What are Financial Statements?

what-are-financial-statementsFour financial statements are widely used: the balance sheet, the income statement, the cash flow statement and the statement of retained earnings. In this section, the main characteristics of each financial statement are discussed and a simple worksheet to record changes to the balance sheet is explained. Also, the relations between the statements are highlighted.

Relations between the Financial Statements

In the figure below the relations between the financial statements are shown for another fictitious company (the company used in the previous examples is not used as the company has no beginning balance). As mentioned above, the balance sheet shows the financial position at a point in time. It therefore cannot contain information that is related to some period, such as sales or wages expense.



It is common practice to include a beginning of period balance sheet as well as an end of period balance sheet in a financial report. This way the reader can form an opinion about how the firm’s financial position has changed.

The cash flow statement and the income statement both give information about the firm’s performance over the period, albeit from different angles. The cash flow statement explains the change in cash. In other words, it explains how the beginning of period cash has turned into the end of period cash by differentiating between operating, investing and financing activities.

The income statement shows a presentation of the sales, the main expenses and the resulting net income over the period. Net income is based on accounting principles which gives guidance/rules on when to recognize revenues and expenses, whereas cash from operating activities, obviously, is cash based.

As dividends do not reduce net income, the income statement does not always explain the change in retained earnings over the year. (Net income only equals the change in retained earnings when no dividend is paid out). The statement of retained earnings (or a similar statement) is included to show how equity has changed because of net income and possible dividend payments. It shows the beginning value of retained earnings, to which net income is added and dividends subtracted, resulting in end of year retained earnings.

Financial Statements Explained

Key points:

– the balance sheet is used to assess the firm’s financial position at a point in time

– the cash flow statement and the income statement are used to assess performance over the period

– the cash flow statement explains the change cash from the beginning of year versus end of year

– the income statement shows the performance over the year

– the statement of retained earnings shows how beginning of year retained earnings increases with net income and decreases with dividends, resulting in end of year retained earnings.

Continue with reading the next tutorial: double entry bookkeeping. In this section a more advanced bookkeeping system is explained where in addition to the balance sheet items also changes in retained earnings (expenses, revenues and dividends) are recorded.

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