What is a financial statement?

By Ken Boyd

Financial statements are historical reports that show a company’s financial position and profitability for a period of time. Basic accounting principles need to be applied to all financial statements prepared in the U.S. Public companies publish them in an annual report that disclose their financial information for each fiscal year.

Some financial statements include a balance sheet, income statement (profit and loss statement), and statement of cash flows, though many other reports exist. Balance sheets and income statements are connected. The balance sheet’s cash balance is the same as the ending balance in the statement of cash flows. Financial statements are important because they let stakeholders—shareholders, creditors, and regulators—understand a company’s financial condition.

Balance sheet defined

A balance sheet is a financial statement that lists a company’s assets, liabilities, and equity balances as of a specific date.

A balance sheet provides detail for these categories:

Assets: Resources used to generate revenue (sales) and profits in a business. An asset may be tangible, like a vehicle, or intangible, like a patent or other intellectual property.
Liabilities: Amounts owed to other parties, including accounts payable (current liabilities) and long-term debt.
Equity: Also referred to as stockholder’s equity or shareholder’s equity, equity is the difference between assets and liabilities, and includes common stock, additional paid-in capital, and retained earnings. The equity balance is the true value of a business.

The three components of the balance sheet are driven by the balance sheet formula:

Assets – liabilities = equity

The double-entry system of accounting requires that the accounting equation above stay in balance as transactions are posted.

Connection to the income statement

The income statement (or profit and loss statement) is connected to the balance sheet through the net income account. An income statement is generated using the income statement formula:

Revenue – expenses = net income (profit)

Income statement accounts are referred to as temporary accounts because the account balances are adjusted to zero at the end of each month and year. However, balance sheet accounts are permanent, and the ending balances are carried forward from one month to the next.

At month-end, the accounting books are closed, and all revenue and expense accounts are adjusted to zero. The net impact of the income statement activity is posted to net income in the balance sheet. This increases the owner’s equity balance in the balance sheet.

Income statement defined

As stated above, the income statement is created using this formula:

Revenue – expenses = net income

Most companies produce a multi-step income statement, which documents how a firm produces net income.

Multi-step income statement

Assume, for example, that you’re a small furniture manufacturer, and that you’re creating a multi-step income statement for May. Most of your business activity will flow through gross profit:

$1,200,000 sales – $900,000 cost of goods sold = $300,000 gross profit

The materials, labor, and overhead costs are posted to cost of goods sold. In May, you sold $1,200,000 of furniture, but cost totalled $900,000.

You incurred other expenses to operate your business in May, such as advertising costs, commissions paid to salespeople, and the cost to operate your home office. Operating expenses are subtracted from gross profit to calculate operating income:

$300,000 gross profit – $170,000 operating expenses = $130,000 operating income

Operating income vs. non-operating income

Operating income is generated from the day-to-day activities of running your business. In May, furniture sales produced $130,000 of operating income. Your company also earned non-operating income, including $2,000 in interest income on bank account balances and a $4,000 gain from the sale of equipment.

$130,000 operating income + $6,000 non-operating income = $136,000 net income

Your business must be able to produce the vast majority of net income from operating income activities, because operating income is sustainable. Non-operating income is not consistent or predictable, and no company can survive over the long-term by relying on it to produce annual profits.

Statement of cash flows

The statement of cash flows (also called a cash flow statement) documents the cash inflows and outflows in a business, which are separated into three categories:

Operating activities: Sources and uses of cash related to the daily operating activities of a business, such as cash from customer sales and paying for inventory. A company should produce the vast majority of its cash inflow from day- to-day operations, which can be sustained over months and years.
Investing activities: Cash activity related to buying and selling assets, such as machinery, equipment, and vehicles.
Financing activities: When a company raises money from a stock or bond issue, the transaction is a cash inflow from financing. This category also accounts for cash repayments to investors, such as the payment of a cash dividend.

Most of the cash activity in a business takes place in the operating category. When an accountant reviews the checkbook to create the statement of cash flows, the accountant should identify the investing and financing transactions first. All remaining cash activity is in the operating category.

Connection to balance sheet

The statement of cash flows adds the cash inflows and outflows for all three categories to compute the net change in cash for the period (month of year).

Beginning balance in cash + net changes = ending cash balance

The ending cash balance in the cash flow statement should equal the ending cash balance in the balance sheet.

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