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Four Basic Financial Statements

The four basic financial statements provide the most accurate information to determine the health of your company. Learn why they are essential to growing your business.

We understand accounting and bookkeeping are known for their upbeat and exciting personalities …wait, that’s not right. Accountancy has a perception as being one of the most boring, albeit, essential pieces to running a business. But what exactly is the bread and butter of this practice?

Well, there is the primary rule: debits on the left and credits on the right. When each column is totaled, they should be equal, or in other words, the books should be balanced. This is great but what we really need to discuss are the four basic financial statements: Income Statement, Balance Sheet, Statement of Cash Flows, and the Statement of Stockholder’s Equity.

“Why?” you may ask. On a fundamental level, these statements provide the most accurate information to determine the health of the company. So, what exactly are each of the statements? What information do they provide? And why are they important?

Income Statement

This financial statement shows a company’s profit or loss by displaying a summary of a company's revenues, expenses, and profits or losses over a given period of time, usually one month, three months (i.e., quarterly), or one year. The profit or loss is determined by taking all revenues and subtracting all expenses from both operating and non-operating activities. The components of an Income Statement typically include Revenue, Expenses, Cost of Goods Sold (COGS),  Operating Income, Interest Expense, Pre-Tax Income, Income Taxes, and Net Income, in a coherent and logical manner. These periodic statements are aggregated into total values for quarterly, year-to-date, and annual results. The income statement is sometimes given prominence over the other three core statements – particularly among small- to medium-size businesses; an income statement is important because it offers a recent picture of the company's revenues and expenses and overall profitability. It shows a company's ability to generate sales, manage expenses, and create profits over a period of time.

Balance Sheet

The Balance Sheet is a statement of the Assets, Liabilities, and Stockholder’s Equity of a business or other organization at a particular point in time. It reflects the income and expenses of the period on an entity's assets, liabilities and stockholder's equity. The basic accounting equation to remember here is Assets = Liabilities + Stockholder’s Equity. This equation explains that a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing equity). Assets generally can be described as cash, receivables, investments, inventory, and property. Liabilities are payables (including those imminently due, such as rent, wages, taxes, utilities) and loans. And Stockholder’s Equity is retained earnings, paid-in capital, and common stock. By itself, a Balance Sheet for a single period cannot give a sense of the trends that are playing out over a longer period -  rather it is a ‘snapshot’ of the business’s financial health at a specific point in time. For this reason, the balance sheet should be compared with those of previous periods. It also should be compared with those of other businesses in the same industry since different industries have unique approaches to financing and the use of assets. The balance sheet is used alongside other important financial statements in order to conduct fundamental analyses. It provides a basis for computing rates of return and evaluating the organization’s capital structure. A number of ratios can be derived from the balance sheet, helping investors get a sense of the financial health of a company. These ratios might include, for example, the debt-to-equity ratio and the acid-test ratio, along with many others. Taken together, the income statement and statement of cash flows also provide valuable context for assessing a company's finances.

Statement of Cash Flows

This financial statement summarizes the amount of cash and cash equivalents entering and leaving a company. The main components of the cash flow statement, or SoCF, are the cash from operating activities, cash from investing activities, and cash from financing activities; and the disclosure of noncash activities is sometimes included. The operating activities on the SoCF include any sources and uses of cash from business activities such as sales of goods and services and interest payments. The investing activities include sources and uses of cash from a company's investments such as the purchase of a plant and equipment or providing a long-term loan to another party. Financing activities include the sources of cash from investors or banks, as well as the cash paid to stockholder’s. Examples of financing activities include repurchasing stock from shareholders or issuing debt and equity. Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in revenue, expenses, and credit transactions – which are shown via the balance sheet and income statement – resulting from transactions that occur from one period to the next. The SoCF measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses. A cash flow statement is a valuable measure of strength, profitability, and of the long-term future financial outlook for a company. The SoCF can help determine whether a company has enough liquidity or cash to pay its expenses. A company also may use a cash flow statement to help predict future cash flow, which helps with matters of budgeting.

Statement of Changes in Stockholder’s Equity

This financial statement conveys any changes in the value of stockholder’s equity in a company during a year - or between years. Business activities that have the potential to impact stockholder’s equity are recorded in the statement of stockholder’s equity. In other words, it shows all equity items that may affect the equity balance, such as dividends, net profit or income, and common stock. Stockholder’s equity is basically the difference between total assets and total liabilities. In equation form, it looks like this: Stockholder’s equity = Assets – Liabilities. Another way to calculate Stockholder’s Equity = Contributed Capital + Retained Earnings. This statement is valuable for investors because it shows profits earned and held, potentially for internal use. These profits may show if a company can cover future expenses or if a company should reinvest. This statement also shows if dividends are paid to stockholders and allows them to see how their investment is doing. It also may facilitate management’s decision-making regarding the future issuances of stock shares or stock buy-backs.

How are they related?

The financial statements are not isolated items, they are closely related and flow between each other to give a larger picture of the business’ financial circumstances. Each statement can stand alone to offer a snapshot of the given information; however, separately, they do not allow an in-depth view of the whole financial state of the company.

Typically, the income statement is the first financial statement prepared during the accounting cycle because the net income or loss must be calculated and carried over to the statement of stockholder’s equity before other financial statements can be prepared. More specifically, net income from the income statement flows to the balance sheet and statement of cash flows. As another example Depreciation and Capital Expenses determine Property, Plant, and Equipment on the balance sheet.

The cash flow statement complements the balance sheet and income statement. It's important to note that the SoCF is distinct from the income statement and balance sheet because, under the accrual method of accounting, the SoCF does not include sales made on credit and expenses related to the current period that will actually be paid in the future.

Got it?? Maybe not completely…

We pretty much just covered the first semester of a college-level course on accounting! This can be pretty overwhelming for someone who is new to financial statements and accounting in general. It may seem confusing and complicated at first, but understanding how to review and analyze these statements will be key to the future of your business. Need help? Check out KPMG Spark! We are here to help with your bookkeeping and CPA needs. We use live data to give you feedback on your business anywhere from income and expenses to balances and more. We’d love to answer your questions… and chat about your favorite financial statement!

 

 

 

 

This blog article is not intended to address or provide advice concerning the specific circumstances of any particular individual or entity and does not constitute an endorsement of any entity or its products or services.

Some or all of the services described herein may not be permissible for KPMG audit clients and their affiliates or related entities.

Timothy A A StilesFebruary 17, 2021Posted In: Tax Tips

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