Lesson 5: Financial Statements
In this lesson, we will cover the purpose of financial statements. Then, we
will discuss each of the general purpose financial statements: the income
statement, the retained earnings statement, the balance sheet and the cash flow
statement. Finally, we will study the order in which the statements are prepared.
Users look at financial data in
order to make business decisions. Financial statements present a snapshot of
all of the relevant data which ultimately is the end result for all accounting
data. This makes it easy to see the performance of the company without sifting
through thousands of transactions.
Businesses adhere to
the generally accepted accounting principles (GAAP) by preparing financial data
in a standardized format across the various types of financial statements. As
the information accumulates, the company summarizes the financial data,
normally on a quarterly and annual basis.
You can easily remember the 4 different types of financial statements by using
the following acronym: BRIC.
Think of the combination of financial statements as the weight of a brick, as
the combination of financial information in these 4 types of statements are
full of information. In this acronym, we are using BRIC instead of BRICK as
there are only 4 main types to remember.
While you will use the BRIC acronym to remember the names of the financial
statements, keep in mind the order that these items are prepared in is slightly
different. They flow in the order below; each statement is a precursor for the
next. For example, to prepare the retained earnings statement, you will need
income data from the income statement.
1. Income Statement
2. Retained Earnings
3. Balance Sheet
4. Cash Flow Statement
Picture a measuring stick. Similar to how the measuring stick measures size,
the income statement measures how a company is performing financially.
The revenue and expense transactions are summarized into categories that
best represent their purpose. All income statements are
organized in the same way, providing a standardized format for users to review
the total revenue, profits, expenses and net income of a company.
Take a look at the example above:
the revenue is summarized in one category, while the expenses are listed in
categories such as research development, interest expenses and non-recurring
expenses.
Let's break down some of the important sections of the income statement.
Total Revenue accounts for the total amount of income the company earned in
the given time period. Sometimes this figure is broken down into multiple
categories such as sales revenues, interest revenues and gains on the sale of
assets.
The Cost of Revenue,
also known as the cost of goods sold is deducted to provide the gross profit.
Expenses are further deducted in groupings and
subcategories, leaving you with the final net income figure at the bottom of
the statement. If the revenue does not exceed expenses, you are left with a net
loss figure instead.
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The income statement will tell you whether a company is profitable or losing
money which ultimately defines their performance. Running a solvent business
requires revenue in order to pay debts, taxes and expenses. After all of these
items are paid, the money left over is the net income.
Think about the retained earnings statement as a large pie chart,
it defines the amount that is issued to shareholders and owners in
the form of dividends or retained earnings.
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The retained earnings statement adds in the net income figure from
the income statement to the current retained value. This figure is then
deducted by the amount that is paid out to shareholders. In short, this
statement answers how profit is distributed. It answers the fundamental
question of how much of the income is being distributed to owners, and how much
is kept within the company.
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The company may decide to retain all of their earnings in order to
position themselves for growth, in which case no dividends would be paid out.
As you can see from the sample retained earnings statement above,
the net income figure is added to the amount of retained earnings. This figure
is then deducted by the dividends that are paid out to stock holders to
conclude with the final balance of retained earnings.
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This is a very simple example to demonstrate the concept. Many retained
earnings statements break down additional values such corrections to the
previous period retained earnings value to account for depreciation.
The balance sheet is best thought of as a snapshot that
speaks to the financial position of the company and whether they can pay their
bills on time. It also shows their ability to acquire additional cash flow and
payout dividends to their shareholders.
The example for Microsoft Corporation above represents their assets,
liabilities and shareholders equity with each entry recorded on a specific
point in time.
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Take note of each section on the balance sheet:
The assets shown in the top section are financial items such as investments,
equipment and inventory. They are everything that
the corporation owns summarized in groupings.
The liabilities section in
the middle represents every obligation they are responsible for; how much money
they are owe to various debts.
Equity is what remains in
residual interest after the liabilities are
deducted from the assets; essential what is left to pay the shareholders.
The cash flow statement can be pictured as the veins and arteries of the human
body. The money is flowing constantly, flowing in and out of the company. This
statement provides a real-time view of how the cash flow is affected by
business activities.
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We talked about the three types of business activities (operating,
investing and financing) in
one of the previous lessons. The cash flow statement looks at the same
activities to measure the amount of cash that enters and leaves the company.
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Often,
the income statement may reflect revenues but there can be a difference in
timing of when the cash is actually received. Investors often look more at the
cash flow statement because it is the most transparent view of a company's cash
flow.
Looking at the sample cash flow statement above,
you can see that there are two directions of cash flow:
Sources of income flowing in, such as net earnings and notes payable.
Uses of income flowing out, such as inventory and equipment purchases.
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The cash flow statement integrates information from
the other three financial statements to
reflect all cash flowing through the business.