Hello and welcome. . .
Hello and welcome back to Accounting Stuff. I'm James and today we're talking financial statements. The income statement, the balance sheet and the cash flow statement.
I'm going to try and explain all the basics in under eight minutes which is going to be a challenge because we have a little puppy here who's uh trying to bite my finger. So let's get started! What are financial statements?
Financial statements are reports that summarize the activities and financial performance of a business. They're prepared at the end of each accounting period and they're designed to give investors and lenders a feel for a business's financial health. The three main financial statements are the balance sheet, the income statement and the cash flow statement.
Now I'll explain how each of these work with an example. Tea-licious is a family-run business that produces a popular blend of black tea. Their financial year has come to a close and they've finished putting together their financial statements so let's look at them.
We'll start with the balance sheet. What is a balance sheet? The balance sheet is a financial statement that gives us a snapshot of a business's assets, liabilities and equity at a single point in time.
The balance sheet is also called the statement of financial position and it looks like this. In the header we have the business's name followed by the name of the financial statement and directly below that we have the point in time that we're looking at. A snapshot of December 31st.
On the left hand side of the balance sheet we have a list of everything the business owns - its assets - and on the right we have everything the business owes its liabilities and equity. Tea-licious owes liabilities to third parties like its suppliers, its employees and the tax office. But it also owes equity back to the owners of the business.
This includes their original capital contributions which is the cash the owners injected into the business and retained earnings which are the cumulative profits that the business has held onto. If we collapse the balance sheet down into its core components then we can see that Tea-licious has total equity of 129. 5 million dollars.
What does this mean? Well if the business were to suddenly sell off all of its assets and pay off all of its debts then in theory, this is how much money the owners would get. At the bottom of the balance sheet Tea-licious has total assets of 169 million dollars and total liabilities and equity of 169 million dollars.
The stuff it owns is equal to the stuff it owes. So the balance sheet is in balance. Which is fantastic news because a balance sheet always has to balance.
Why? Because it says so in the accounting equation. Assets shall always equal liabilities plus equity.
Or the stuff that a business owns is equal to the stuff that a business owes. What is an income statement? An income statement is a financial statement that summarizes a business's revenues and expenses over a period of time.
If the balance sheet is a snapshot of a point in time then the income statement is more like a video or a boomerang covering a range of time. The income statement looks like this. As you can see in the header the income statement covers a period of time.
The year ended December 31st. And in the body of the report we have a summary of revenue earned and expenses incurred. If we collapse it then we find it the income statement is really showing us three things.
Firstly, Tea-licious made 255 million dollars in revenue. Which is their top line income that it earned from selling products during the year. Secondly, it incurred 248 million dollars in expenses.
This includes the direct and indirect costs of running the business and finally when we subtract expenses from revenue we see that Tea-licious generated seven million dollars in net profit on the bottom line. Profitability is key to the income statement which is why it's also called the statement of profit and loss. It tells us how much profit the business earned over a period of time.
But be careful here because profit doesn't necessarily translate to cash flow. Which is why businesses also need a cash flow statement. What is a cash flow statement?
A cash flow statement is a financial statement that shows a business's cash inflows and outflows over a period of time. Businesses need to make a cash flow statement if they are using accrual accounting. You see there are two methods of accounting.
We have the cash method and the accrual method. The cash method of accounting is often used by smaller businesses it says that revenue is recognized when cash is received and expenses are recorded when cash is paid out. Under the cash method the income statement and the cash flow statement are equivalent to one another.
If cash comes in we record revenue and if cash goes out we record an expense. It's nice and simple but it has its limitations. What if Tea-licious makes a large sale but the customer doesn't pay the invoice until the following accounting period.
Their revenue could be understated in the period that they made the sale and overstated in the following period when they received the cash. There has to be a better way! And thankfully there is.
The accrual method says that we should recognize revenue as it's earned and record expenses as they are incurred. When the substance of the transaction takes place. This means that cash inflows and outflows aren't equivalent to revenues and expenses.
They need to be tracked separately in the cash flow statement. A cash flow statement looks like this. In the header we have the period of time that it relates to, just like we had in the income statement.
And in the body we have two main sections. At the bottom we have the opening and closing cash balances for the financial year. We get these numbers from the balance sheet Tea-licious started out with 11 million dollars and finished up with 12 million dollars.
So overall that's a net increase in cash of one million dollars. But how did this come about? This is where the top section comes in.
We work out the cash flow from operating activities, investing activities and financing activities. Cash flow from operating activities covers regular business activities. How much cash Tea-licious brought in and spent whilst selling tea.
Tea-licious is using the direct method so this section mirrors an income statement prepared under the cash method of accounting. Cash flow from investing activities looks outside of the core operations of the business. These are the cash inflows and outflows from investments and buying or selling property and equipment.
Cash flow from financing activities is all about funding the business, either through loans from banks or equity from the owners of the business. If we collapse this all down then the net cash flow on the top should match up with the net cash flow on the bottom. It does here which means the cash flow statement is reconciled.
Let's do a quick recap. The balance sheet gives us a snapshot of a business's assets, liabilities and equity at a single point in time. It shows us what a business owns and what it owes.
It also tells us how much the business is worth to its owners. And then we have the income statement which shows us a business's revenues and expenses over a period of time. When we take the difference we can see if it made a profit or a loss.
The cash flow statement reveals a business's cash inflows and outflows over a period of time. These are reconciled back to the movement in cash in the balance sheet. I've made videos and cheat sheets covering each of these financial statements.
You can find links to all of that down in the description. And a big thanks to all my channel members you know who you are and I appreciate your support. Thank you from both of us.
This is Winnie by the way. . .
and we'll see you in the next one!
