The four basic financial statements every business needs are the income statement, balance sheet, cash flow statement, and statement of retained earnings. Taken together, these four financial statements provide an accurate representation of the company’s overall financial status.
Understanding the main four types of financial statements is crucial for investors, analysts, and other stakeholders seeking insights into a company’s financial well-being and future prospects. Furthermore, as a business owner or finance officer, you might be interested in using them to assess the performance of different facets of your operations to identify areas of strength and opportunities for improvement.
Income Statement: Unveiling Profitability
The income statement, often referred to as a profit and loss (P&L) statement, shows a company’s financial performance over a specific period, such as monthly, quarterly, or annually. This financial document is the first port of call for stakeholders like investors and business owners because it encapsulates the essence of the business’s operational outcomes.
As the most crucial among the four financial statements, the income statement provides a comprehensive report of revenues, expenses, profits/losses, and net income (i.e. net profit). It offers a dynamic view of a company’s financial health and its ability to control expenses for enhanced profitability.
Investors rely on the income statement to discern trends and assess investment potential, while lenders scrutinize it to evaluate repayment capacity. That’s why accurate financial statement preparation is so critical to a company’s success.
The income statement includes three major components: revenue, expenses, and profit and loss.
Revenue
Revenue includes the following:
- Operating revenue. This represents income generated from a company’s core business activities, such as the sale of products or services. For example, a construction company’s operating revenue is derived from its construction and consulting activities.
- Non-operating revenue. Income from peripheral activities falls under non-operating revenue. This can include interest earned on cash holdings, rental income from properties, royalty payment receipts income received from partnerships, and other sources unrelated to the primary business.
- Other income. Gains from the sale of long-term assets, like land or vehicles, and revenues from activities beyond routine operations contribute to other income.
Expenses
Expenses are categorized into primary and typical expenses:
- Primary expenses include the cost of goods sold (COGS); selling, general, and administrative expenses (SG&A); depreciation or amortization; and research and development (R&D).
- Typical expenditures encompass employee salaries, sales commissions, utilities, transportation, and costs associated with secondary activities such as the interest paid on loans or debt. Any losses that are incurred from the sale of assets are also recorded as an expense.
Profit or Loss
Profit represents the earnings a company generates from its operational activities, including gross, operating, and net profit. Loss, on the other hand, indicates a deficit in revenue compared to expenses. Both profit and loss are crucial metrics for assessing a company’s financial performance.
Income Statement Example
Let’s consider a fictitious company ABC Construction, Inc. located in Ft. Lauderdale, Florida, that builds new housing developments and high-rise condominiums.
| ABC Construction, Inc.
Statement of Income for the year ended December 31, 2022 |
||
| Contract revenue | $85,500,000 | |
| Contract costs: | ||
| Labor and labor costs | $2,350,000 | |
| Subcontractors | 65,000,000 | |
| Materials | 5,000,000 | |
| Equipment | 90,000 | |
| Other costs | 250,000 | |
| Total contract costs | (72,690,000) | |
| Gross profit from contracting | 12,810,000 | |
| General and administrative expenses | (2,290,000) | |
| Income from operations | 10,520,000 | |
| Other income (expense): | ||
| Interest income | 195,000 | |
| Miscellaneous income | 72,000 | |
| Interest expense | (3,000) | |
| Total other income, net | 264,000 | |
| Income before income taxes | 10,784,000 | |
| Income tax expense | (2,264,000) | |
| Net income | $8,520,000 | |
Balance Sheet: Assessing Assets and Liabilities
The balance sheet, the second most crucial financial statement, presents a static overview of a company’s financial position as of a specific date. As per the U.S. Securities and Exchange Commission (SEC), the balance sheet illustrates “what a company owns and what it owes at a fixed point in time,” by outlining its assets, liabilities, and shareholders’ equity.
The balance sheet is a crucial tool for stakeholders as it provides a comprehensive view of a company’s financial structure and offers valuable insights into a company’s liquidity and capitalization.
Its components include the following items: assets, liabilities, and shareholders’ equity.
Assets
The following constitute a company’s assets:
- Current assets are items anticipated to be utilized, sold, or converted into cash within a year. Examples comprise cash, inventory, prepaid expenses, and amounts owed to the business by debtors (accounts receivable).
- Non-current assets are items that cannot be converted into cash within a year and are utilized to operate the business, for example, property, buildings, and machinery. It also includes investments and intangible assets (trademarks, patents, and goodwill).
Liabilities
The following constitute a company’s liabilities:
- Current liabilities are obligations to be settled within a year, such as the funds the business owes to creditors (accounts payable), wages payable, and impending payments on the overall long-term debt due within the next 12 months.
- Non-current liabilities are long-term obligations, such as pension benefits, that extend beyond a one-year horizon and are not expected to be settled in the short term.
Shareholders’ Equity
Shareholders’ equity (stockholders’ equity) denotes the residual value of a company’s total assets after subtracting its total liabilities. It signifies the funds that would be distributed to shareholders if all assets were liquidated and all debts were settled.
Retained earnings constitute a segment of shareholders’ equity, representing the accumulated net earnings that haven’t been disbursed to shareholders in the form of dividends.
Balance Sheet Example
Consider ABC Construction, Inc.’s balance sheet.
| ABC Construction, Inc.
Balance Sheet for the year ended December 31, 2022 |
||
| Assets | ||
| Current assets: | ||
| Cash and cash equivalents | $5,200,000 | |
| Receivables: | ||
| Contracts – current | $14,450,000 | |
| Contracts – retention | 6,000,000 | |
| Other | 39,000 | |
| Total receivables | 20,489,000 | |
| Prepaid expenses | 13,000 | |
| Total current assets | 20,502,000 | |
| Property and equipment, net | 320,000 | |
| Total assets | $20,822,000 | |
| Liabilities and Stockholders’ Equity | ||
| Current liabilities: | ||
| Trade accounts payable: | ||
| Current | 8,555,000 | |
| Subcontractor retentions | 4,533,000 | |
| Total trade accounts payable | 13,088,000 | |
| Current maturity of long-term debt | 15,000 | |
| Total current liabilities | 13,103,000 | |
| Long-term debt, net of current maturity | 153,000 | |
| Total liabilities | 13,256,000 | |
| Stockholders’ equity: | ||
| Common stock, no par value,
10,000 shares authorized, 2,300 shares issued and outstanding Retained earnings |
$230,000
7,336,000 |
|
| Total stockholders’ equity | 7,566,000 | |
| Total liabilities and stockholders’ equity | $20,822,000 | |
Cash Flow Statement: Tracking Financial Movements
The cash flow statement (CFS) serves as a bridge between the income statement and the balance sheet, offering insights into how well a company generates cash to meet its obligations and fund operations and investments. The CFS enables investors to grasp the operational efficiency of a company, tracking its revenue sources, expenditure allocation, and overall financial stability.
It uses three major sections to offer valuable details about the company’s financial health and solidity.
Operating Activities
This section addresses cash generated or used in the day-to-day running of the business. It includes changes in cash accounts receivable, depreciation, inventory, and accounts payable. It also encompasses wages, interest payments, rent, income tax payments, and cash receipts derived from product or service sales.
Investing Activities
Investing activities involve cash transactions for the purchase or sale of assets and investments in the company’s long-term future. This includes acquisitions, mergers, and purchases of property, plant, and equipment (PPE).
Financing Activities
Financing activities reflect cash flows between the company and its capital providers, including transactions related to debt, equity, and dividends.
Cash Flow Statement Example
Consider ABC Construction, Inc.’s cash flow statement.
| ABC Construction, Inc.
Cash Flow Statement for the year ended December 31, 2022 |
||
| Cash Flow From Operations | ||
| Net Earnings | 8,520,000 | |
| Additions to Cash | ||
| Depreciations
Decrease in Accounts Receivable Increase in Accounts Payable Increase in Taxes Payable |
50,000
20,000 20,000 3,000 |
|
| Subtractions From Cash | ||
| Increase in Inventory | (10,000) | |
| Net Cash From Operations | 8,603,000 | |
| Cash Flow From Investing | ||
| Equipment | (90,000) | |
| Cash Flow From Financing | ||
| Notes Payable | 20,000 | |
| Cash Flow for FY Ended 31 Dec 2022 | 8,533,000 | |
Statement of Retained Earnings: Understanding Equity Changes
The statement of retained earnings tracks changes in equity, reflecting share transactions, dividend payments, and profits or losses during a reporting period. While not as commonly used as the other statements, it provides valuable details about a company’s dividend policy and its ability to reinvest in the business. Understanding this statement is crucial for investors interested in a company’s distribution of profits and reinvestment strategies.
If your CPA firm produces a statement of retained earnings for your company, it will normally include the following sections.
Beginning Retained Earnings
This represents the retained earnings at the end of the previous period, rolling over to the current period. This figure appears on the balance sheet as shareholder equity.
Adjustments
Adjustments encompass modifications made by a company to its financial statements, addressing overestimations, underestimations, and revisions triggered by the receipt of tax benefits.
Net Income
Net income from the income statement is a key component, representing profits earned during the period.
Dividends
Dividends paid to shareholders during the period are reported here.
Ending Retained Earnings
The resulting figure after accounting for the changes in net income and dividends reflects the retained earnings at the end of the current period.
Statement of Retained Earnings Example
Consider ABC Construction, Inc.’s statement of retained earnings.
| ABC Construction, Inc.
Statement of Retained Earnings for the year ended December 31, 2022 |
||
| Retained earnings, January 1, 2022 | $5,880,000 | |
| Net income | 8,520,000 | |
| Total | 14,400,000 | |
| Dividends paid | (800,000) | |
| Retained earnings, December 31, 2022 | $13,600,000 | |
Empowering Stakeholders With Financial Insights
Financial statements are indispensable tools for evaluating a company’s performance and financial health. They provide a foundation for informed decision-making, allowing stakeholders to assess a company’s past performance and future potential. Each financial statement plays a unique role, contributing specific insights into different aspects of a company’s financial landscape.
Armed with this knowledge, stakeholders, investors, and analysts can make informed assessments and strategic decisions for the future by understanding a company’s financial well-being, its ability to generate cash, and its potential for sustained growth. In the dynamic realm of corporate finances, a thorough understanding of financial statements is a powerful tool for those seeking to make sound investment and business decisions.
