The financial statements include the balance sheet, income statement, statement of cash flows, and several other reports. These statements report the financial condition of a business to stakeholders, including shareholders, creditors, and regulators.
The financial statements are historical reports, which reveal a company’s financial position and profitability for a period that has ended.
The balance sheet and income statements are connected, and the balance sheet’s cash balance is equal to the ending balance in the statement of cash flows.
Balance Sheet Defined
A balance sheet is a financial statement the lists a company’s assets, liabilities, and equity balances as of a specific date.
A balance sheet provides detail for these categories:
- Assets: Assets are defined as resources that are used to generate revenue (sales) and profits in the business. An asset may be tangible, such as a vehicle, or intangible, such as a patent or other intellectual property.
- Liabilities: Liabilities represent amounts owed to other parties, including accounts payable and long-term debt.
- Equity: Equity (also referred to as stockholder equity) is the difference between assets and liabilities, and equity 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 equation stay in balance as transactions are posted.
Connection to The Income Statement
The income 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. Balance sheet accounts, however, are permanent accounts, 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
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, and this more detailed format 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 you incur to make furniture are posted to cost of goods sold. In May, you sold $1,200,000 of furniture, and the units you sold had a total cost of $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 non-operating income to produce annual profits.
Statement of Cash Flows
The statement of cash flows documents the cash inflows and outflows in a business, which are separated into three categories:
- Operating: Sources and uses of cash related to the daily operations of a business, such as cash collections from customer sales and paying for inventory. A company should produce the vast majority of its cash inflow from day-to-day operations, because these operations can be sustained over months and years.
- Investing: Cash activity related to buying and selling assets, such as machinery, equipment, and vehicles.
- Financing: 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). The beginning balance in cash, plus the net change equals the ending cash balance. The ending cash balance in the cash flow statement should equal the ending cash balance in the balance sheet.