The data in a company's financial statements is crucial for corporate accounting. It's examined by management, investors, and lenders to understand the company's finances and calculate important financial ratios. These ratios reveal how well the company is doing financially and any problems that might need fixing.
There are three main financial documents that tell us about a company's money: (1) the income statement, (2) the balance sheet, and (3) the cash flow statement. These are important for people both inside and outside the company.
The income statement tells us how much money the company made, following certain accounting rules. The balance sheet shows what the company owns, owes, and the money that belongs to the owners at a specific time. The cash flow statement reveals how money moves in and out of the company through its operations, investments, and financing.
The 3 Key Financial Statements
These three financial documents are connected, and we'll explain how they work together in this guide, so you don't need to be an accounting expert to understand them:
Income Statement
Investors and analysts usually start by checking the income statement when they want to know how a business is doing financially. This statement tells us how the business performed during a certain period, with sales revenue at the top. Then, it subtracts the cost of goods sold to find the gross profit.
After that, other operating expenses and income affect the gross profit, depending on the type of business, and this leads to the net income at the bottom, which is also called "the bottom line" for the business.
Important points to remember:
It shows a business's earnings and spending.
It covers a specific time frame (like a year or a quarter).
It uses accounting rules like matching and accruals to show numbers (not cash transactions).
It helps assess if the business is making a profit.
Balance Sheet
The balance sheet is like a financial snapshot of a company. It tells us what a company owns (assets), what it owes (liabilities), and what's left over for the owners (shareholders' equity) at a specific moment. It's like a scale where both sides must be equal: assets must be the same as liabilities plus equity.
It starts with cash and similar things, which should match what's shown at the end of the cash flow statement. Then, it shows how the amounts in different accounts change over time. The profit from the income statement becomes part of the balance sheet as a change in retained earnings (adjusted for dividends paid out).
Important points to remember:
The balance sheet shows a company's financial status.
It's like a snapshot of the company's financial situation at a certain date (e.g., December 31, 2017).
It has three parts: assets, liabilities, and shareholders' equity.
Assets = Liabilities + Shareholders' Equity
Statement of Cash Flow
Like an income statement, the cash flow statement tells us about a company's money activities during a specific time. It reveals where the company gets its cash and how it spends it on day-to-day activities or for future plans. This statement helps us see how well the company handles its cash, which can give us a better idea of its ability to pay bills and debts and invest in growth compared to the income statement or balance sheet.
The cash flow statement does a few important things:
It shows how your cash went up or down.
It covers a specific time, like a year or a quarter.
It focuses on real cash, not accounting stuff.
It has three parts: cash from daily operations, cash used for investments, and cash from financing.
It reveals the overall cash change from the beginning to the end of that time.
How Are These 3 Key Statements Used in Financial Models?
The interplay of information within each of the three financial statements is essential in financial modeling. These models rely on analyzing the relationships between data points within these statements and trends over different historical periods to make predictions about future performance.
While the preparation and presentation of this data can be complex, the following general steps are typically followed to construct a financial model:
Creation of line items for each of the core statements: This step establishes the overall structure and framework that the financial model will adhere to.
Incorporation of historical figures into each line item: Historical data is inserted into the respective line items within the model.
Reconciliation of core statements: At this stage, the model creator often verifies that the numbers in each of the core statements align with the data in the others. For instance, the ending cash balance computed in the cash flow statement must match the cash account in the balance sheet.
Development of an assumptions section: This section is added to the model to analyze trends within each line item of the core statements over different time periods.
Use of historical data for forecasting assumptions: Existing historical data is used to generate forecasts for the same line items in the model.
Population of forecasted values in the core statements: The forecasted section of each core statement is filled in with values based on the forecasted assumptions. These values should align with historical trends, as the analyst or user has assessed past patterns when creating these assumptions.
Implementation of supporting schedules: More complex line items are calculated using supporting schedules. For example, a debt schedule is employed to determine interest expenses and the balances of debt items, while a depreciation and amortization schedule is used to calculate depreciation expenses and the balances of long-term fixed assets. These calculated values are then integrated into the three primary financial statements.
Final Thoughts
Each of the three accounting statements holds significance in comprehending and assessing a company's performance from various perspectives. The income statement offers a profound understanding of the fundamental operational activities that generate profits for the company. Conversely, the balance sheet and cash flow statement primarily concentrate on the company's capital management, encompassing assets and structural aspects.
In essence, top-performing companies will excel in operating efficiency, asset management, and capital structure. It is the responsibility of management to oversee these three factors in a manner that aligns with the shareholders' best interests, and the interconnected reporting of these factors underscores the critical importance of financial statement reporting.