the sales ledger is maintained by the client company. Unlike factoring customers are not aware of invoice discounting since the debt collection is undertaken by the client firm. Disadvantages Debt should be collected by the client company itself and thus resources and time are wasted in debt collection. Sales ledger has to be maintained by the client company itself.