Think of the financial statements as scorecards that collect the performance data of your company and report it to the owners (shareholders), managers and the government. There are three of them—the Balance Sheet, Income Statement (P&L), and Cash Statement. Each is unique, but they are related.
The balance sheet is like a snapshot of your business that shows the company’s financial position at a specific moment in time. It’s set up with two sides—left side and right side. The left side is called, Assets, the things you have in the company like cash, accounts receivable, inventory, equipment, etc. The right side shows who provided the assets and is sub-divided into two parts, called liabilities and owner’s equity. Liabilities represent people who provided something and have not yet been paid. Owner’s equity represents the portion of the assets provided by the owners of the company, free and clear of any debt or liability. This balance sheet structure expresses the basic accounting equation: Assets = Liabilities + Owner’s Equity. The balance sheet always balances because if you have something, someone had to provide it.
Owner’s usually put some of their own money in a company to get it started, but their objective is to make money. They set up the operations of the business which makes and sells a product or service. The objective is to sell the product or service for more than what it cost to make it and run the business, so that the company makes a profit. The earnings line on the balance sheet indicates how much profit (or loss) the company made in each accounting period (a month, a quarter, or a year) from the operations of the business.
The income statement gives all the details of how the profit or loss was achieved. It starts with Revenue, which represents the amount billed to customers for products & services delivered. Next, it divides the costs into two categories and subtracts them from the revenue to get the earnings (or losses) for that accounting period. The two operating cost categories are Cost of Sales and Operating Expenses. Cost of sales represents all the costs to make and deliver a company’s product or service. Think of the operating expenses as the overhead to run the company—things like marketing and sales, human resources, accounting, information technology, administration, and legal.
The earnings on an income statement answers the question, “Are we making money?”
The first line on the Balance sheet is cash, but it only tells you how much cash you have at one moment in time. For the details of where cash came from and where it was spent, you need the cash statement. The cash statement has three parts because there are three types of cash flow in a business—operating cash flow (OCF), investing cash flow (ICF) and financing cash flow (FCF). OCF is the cash received or spent running daily operations. ICF is cash received or spent on investments such as property, plant and equipment or buying and selling a company. FCF is cash received or spent in financing activities such as loans or paid in capital from shareholders. The cash statement is a statement of changes in a company’s cash position in a specific accounting period, divided into these three types of cash flow.
Relationships of the Statements
Think of the balance sheet as the most comprehensive of the three statements. It shows the company’s current financial position. A company’s financial position is represented by its total assets and what portion of them were provided by people that are still owed money (liabilities) and what portion is owned by the owners of the company, free of any liabilities (owner’s equity). Every company’s objective is to improve its financial position. Your financial position is improved by earning money on the products or services sold and by quickly converting the money earned to cash. This means that the first asset, cash, and the last equity item, earnings, are the two most important numbers on a company’s balance sheet.
The weakness of the balance sheet is that it is a ‘snapshot’ that only gives you the totals of cash or earnings at the end of a month, quarter or year. The balance sheet will not tell you where you got cash or where you spent it. It also will not tell you how you achieved your earnings. Companies need to know about cash and earnings in more detail, hence the need for a ‘cash statement’ and an ‘income statement.’
Cash is received or spent daily in companies, so think of the cash statement as a ‘movie’ of all the cash flow changes that have occurred in a specific accounting period. This movie is divided into the cash flow from operating, investing and financing activities. The total cash from these three activities represents the ‘net change in cash.’ The cash statement literally is a statement of changes in a company’s cash position during a specific period.
The income statement is a ‘movie’ that shows the details from the earnings year-to-date line on the balance sheet. The balance sheet tells you how much you earned and the income statement shows how you did it. This movie begins with revenue—the total amount of sales billed to customers during the period of the movie. Next is subtracted all the ‘costs of sales’ to result is gross profit. From gross profit the operating expenses are subtracted to end at net income. The income statement is a statement of changes in a company’s financial position in a specific period.
The following graphic represents the relationship among these three statements—one snapshot and two movies to give the details of what happened to cash and earnings. From the graphic you can see that although these are separate documents, they are not independent of each other.