Financial Statements and Their Linking

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The core three financial statements of the company are Income Statement, Balance Sheet and Cash Flow Statement. Every public company is required to disclose all the three financial on quarterly, half yearly and annual basis in their filings such as quarterly report/Annual Report or 10Q/10K.

What is Income Statement?

Income statement keeps track of all incomes and expenditures done by the company from both operating and non-operating activities. Top line of any income statement is Revenue and bottom line is net income. Further net income is distributed either as dividend or retained in the business as retained earnings. It is also known as profit and loss statement. Income statement tells the performance of the company over a period of the time.

Equation of Income Statement: Revenue less expenses equal profit/loss.

Income Statement Format

Net Sales
(-) Cost of Goods Sold
Gross Profit
(-) Sales & Marketing
(-) Research and Development
(-) General Administrative Charges
Operating Expenses
Income from Operations/EBIT/Operating income
(-) Interest expenses
(+) Interest Income
Profit before taxes/PBT
(-) Income Taxes
Net Income

 

What is Balance Sheet?

Balance sheet is the statement of the financial position of the company which shows the assets, liabilities and owner’s equity at a particular point in time. In simple words, the balance sheet explain net worth of the business. . . Balance sheet can be used to determine how to meet the financial obligations and figure out the best ways in which the company can use credit to finance operations. Both side of balance sheet must be matched always.

Balance Sheet Equation: Assets (What you have) = Liabilities (What you owe) + Worth (Value to owners)

This equation must always be balance with assets equaling the sum of liabilities and worth.

 

Balance Sheet Format

ASSETS LIABILITES & EQUITY
Cash Accounts Payables
Account Receivables Accrued Expenses
Inventory Current portion of debt
Prepaid Expenses Income Tax Payables
Current Assets Current Liabilities
Other Assets Long-Term Debt
Fixed Asset at Cost Capital Stock
Accumulated Depreciation Retained Earnings
Net Fixed Assets Shareholders’ Equity
TOTAL ASSETS TOTAL LIABILITIES & EQUITY

 

What is Cash Flow Statement?

Cash flow statement shows cycle of cash inflows and outflows. It tells about the company’s change in cash balance during a given period. It tells how much cash company is generating. It contains three sections, cash flow from operations, cash flow from investing and cash flow from financing. At the end it shows net change in cash over a given period.

Cash Flow Statement Format

Beginning Cash Balance (1)
Cash Receipts (2)
Cash Payments (3)
Cash Flow from Operations
Fixed Asset Purchases (5)
Cash Flow from Operations (5)
Net Borrowings (6)
Income Tax Paid (7)
Sale of Stock (8)
Cash Flow from Operations (9)
Ending Cash Balance 1+4-5+9

 

Difference between 3 Financial Statements:

Basis of Comparison Income Statement Balance Sheet Cash Flow Statement
Time It is measured in “period of time” It is measured at a “point in time” It is measured in “period of time”
Purpose It is an indicator of profitability It shows financial position of the company It shows movement of cash in the company
Start Point It starts with revenue It starts with cash and cash equivalent It starts with net income
Final Point It ends with net income It ends with retained earnings It ends with net cash or cash balance

 

How 3 financial statements are interlinked:

The financial statements are very much interrelated. Income statement and Balance sheet can make up the Cash flow statement. Net Income i.e the bottom line item of the income statement flows from the income statement to the retained earnings in the balance sheet and becomes the first line item in the cash flow statement to calculate cash flow from operations. Formula to calculate retained earnings is “Previous year retained earnings + net income in particular period less dividend declared in particular period”.

Any non-cash items in the income statement will flow to the cash flow and impact the ending cash result for the given period.

Ending cash in the cash flow statement becomes the first line item in the balance sheet as cash shown in the asset side of the balance sheet under current asset. Depreciation in the income statement directly affects the PPE in the balance sheet and need to be added back to net income to calculate the cash flow from operations. . Items in the balance sheet that have cash impact will show as a source and use of cash in the cash flow statement. Any balance sheet items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash.

Using all three financial statements one can see the true & clear picture of the company and how well it is performing.

Let’s discuss one example to understand the relationship between the 3 financial statements. If depreciation increase, in Income statement operating income, pre-tax income and net income will fall. In Cash flow statement there is increase in cash flow from operations due to add back effect of non-cash expenses In Balance sheet cash will increase and PPE down and thus total assets will fall and balance sheet will get matched

Financial Statements and their linking

Conclusion

To understand the true picture of company, user must look at the three financial statements and need to keep in mind the importance of each line item and how each line item impacts the value of the company.

Author: Akhil S. – Jr. Analyst

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