Which financial statement is the most important?
/What are Financial Statements?
Financial statements are a collection of summary-level reports about an organization's financial results, financial position, and cash flows. The key components of the financial statements are the income statement, balance sheet, and statement of cash flows. These statements are designed to be taken as a whole, to present a complete picture of the financial condition and results of a business. A case can be made for each of the financial statements being the most important, though the ultimate answer depends on the needs of the user. The key points favoring each of these financial statements as being the most important are noted below.
Importance of the Income Statement
The most important financial statement for the majority of users is likely to be the income statement, since it reveals the ability of a business to generate a profit. Also, the information listed on the income statement is mostly in relatively current dollars, and so represents a reasonable degree of accuracy. However, it does not reveal the amount of assets and liabilities required to generate a profit, and its results do not necessarily equate to the cash flows generated by the business. Also, the accuracy of this document can be suspect when the cash basis of accounting is used. Thus, the income statement, when used by itself, can be somewhat misleading.
Importance of the Balance Sheet
The balance sheet is likely to be ranked third by many users, since it does not reveal the results of operations, and some of the numbers listed in it may be based on historical costs, which renders the report less informative. Nonetheless, the balance sheet is of considerable importance when paired with the income statement, since it reveals the amount of investment needed to support the sales and profits shown on the income statement.
Importance of the Statement of Cash Flows
A possible candidate for most important financial statement is the statement of cash flows, because it focuses solely on changes in cash inflows and outflows. This report presents a more clear view of a company's cash flows than the income statement, which can sometimes present skewed results, especially when accruals are mandated under the accrual basis of accounting. At a minimum, it provides a backstop to the income statement, which can be used to see if the profit figure stated in the income statement is reasonable. For example, if the income statement shows a large profit, while the statement of cash flows shows a large cash outflow, then some investigating is in order to ascertain the reason for this disparity.
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Other Variations
Another way of looking at the question is which two statements provide the most information? In that case, the best selection is the income statement and balance sheet, since the statement of cash flows can be constructed from these two documents. Yet another variation on the topic is to infer which statement is the most important, based on the perspective of the user. For example:
Auditor perspective. Auditors audit the balance sheet, so that is the document that they have the greatest interest in.
Investor perspective. Investor analysis of share value is largely based on cash flows, so they will have the greatest interest in the statement of cash flows.
Lawyer perspective. Anyone bringing a lawsuit against a company will want to review its balance sheet first, to see if there are enough assets to attach if the lawsuit is successful. Otherwise, it is not cost-effective to pursue a lawsuit.
Management perspective. Managers are responsible for fine-tuning the business, so they are likely to delve most deeply into the income statement.
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