Question

Financial Statements reflect the effects of business transactions and events on the entity. The different types of financial statements are not isolated from one another but are closely related to one another. Critically discuss the relationship and links among different financial statements.

Answer 1

Relationship between various financial statements:

The income statement, balance sheet and cash flow statement are all interrelated. The income statement describes how the assets and liabilities were used in the stated accounting period. The cash flow statement explains cash inflows and outflows, and it will ultimately reveal the amount of cash the company has on hand, which is also reported in the balance sheet. By themselves, each financial statement only provides a portion of the story of a company's financial condition; together, they provide a more complete picture.

Stockholders and potential creditors analyze a company's financial statements and calculate a number of financial ratios with the data they contain to identify the company's financial strengths and weaknesses and determine whether the company is a good investment/credit risk. Managers use them to aid in decision making.

One important way the financial statements are used together is in the calculation of free cash flow (FCF). Smart investors love companies that produce plenty of free cash flow. It signals a company's ability to pay debt and dividends, buy back stock and facilitate the growth of business - all important undertakings from an investor's perspective. However, while free cash flow is a great gauge of corporate health, it does have its limits and is not immune to accounting trickery.