At the core of corporate accounting are three major financial statements: the income statement, the balance sheet and the statement of cash flows. Together, these statements can provide valuable insights into a company’s financial standing, allowing managers, investors and lenders to assess how efficiently they are operating. Before exploring the interconnected relationship between these statements, it’s important to understand their stand-alone functions.
The income statement provides an overview of a company’s net income for a given period by displaying revenue and subtracting expenses from it. Expenses can be broken down to three levels: direct, indirect, and capital expenditures. Direct expenses, often referred to as Cost of Goods Sold (COGS), represents the total costs directly associated with producing goods/ services for the given period. Indirect expenses are all costs indirectly associated with revenue generation for the company, including administrative salaries, office rent and utilities. Capital expenditures include long-term expenses associated with upgrading or maintaining assets, and may include the acquisition of new land, buildings, or equipment. This breakdown of revenue, expenses and ultimately income allows for analysis of how much a company is profiting and how that compares to costs incurred.
The balance sheet on one side lists the assets of a company, and on the other lists liabilities and equity. Assets, or the resources controlled by a company, can include cash, inventory and property. Liabilities, or a company’s financial obligations, can include rent, wages and loans. Equity consists of shareholders’ initial investment plus their retained earnings. In other words, if shareholders were to sell all the shares in a company, the payout would be equivalent to total equity. All together, the worth of assets must be equal to liabilities plus equity. The balance sheet can be analyzed to determine a company’s value and to assess how significant their debt is.
Statement of Cash Flows
The Statement of Cash Flows provides a more detailed look at the cash entering and leaving a company. Cash activities can be broken down to three levels: cash from operating activities, investing activities, and financing activities. The cash associated with operating activities is that which directly relates to the company’s goods and services, such as receipts from sales, employee payroll and the purchase of materials for manufacturing. The cash associated with investing activities is that which involves the purchase or sale of investments, including property, equipment and stock in other companies. The cash associated with investing activities is that which directly relates to the company’s liabilities or equity, such as dividends to shareholders, a loan from a bank and cash from investors. The Statement of Cash Flows can be analyzed to determine how much cash a company generates, how far along they are in growth and their liquidity.
Data can be pulled from each of the financial statements to calculate various financial ratios that indicate how efficient a company’s operations are. This interconnection of the income statement, balance sheet and statement of cash flows is valuable for understanding, as it sets the foundation for various financial practices including accounting, investment, and financial services.
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Author: Arielle M. Hinrichs