Financial Statements – The Very Basics

I think the balance sheet is probably the easiest of the major financial statements to understand, so we’ll begin there.

The Balance Sheet and the Accounting Equation

Assets are expected to have been financed either through equity or through debt (liabilities). Because of this, we assume that the total assets a company has will be equal to its total liabilities and its total equity – since they are the ultimate source of financing for each each asset. This is given by the accounting equation:

Assets = Liabilities + Equity

This equation can also be rewritten to find either liabilities or equity:

Equity = Assets – Liabilities

Liabilities = Assets – Equity

This is where the balance sheet gets its name. It simply shows at the end of a period the amounts of a firms assets, the amount of equity and the amount it owes to other parties (its liabilities). This statement shows the firms assets, liabilities and equity broken down into more detailed accounts, but will always balance that equation.

The Income Statement

The income statement shows the performance of a company in a given period. It will list revenues and expenses, and provide the overall result for the period typically in terms of positive or negative net income. Positive earnings will increase the assets of a firm while negative earnings will decrease its assets. This linkage between income statements and balance sheets occurs in an account called “Retained Earnings”. Understanding this relationship is crucial to number of models used to value and project the financial performance of companies.

Cash Flows

The cash flow statement helps show more detailed information about the sources of a firms expenses and revenues. It breaks down by classification (financing, operating, and investing) its uses and sources of money and provides a great deal of insight into the firm.

 

This is a very basic introduction to the three main financial statements – there are numerous complexities not discussed from statements of other comprehensive income to the differences between GAAP and IFRS financial reporting standards.

 

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