Finance and financial reporting

Finance

Finance is the study of the allocation of scarce resources. It includes elements of economic costs and benefits. The resources we study include financial capital and economic capital.

Finance is dynamic because time is an important element. Financial decision-making uses significant commitments of resources, since decisions are being made about the future. Finance involves management—information, risk, and uncertainty vary to complicate decisions on adding value to the firm. The planning, organization, leading, and controlling results affect a firm’s objective of maximizing shareholder wealth.

Finance starts with financial accounting—the system of financial accounting (accrual accounting) and scorecards of financial statements (i.e., the balance sheet, the income statement, and the statement of cash flows). Tracking and timing of revenue, expenses, earnings, and cash flow are essential in accounting.

The accounting equation is:

Total Assets (TA) = Total Liabilities (TL) plus Owner’s Equity (OE)

Assets are what we use to create value, and they are financed by liabilities and equity. In the balance sheet the right-hand side balances with the left-hand side of the equation. The accounts (current assets, long-term assets, current liabilities, long-term liabilities, and equity) are measured as stock variables—a measure of the amount of each item at a point in time.

Two key aspect of a balance sheet are:

1. The balance sheet is a picture of the firm as of one point in time. It does not provide information for any period of time.

2. The ordering of the accounts is according to decreasing liquidity (ease of conversion to cash).

Three Capitals of Finance

The field of finance contains four interrelated areas: financial management (corporate finance), financial markets and institutions, international financial management, and investments.

Within those four areas, we focus upon three elements of capital: working capital, capital budgeting, and capital structure.

Capital management is also known as operations. The financial statements associated with it are the balance sheet, income statement, and statement of cash flows. All current assets and current liabilities from sales to EBIT operating activities are associated with capital management.

Capital budgeting is also known as planning and investing. The balance sheet and the statement of cash flows are the financial statements associated with this type of capital management. Long-term or fixed assets and investing activities are the accounts associated with capital budgeting.

Capital structure is also known as financing. The financial statements associated with it are the balance sheet, income statement, statement of cash flows, and retained earnings or equity. Long-term liabilities and equity from EBIT to net income financing activities are associated with capital structure.

The financial statements show the company's operations and results in financial terms. Accountants create these financial statements each accounting period to present the current results of company operations. These financial statements are used internally and externally.

These are the four primary financial statements:

• Income statement: describes a company's revenues and expenses along with the resulting net income or loss over a period. (Net income occurs when revenues exceed expenses. Net loss occurs when expenses exceed revenues.)

• Balance sheet: describes a company's financial position (types and amounts of assets, liabilities, and equity) at a point in time.

• Statement of cash flows: identifies cash inflows (receipts) and cash outflows (payments) over a defined period of time.

• Statement of stockholders' equity: explains changes in equity from net income (or loss) and from owner investment and withdrawals over a defined period of time.

Financial Statements

All of the financial statements used have a different importance. Many people consider the income statement the most important of the four financial reports, because it conveys whether a business achieved its profitability goal; in other words, whether the company earned an acceptable level of income or beat the targeted goal. Sometimes, this is referred to as "making your numbers."

The balance sheet is frequently viewed as runner-up to the income statement in terms of importance. However, this statement shows the company's financial status at a specific date and indicates how effectively assets are being managed to generate returns. This report is unique in that it presents a view of a business as a holder of resources (assets) that are equal to the claims against those assets. The claims consist of the company's liabilities and the owner’s equity in the company.

The statement of cash flows focuses mainly on a company's liquidity versus a company's profitability or financial position. Cash flows are nothing more than the inflows and outflows of cash in and out of a company. The statement of cash flows illustrates the cash produced by business operations during an accounting period, as well as vital investing and financial activities that occurred during the same period. Keep in mind that this statement uses the cash basis method of accounting. Most corporations use accrual based accounting, so the statement of cash flows may be the only place you can determine the current cash situation.

The statement of owners' equity portrays the changes in owners' equity over an accounting period. Typically, net income/loss is added/subtracted from the beginning retained earnings balance. Any withdrawals or dividends that were paid are deducted from this total to determine the ending capital balance.

Each type of financial statement is used in a different way, depending on the needs of the user.

• Income statement: Used to determine a company's profitability

• Balance sheet: Assesses whether the company has enough assets to cover any outstanding liabilities

• Statement of cash flows: Used by creditors to determine whether a company is liquid or not, because the statement tracks inflows and outflows for operating, investing, and financing activities

• Statement of owners' equity: Breaks down a company's capital and ownership accounts