Understanding financial statements is crucial for anyone involved in a financial business or in a finance team, as they provide a comprehensive view of an organization’s financial health and performance. While there are various financial reports, three statements form the cornerstone of financial reporting: the income statement, balance sheet, and cash flow statement.
Each statements provides unique insights into different aspects of a company’s finances, from profitability and asset value to cash management. While each statement serves a different purpose, they’re inherently linked by design and can be used together to gain additional insights into financial performance.
What are the Three Statements?
The three main financial statements are typically found in a company’s annual report, quarterly filings, or financial disclosure documents. Public companies are required to file these statements with regulatory bodies, while private companies prepare these statements for their investors, lenders, and for private use.
Each statement provides distinct information about a company’s financial performance and position:
The Income Statement shows revenues, expenses, and profitability over a specific time period.
The Balance Sheet presents a snapshot of assets, liabilities, and equity at a given point in time.
The Cash Flow Statement tracks the inflow and outflow of cash from the business.
Together, these statements offer a comprehensive view of a company’s financial health and are essential tools for decision-making processes.
Who produces these statements?
Financial statements are primarily produced by a company’s internal finance team, with the following people typically having responsibility in the production of these statements:
Accountants and financial analysts collect and process data.
Controllers oversee preparation.
The Chief Financial Officer (CFO) is ultimately responsible for its final output.
For public companies, external auditors verify the statements, while small businesses may rely on owners or external accountants. The CEO and Board of Directors typically review and approve final statements before release.
Income Statement
The income statement, also known as the profit and loss statement, provides a summary of a company’s revenues and expenses over a specific period, usually a quarter or a year.
Format and Structure:
Revenue/Sales
Cost of Goods Sold (COGS)
Gross Profit (Revenue – COGS)
Operating Expenses
Operating Income (Gross Profit – Operating Expenses)
Non-Operating Income and Expenses
Income Before Taxes
Income Tax Expense
Net Income
Purpose:
The income statement’s primary purpose is to show a company’s profitability. It demonstrates how revenue is transformed into net income through various expenses and costs. This helps stakeholders understand the company’s operational efficiency and overall financial performance.
Balance Sheet
The balance sheet provides a snapshot of a company’s financial position at a specific point in time, showing what the company owns (assets), owes (liabilities), and the shareholders’ equity.
Format and Structure:
Assets: Including both current assets (e.g., cash, inventory, accounts receivable) and non-Current Assets (e.g., property, equipment, long-term investments)
Liabilities: Current (e.g., accounts payable, short-term debt) as well as non-current liabilities (e.g., long-term debt, deferred taxes)
Shareholders’ equity: Share Capital and Retained Earnings
Purpose: The balance sheet displays what a company owns (assets), what it owes (liabilities), and the investments made by shareholders (equity). It provides insights into the company’s financial health, liquidity, and capital structure.
Time Period: Unlike the income statement or cash flow statement, the balance sheet represents the financial position at a single point in time, typically the end of a reporting period (e.g., quarter-end or year-end).
The balance sheet always adheres to the fundamental accounting equation:
This equation must always balance, giving it the name “balance sheet.”
Cash Flow Statement
The cash flow statement illustrates how cash moves through a business, detailing the inflows and outflows of cash from various activities. It provides crucial insights into a company’s liquidity and ability to generate cash.
Format and Structure:
The cash flow statement is typically divided into three main sections detailing cash flow from Operating Activities, Investing Activities and from Financing Activities. Each area calculates its cash flow differently:
Operating: Adjusts net income for non-cash expenses and changes in working capital
Investing: Shows cash used or generated from investments in assets
Financing: Reflects cash from debt, equity, and dividend payments
Purpose:
The cash flow statement offers vital insights into a company’s financial activities, revealing the cash generated from core operations and showing the business’s self-sustainability. The statement also demonstrates how the company invests in future growth and manages financing activities, such as borrowing or paying dividends. This comprehensive view helps stakeholders assess the company’s financial health, strategic decisions, and long-term viability.
How are the 3 Statements Connected?
There are a few crucial connections between these statements. Understanding these connections is crucial for thorough financial analysis, with information flowing between each of the statements in different ways.
Net Income
Net income, which originates in the income statement, plays a crucial role in this interconnection. It flows into the balance sheet as part of retained earnings, representing the profit a company has chosen to reinvest rather than distribute to shareholders. Additionally, net income serves as the starting point for the cash flow statement, bridging the gap between profit and actual cash movement.
Balance Sheet Changes
Any changes in the balance sheet are also directly reflected in the cash flow statement. For instance, if accounts receivable on the balance sheet increases, it appears as a use of cash in the operating activities section of the cash flow statement.
Depreciation
Depreciation appears as an expense on the income statement, reducing reported profit, while decreasing the value of assets on the balance sheet. However, in the cash flow statement, depreciation is added back because it’s a non-cash expense, helping to reconcile net income to actual cash flow.
Capital Expenditures
Capital expenditures demonstrate how investing activities link the statements. These expenditures are shown in the cash flow statement under investing activities, representing a cash outflow. At the same time, they increase the value of assets on the balance sheet, often appearing as property, plant, and equipment.
Debt
Debt is also recorded between and can be read within these statements. The interest expense associated with debt appears on the income statement, impacting profitability, with the principal amount of the debt then recorded as a liability on the balance sheet.
When analysing the reports, it’s recommended you read the Income Statement first, followed by the Balance Sheet, and finally the Cash Flow Statement. This order allows you to follow the flow of financial activities logically:
First, see profitability (Income Statement)
Then, understand the resulting financial position (Balance Sheet)
Finally, analyse how these activities affected cash (Cash Flow Statement)
