Although individual financial statements each provide different snapshots of financial health, all financial reports reflect business activities that produce a company's profit or loss. The balance sheet shows how cash flow changes revenue and expenditure accounts, while the income state shows true net income at a given point in time. Investors use the various reports as tools that inform investing decisions. And, banks consider basic financial statements powerful tools useful for evaluating creditworthiness and profit potential. There are four basic financial statements everyone in business should know how to read and interpret: the income statement, the balance sheet, the cash flow statement, and the retained earnings statement.
Let's look at the similarities and differences of the four financial reports, starting with the retained earnings statement,
What Everyone Should Know About Retained Earning Statements
Retained Earning Statements (RES) reconcile positive and negative changes in the retained earnings account for a specified period. Most statements reflect changes for a particular month, quarter, or year. In its simplest form, the RES formula starts with a beginning balance, adds net income, subtracts dividends, and ends with a new retained earnings balance.
As an example, let's assume Company A started with a retained earnings opening balance of $100,000 on December 31, 2012, paid shareholder dividends of $15,000 during the year ending December 31, 2013, and realized $30, 000 net income for the year ending December 31, 2013, the retained earnings formula would look like this: $100,000 + $30,0000 - $15,000 = $115,000.
If applicable, the statement may also include separate line items for the par value of the common stock, treasury stock, and additional capital paid-in. This statement may also be referred to as a Shareholder Equity Statement or an Owners' Equity Statement. Unlike other basic financial statements, the Retained Earnings report may be included as a footnote on other financial statements or issued as an individual report for investors.
Now, let's talk about the income statement.
What Everyone Should Know About Income Statements
Income Statements provide a snapshot of how much revenue a business earned over a specific period. Most companies produce monthly, quarterly, or yearly reports for internal and external partners. This statement reflects costs and expenditures related to earning revenue. The primary purpose of the report is to show how much money the company earned or lost over the defined period.
Calculating net income, the amount of money you get to keep after paying all associated expenses is simple. You start with all revenue that came into the company from sales of products or services and subtracts all expenses such as discounts, cost of products, and refunds for items returned. The Income Statement may also be called the Profit and Loss Statement (P&L) because it shows whether the period activities resulted in a profit or loss for the company.
Accountants and bookkeepers also deduct depreciation, marketing expenses, interest paid, and other costs of doing business that generates revenue. Income tax is usually the last expense deducted. The income statement and balance sheet are closely related. Let's look at the balance sheet and the role it plays in making business decisions.
What Everyone Should Know About Balance Sheets
The balance sheet provides financial information about business assets, shareholder equity, and liabilities at the close of a predefined reporting period. It does not show the movement of cash in and out of the accounts, rather it is a form that summaries the relationship of assets to shareholder equity and liabilities. This report is called the balance sheet because the asset total must equal the sum of all liabilities and shareholder equity. In other words, the report must balance.
To interpret the report, you'll need to know some basic vocabulary.
- Assets: Cash or items that can be converted into cash equivalent. Product inventory is an asset. Equipment that is used to operate a business such as furniture, real estate, and vehicles used for delivery.
- Liabilities: Bills due in the future, such as payment on loans, insurance, taxes, and charge accounts are liabilities. An income statement may show long-term and current liabilities.
- Shareholder Equity: Earned dividends or the amount invested in a business by purchasing shares.
Finally, let's look at cash flow statements.
What Everyone Should Know About Cash Flow Statements
The Cash Flow Statement is exactly what the name implies. This form reflects movements of cash coming in, going out, and flowing between internal accounts. The Cash Flow Statement provides an overview of certain business activities relating to operating, investing, and financing flows.
Operating activities reported on the cash flow statement reconcile cash and non-cash adjustments used for operating a business.
Investing activities on the cash flow statement represent purchases and sales of long-term assets, such as vehicles and manufacturing equipment. If a company sells investment to generate cash, the sale would also be recorded on the cash flow statement.
Financing activities shown on a cash flow statement may include selling bonds or securing a mortgage. Paying down debt is also an example of financing activities.
Each basic financial statement has a unique purpose and provides specific financial information to inform business decisions. Understanding basic financials is the first step toward making wiser business management decisions.