Your Friendly Guide to the Key Accounting 3 Statements Explained

Getting the Hang of Financial Statements

What Are Financial Statements?

Financial statements are like the report cards of a business, showing how it’s doing over a certain period. They tell you if a company is making money, paying its bills, and staying in the black (Yeshiva University). The big three are:

1. Income Statement
2. Balance Sheet
3. Cash Flow Statement

Each one gives a different piece of the puzzle, but together, they paint a full picture of a company’s financial health (Investopedia).

Why Bother with These Statements?

If you’re into accounting or just want to know if a company is worth your time and money, these statements are your best friends. Here’s the lowdown on each:

• Income Statement: Think of this as the scorecard for a specific period. It lists all the money coming in (revenue) and going out (expenses). The bottom line? Net income, which tells you if the company is making a profit. Curious for more? Check out our accounting 101 pdf.

• Balance Sheet: This one’s like a snapshot of the company’s financial standing at a particular moment. It lists what the company owns (assets), what it owes (liabilities), and what’s left over (equity). Want to see an example? Peek at our accounting balance sheet example.

• Cash Flow Statement: This shows where the cash is coming from and where it’s going, covering operations, investments, and financing. It’s all about how well the company handles its cash. Dive deeper with our accounting 3 way match.

When you put these statements together, you get a clear view of how efficiently a company is running, how well it’s managing its assets, and how it’s structuring its capital (Investopedia). They’re essential for making smart business decisions and figuring out if a company is on the right track. For more on how these statements fit together, check out our accounting made simple guide.

The Balance Sheet

The balance sheet, also known as the statement of financial position, is a key financial document that shows a company’s assets, liabilities, and shareholders’ equity. It follows the basic formula: assets = liabilities + equity (Investopedia).

What’s Inside a Balance Sheet?

A balance sheet has three main parts: assets, liabilities, and shareholders’ equity. Each part gives a peek into the company’s financial health.

• Assets: These are things the company owns that can bring future benefits. Assets are split into current assets (like cash, accounts receivable, inventory) and non-current assets (like property, equipment, long-term investments).

• Liabilities: These are what the company owes. Liabilities are divided into current liabilities (like accounts payable, short-term loans) and non-current liabilities (like long-term debt, deferred tax liabilities).

• Shareholders’ Equity: This is what’s left for the owners after all debts are paid. It includes common stock, retained earnings, and additional paid-in capital.

How Assets, Liabilities, and Equity Work Together

Knowing how assets, liabilities, and equity relate helps you understand a company’s financial standing. The balance sheet must always balance, meaning total assets equal total liabilities plus shareholders’ equity (Corporate Finance Institute).

Component	Description	Example
Assets	What the company owns	Cash, inventory, property
Liabilities	What the company owes	Accounts payable, loans
Equity	Owners’ share after debts	Common stock, retained earnings

This balance ensures the balance sheet gives a clear picture of the company’s financial status at a specific time, showing its ability to handle short-term and long-term obligations (Yeshiva University).

For more details on making and understanding balance sheets, check out our resources on accounting balance sheet example and related topics like accounting 5 principles and accounting 5 types of accounts. These resources can boost your accounting knowledge and offer practical tools for better financial analysis.

The Income Statement

The income statement is your go-to financial report for a snapshot of a company’s revenue, expenses, and net income over a set period. Think of it as the report card for a business’s profitability and financial health. Let’s break down the key parts of an income statement: revenue, expenses, and net income.

Revenue and Expenses

Revenue, also known as sales or turnover, is the total cash a company rakes in from selling goods or services. It’s the starting point of the income statement. Expenses, on the other hand, are the costs a company incurs to generate that revenue. These expenses can be broken down into several categories:

• Cost of Goods Sold (COGS): The direct costs tied to producing the goods a company sells.
• Operating Expenses: These include selling, general, and administrative expenses (SG&A), like salaries, rent, and utilities.
• Depreciation and Amortization: The gradual write-off of the cost of tangible and intangible assets over their useful lives.
• Interest Expenses: Costs from borrowed funds.
• Tax Expenses: The taxes owed to the government.

Here’s a simple table to illustrate:

Category	Amount ($)
Revenue	100,000
Cost of Goods Sold (COGS)	40,000
Gross Profit	60,000
Operating Expenses	20,000
Depreciation & Amortization	5,000
Interest Expenses	2,000
Tax Expenses	8,000
Net Income	25,000

Calculating Net Income

Net income, often called the “bottom line,” is the final figure on the income statement. It’s what you get after subtracting all expenses from total revenue. Net income shows how profitable a company is after covering all its costs.

The formula to calculate net income is:

Net Income = Total Revenue - Total Expenses

Using the numbers from the table above:

Net Income = 100,000 - (40,000 + 20,000 + 5,000 + 2,000 + 8,000) = 25,000

Understanding the income statement is key to analyzing a company’s profitability and making smart financial decisions. It’s also linked to other financial statements like the balance sheet and the cash flow statement, giving you a full picture of a company’s financial performance. For more on how these statements connect, check out our article on linking income statement to balance sheet.

If you’re keen to boost your accounting knowledge or explore accounting courses part-time, we’ve got plenty of resources for you.

The Cash Flow Statement

The cash flow statement is like a financial x-ray, showing where a company’s money is coming from and where it’s going. It’s split into three parts: operating activities, investing activities, and financing activities.

Operating Activities

This part shows the cash made or spent from the company’s main business. It adjusts net income for non-cash items and changes in working capital, giving a clear view of daily cash flow.

Description	Amount
Net Income	£50,000
Depreciation	£5,000
Changes in Working Capital	£3,000
Cash Flow from Operating Activities	£58,000

Here’s how it breaks down:

• Net Income: The profit from the income statement.
• Depreciation/Amortisation: Non-cash costs added back in.
• Changes in Working Capital: Adjustments for changes in current assets and liabilities.

Investing Activities

This section covers cash spent or received from buying or selling long-term assets like equipment or investments.

Description	Amount
Purchase of Equipment	£(10,000)
Sale of Investments	£7,000
Cash Flow from Investing Activities	£(3,000)

Examples include:

• Purchase of Equipment: Money spent on new machinery or tech.
• Sale of Investments: Money earned from selling stocks or other investments.

Financing Activities

This part deals with cash flows from borrowing or repaying money, and transactions with shareholders.

Description	Amount
Issuance of Shares	£20,000
Repayment of Loans	£(15,000)
Dividends Paid	£(5,000)
Cash Flow from Financing Activities	£0

Key points here are:

• Issuance of Shares: Money from selling new shares.
• Repayment of Loans: Money spent paying off debt.
• Dividends Paid: Money given to shareholders.

The cash flow statement ties in with the balance sheet, giving a full picture of a company’s financial health. For more details, check out our resources like accounting 101 book and accounting handbook and study guide.

Knowing how to read each part of the cash flow statement helps you see if a company can generate cash, invest wisely, and stay financially stable. This is key for judging a company’s performance and making smart financial choices. For more info, take a look at our article on accounting balance sheet example.

How Financial Statements Connect

Grasping how the three main financial statements tie together is a must for anyone dabbling in accounting or finance. Let’s break down how the income statement, balance sheet, and cash flow statement are all buddies in the financial world.

Income Statement Meets Balance Sheet

Your net income from the income statement finds its way to the balance sheet as retained earnings in stockholders’ equity. Retained earnings are basically the company’s piggy bank, showing cumulative profits after accounting for dividends.

Here’s a quick example to make it clear:

Description	Amount
Net Income (Income Statement)	$10,000
Prior Period Retained Earnings (Balance Sheet)	$50,000
Dividends Issued	$2,000
Current Retained Earnings	$58,000

So, if you made $10,000 in net income, had $50,000 in retained earnings from before, and paid out $2,000 in dividends, you’d end up with $58,000 in retained earnings on the balance sheet.

Cash Flow Adjustments

The cash flow statement is like the referee, making sure everything balances out. It adjusts net income for non-cash expenses and tracks cash coming in and going out, showing how cash changes over time.

For instance, if you buy new equipment, it bumps up the Property, Plant, and Equipment (PP&E) account on the balance sheet but doesn’t show up on the income statement directly.

Here’s a table to show how different activities link the statements:

Activity	Income Statement	Balance Sheet	Cash Flow Statement
Net Income	Yes	Retained Earnings	Operating Activities
Depreciation	Expense	Accumulated Depreciation	Operating Activities (add back)
Capital Expenditures	No	Increase PP&E	Investing Activities (cash outflow)
Issuing Dividends	No	Decrease Retained Earnings	Financing Activities (cash outflow)

Knowing these connections helps you see the big picture of a company’s financial health. For more on financial ratios and evaluating company performance, check out our section on practical applications.

Practical Applications

Getting the hang of the accounting 3 statements is a game-changer for anyone diving into accounting and finance. Let’s break down how to use financial ratios and assess company performance with these key statements.

Using Financial Ratios

Financial ratios are like the Swiss Army knife for analysts. They help you gauge a company’s performance, efficiency, and financial health. These ratios come from the three main financial statements: the balance sheet, income statement, and cash flow statement. Here are some must-know ratios:

Asset Turnover

Asset turnover tells you how well a company uses its assets to make sales. Here’s the formula:

[ text{Asset Turnover} = frac{text{Net Sales}}{text{Average Total Assets}} ]

Company	Net Sales (£)	Average Total Assets (£)	Asset Turnover
Company A	500,000	250,000	2.0
Company B	1,000,000	500,000	2.0

Gross Margin

Gross margin shows the percentage of revenue left after covering the cost of goods sold (COGS). The formula is:

[ text{Gross Margin} = frac{text{Net Sales} – text{COGS}}{text{Net Sales}} times 100 ]

Company	Net Sales (£)	COGS (£)	Gross Margin (%)
Company A	500,000	300,000	40%
Company B	1,000,000	700,000	30%

Operating Margin

Operating margin reveals what percentage of revenue remains after paying for production costs like wages and raw materials. Here’s how you calculate it:

[ text{Operating Margin} = frac{text{Operating Income}}{text{Net Sales}} times 100 ]

Company	Operating Income (£)	Net Sales (£)	Operating Margin (%)
Company A	100,000	500,000	20%
Company B	150,000	1,000,000	15%

These ratios give you a peek into different parts of a company’s operations and are crucial for solid financial analysis (Investopedia).

Assessing Company Performance

To really get a handle on a company’s performance, you need to look at how the financial statements connect to see its profitability, efficiency, and financial stability. Here’s the lowdown:

Profitability

The income statement is your go-to for checking profitability. It shows how well the company generates revenue and controls expenses. Key figures to watch are gross profit, operating profit, and net income. Ratios like gross margin and operating margin give you a clearer picture of profitability.

Efficiency

Efficiency is all about how well a company uses its assets and manages its liabilities. The balance sheet is your best friend here. Ratios like asset turnover and inventory turnover are super helpful. For example, a high asset turnover ratio means the company is good at using its assets to make sales.

Financial Stability

To check financial stability, look at the balance sheet and cash flow statement. Important metrics include the debt-to-equity ratio, current ratio, and cash flow from operating activities. A low debt-to-equity ratio means a healthy capital structure, and positive cash flow from operations shows good liquidity.

For more detailed guides and examples, check out our accounting notebook and accounting 101 pdf.

By using these practical tips, you can get a solid understanding of a company’s financial health and make smart decisions. For more learning, dive into our accounting courses part time and accounting videos.