What are financial statements? What do they mean? Why do they matter? Do you sometimes find yourself asking these questions? Well, you are in the right spot. Let's take a high level look at the three primary financial statements and how they are correlated.
The balance sheet, income statement and cash flow statement are the three primary financial statements you will find with most any “for-profit” business. These statements offer three perspectives on a company’s financial performance. They tell three different but related stories about how well, or not so well, your company is performing financially.
The balance sheet shows a company’s financial position at a specific point in time. It provides a snapshot of assets, liabilities, and equity on a given day. For example, at the end of the day, on December 31, 2016, my company owned, X, Y and Z. It is called a “Balance” Sheet because Assets = Liabilities + Equity.
- Assets are things in which the business owns. Think about cash, accounts receivable (money owed to you), property, buildings, equipment, inventory, deposits and so forth.
- Liabilities on the other hand are items that you owe to others. Think about accounts payable (money you owe vendors), loans from bank, auto loans, accrued payroll and so on.
- Equity is the amount of capital or money that was initially put into the business plus all the earnings or losses since the business started, minus any distributions, plus any new money invested.
The income statement shows the bottom line. It indicates how much profit or loss was generated over a period of time – usually a month, a quarter, or a year. For example, For the year ended December 31, 2016, would be a type of heading used on the income statement, not just as of the day as you saw above in the balance sheet. The Income Statement is generally comprised of 4 major sections; Revenues or Sales, Cost of Goods Sold, Overhead and Other.
- Revenue or Sales is generally the first section of the income statement and denotes, as you might expect the income from your business for the period.
- The Cost of Sales or Cost of Goods Sold (COGS) is generally the next section of the statement and that is the costs to produce or purchase the items or services to sale. For example if you are selling T-shirts, and you sell the shirts for $20 each and buy them for $12 each. Then your revenue is $20 and your COGS is $12. Therefore your “gross margin” is $8, so you are making $8 per shirt before any selling, general and administrative costs are factored into the equation.
- Selling, General and Administrative or Overhead costs makes up the third section. This includes items that the business incurs that aren’t directly linked to the product or service. Some examples are rents, utilities, sales commission, accounting and legal. These costs would probably occur no matter if you sold 20 items or 30 items, therefore they are not linked directly to an item.
- Lastly is the Other section. As you might expect, if it doesn’t fit into one of the above sections, it goes into this one. This section is for “one-time” events and is also for interest payments and for interest received, taxes, depreciation and things of that nature.
The final statement is the cash flow statement. This statement tells where the company’s cash came from and where it went. It shows the relationship between net profit and the change in cash recorded from one balance sheet period to the next. This statement has three sections
- Cash flow from Operations is the first section. This section includes any cash generated or used in the day-to-day operation of the business. It shows things like change in accounts receivable, change in accounts payable, depreciation, etc..
- Cash from Investing is the second section. This section shows cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment, or other long-term assets.
- Cash flow from Financing is the third section. It shows cash paid or received from issuing and borrowing of funds. This section also includes dividends paid.
Together, these financial statements can vastly improve your knowledge and understanding of what is going on in your company or in any other business you are researching.
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