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Best Guide to Balance Sheet, Income Statement and Cash Flow | Three Major Financial Statements

Financial statements offer the initial step toward assessing a company’s performance. Balance Sheet, Income Statement, and Cash Flow Statement are the three basic financial statements.

The Balance Sheet depicts the assets, liabilities, and capital of the company. The income statement shows revenue and the expenses. It allows the users to understand the profitability for a time period. And the cash flow statement focuses on cash movements in terms of liquidity and operational flows.

All of them provide well-informed strategic choices on a range of issues such as risk handling or growth strategies. As such, these documents are helpful to all businesses and investors.

The Balance Sheet

The balance sheet sounds right, it shows you a company’s current financial situation. It describes a company’s economic soundness and resource management in some basic terms.

Balance sheets are used hand-in-hand by investors, creditors, and analysts. Balance sheets determine profitability, and creditworthiness, and follow performance trends.

Balance Sheet Structure

The first component is the balance sheet itself which consists of three top-level categories. These are Assets? Liabilities? And Equity? This enables users to understand what a business owns, owes, and its overall value.

Assets

Assets are resources owned by a company, which have economic value. They are categorized as:

Current assets: intended to be used or converted into cash in the short term, usually within a year.

For example: Cash, accounts receivable, inventory

Loans: Capital that is used over multiple years rather than months.

For instance: Property, includes property equipment patents.

Liabilities

Liabilities are what the company owes to a 3rd party.

They are classified into:

Short-term Liabilities: Due within one year.

This includes things like accounts payable, and short-term debt.

Non-current liabilities: Liability not due to be settled within 1 year.

Case in Point: Non-current liabilities, such as Long-term debt Lease liability

Equity

Equity is the net worth of a business. Equity represents ownership stakes and a metric associated with financial soundness.

Shareholder’s equity: It is the amount of assets to be claimed by shareholders after paying all debts.

Retained earnings: Retained earnings are profits reinvested into the business.

The Accounting Equation of Balance Sheet

The fundamental accounting equation of balance sheet is:

Assets = Liabilities + Equity

This equation reflects a balanced relationship between the components. When a company buys an asset, it funds it through debt or equity. This balancing formula is the foundation of the double-entry accounting method.

The Income Statement

The income statement summarizes the income, expenses, profit and loss incurred over a particular period. Investors and analysts use this to assess operational performance and decide on further investments.

Structure of the Income Statement

The income statement gives a detailed picture of the company’s net income for the accounting period.

Revenue

Revenue is all the money that flows into the company from selling goods or services. It is counted when the sale is made or service is provided. Not when the company finally gets paid.

Cost of Goods Sold (COGS)

Cost of goods sold is the amount spent to produce sold products. Materials, labor, storage costs, shipping, etc. are examples of COGS.

Operating Income

Operating income shows the company’s earnings from its primary business activities, such as selling its products or services. Operating income is calculated by subtracting operating expenses from gross profit. Here, operating expenses are SG&A (Selling, General & Administrative) and R&D (Research and Development).

Net Income

Net income is the final bottom line profit or loss after deducting all costs, taxes, and interest from revenue. This is the number everyone looks at to see if the company has made money or is losing it.

Formula for Calculating Net Income

The formula is as follows:

Net Income = Revenue − COGS − Operating Expenses − Other Expenses − Taxes

Financial Ratios Derived from the Income Statement

The income statement gives us the inside scoop on how a business is performing. When you look at it, you can find out the following terms.

Profit margins: You can get gross profit margin, operating income margin, and net profit margin from the income statement.

Earnings Per Share (EPS): EPS shows the profits of each outstanding share of common stock.

Return on Sales (ROS): ROS shows the efficiency of a company to turn sales into profits.

The Cash Flow Statement

The cash flow statement is all about tracking a company’s actual cash. It shows how much cash is coming in and how much going out over a specific period.

Structure of the Cash Flow Statement

The cash flow statement comprises three distinct components. Each of them illustrates specific cash-related activities:

Cash Flows from Operating Activities

Cash flows from operating activities are the cash generated from daily business operations. For example, customer collections, sales-generated cash, and payment to suppliers.

Cash Flows from Investing Activities

Any cash inflows or outflows for long-term periods results in cash flows from investing activities. This can include purchase and sale of long-term assets and other business investments.

Cash Flows from Financing Activities

This section shows the net cash flows used to fund the company. Think of things like issuing new shares, debt, or dividends.

Free Cash Flow

Free Cash Flow (FCF) is the amount of cash available after paying operational expenses and capital expenditures. What makes this number important is that it tells you how much cash the company has to reinvest, pay back debt, or distribute to shareholders.

How the Three Statements are Interconnected

Each statement has its own role, but they’re all connected. To understand the financial situation, it’s important to see how they interact with each other.

Balance Sheet and Income Statement

The balance sheet and income statement are closely linked. Net income from the income statement flows into retained earnings on the balance sheet, influencing equity.

Depreciation from the income statement reduces asset values on the balance sheet. Interest expenses, which cut down profits on the income statement, also decrease liabilities like loans on the balance sheet.

Balance Sheet and Cash Flow Statement

When a company purchases equipment, it shows up on the balance sheet as an asset. It also shows as a cash outflow in the cash flow statement. Cash is a crucial component for both balance sheet and cash flow statements. The cash balance on the balance sheet matches the opening and closing amounts in the cash flow statement.

Income Statement and Cash Flow Statement

The net income from an income statement is the starting point of a cash flow statement. Then non-cash items like depreciation and changes in working capital are adjusted to find out the actual cash flow. If a company earns profit but faces delays in collecting payments, the income statement still shows profit. But the cash flow statement will show a cash shortfall.

Practical Example: How the Three Statements Work Together

Understanding how financial statements interconnect is key to analyzing a company’s financial performance. Let’s consider a practical example showcasing the integration of the income statement, balance sheet, and cash flow statement during a year-end financial report.

Transition of Net Income to Balance Sheet’s Equity Section

At the end of the year, a company reports a net income of $120,000 on its income statement. This amount will be added to the retained earnings under equity on the Balance Sheet.

Cash Flow from Operations Affecting the Balance Sheet's Cash Balance

Now, imagine a company’s cash flow statement showing $110,000 cash from operating activities. Even though the income statement showed $120,000 in net income. It is because not all of this was in cash. Some items, such as depreciation or changes in working capital, are non-cash items that should be adjusted. After adjustments the amount of cash flow from operations will have an impact on the cash balance on the Balance Sheet.

Investing and Financing Activities

Let’s assume, a company buys $40,000 worth of new equipment. This is reflected as a cash outflow in the investing section of the cash flow statement. On the balance sheet, this purchase increases the assets by $40,000. The company also raises $20,000 by issuing new shares. This will show up as a cash inflow in the financing section of the cash flow statement. And it will increase the cash balance on the balance sheet.

Differences Between the Three Statements

Each one is important in its way, and each tells you something a little different about the business. Lets see the differences between the three statements based on some specific points.

Purpose and Focus

The balance sheet represents where the company stands right now. It shows what the company owns, and what it owes, all summed up in one place. Think of it as a freeze-frame of the company’s financial position at a particular moment.

Next up is the income statement. It shows how much money the company made or lost over a period of time. You can see all the revenue, costs, and expenses.

The cash flow statement shows exactly where the cash is coming from, where it’s going. Unlike the other two, which use accrual accounting, this one is strictly about cash inflow and outflow.

Time vs. Point in Time

The balance sheet is the result of a specific point in time like as of December 31. The income statement covers a period. It could be monthly, quarterly, or yearly, depending on how the company is reporting. And then you have the cash flow statement. It’s like the income statement, which looks at a specific time frame but focuses purely on cash movement during that period.

Accrual vs. Cash Basis

The balance sheet and income statement use accrual accounting. It means they track things when they happen, even if the money hasn’t changed hands yet. The cash flow statement is a little different. It focuses only on cash when it actually came in or went out during the period.

Accounting Software in Financial Reporting

Accounting software is a financial management tool for bookkeeping, reporting, payroll, and more. This software automates financial calculations and provides detailed reporting with predefined rules. Which eventually minimizes errors, saves a lot of time, and offers instant insight for businesses.

There are so many accounting software available for businesses, including QuickBooks, Financfy, Xero, and Sage Blue. For local business and regulatory compliance, Financfy is one of the best accounting software in Bangladesh. It is a leading innovative accounting solution, packed with international line features.

Automating Financial Statements Generation

Accounting software makes preparing the financial statement easier by incorporating automation for traditionally time-consuming tasks. This enables the construction of the Balance Sheet, Income Statement, and Cash Flow Statement quickly with accurate calculations of synced data points. And it keeps accounting standards intact. Thus, the software is able to provide error-free financial reporting especially with complex financial data.

Integrating Data Across Financial Statements

Accounting software connects data between the three main financial statements, making accounting software a consistent tool. All statements are updated at the same time for each transaction. So, the records are accurate and synchronized. As an example, a recorded sale impacts revenue in the income statement, accounts receivable in the balance sheet, and operational cash inflow in the cash flow statement. Here, automated calculations are helping to reduce repetitive tasks and improve efficiency.

Benefits of Accounting Software for Small and Large Businesses

The advantages of using accounting software for businesses largely depend on their style and level of operation. Accounting solutions are cost-effective, easy-to-deploy, and have high-user-friendliness for small businesses.

The software has features like invoicing, expense tracking, tax calculations and so on. They allow small businesses to simplify accounting processes without deep financial expertise.

Accounting software system offers more advanced features for larger businesses. It facilitates the effortless transfer of data from department to department. For enterprise level businesses, the software has complex reporting capabilities, scalability, integration with other business tools and compliance across different markets and regulations.

Conclusion

The Balance Sheet, Income Statement, and Cash Flow Statement form the foundation of financial analysis. Each statement offers a distinct perspective on a company’s financial standing, crucial for informed decision-making.

Together, they provide a complete overview of a company’s profitability, cash flow, and financial stability. The result and calculation of one statement has effects on others. So, it’s important for investors, analysts, and management to understand how the statements interact.

Reviewing all three financial statements together provides a clear understanding of a company’s performance. Regular analysis ensures a better grasp of a business’s liquidity, sustainability, and potential for growth. Utilize these insights to make informed investment choices and drive effective business strategies.