The Four Primary Financial Statements

Study Guide: Introduction to Financial Statements

The Four Primary Financial Statements

All businesses, whether public or private, prepare four key financial statements that summarize their financial activities:

1. Income Statement

   • Measures revenues and expenses over a set period.

   • Key question: How much money was earned, and how much was spent?

2. Balance Sheet

   • Shows the financial position of a business at a specific point in time.

   • Key question: What does the business own (assets) and owe (liabilities)?

3. Statement of Cash Flows

   • Tracks cash inflows and outflows from operating, investing, and financing activities.

   • Key question: How did these activities impact the cash position of the business?

4. Retained Earnings Statement

   • Highlights how net income is distributed to shareholders or retained in the business.

   • Key question: How much money was reinvested into the business versus paid out?

Interrelationships of Financial Statements

Each financial statement is interconnected, and a trained user can trace amounts from one statement to another. Together, these statements provide a comprehensive view of a business’s financial health.

1. Income Statement

• Header Key Phrase: "For the Month Ended..."

• Measures revenues against expenses over a specific time period.

• Net Income: Represents the total money flowing in and out during the period.

Components:

• Revenues (may be labeled as Gross Revenues or Sales)

• Expenses (including financing and investing activities)

Examples:

• Financing Activity: Interest paid on a loan is an expense, but the loan itself is not revenue.

• Investing Activity: Revenue from investments (e.g., stocks or bonds).

Typical Uses:

• Assess a company’s trajectory (e.g., growing revenues or shrinking net income).

• Compare performance across years or competitors.

• Evaluate stability for lending purposes (e.g., for banks granting loans).

2. Balance Sheet

• Key Concept: "As of [specific date]"

• Captures the financial status of a business on that exact date.

• Core Equation: Assets = Liabilities + Stockholders' Equity (ALWAYS true).

Key Terms:

• Assets: What the business owns (e.g., cash, buildings).

• Liabilities: What the business owes (e.g., loans, unpaid bills).

• Stockholders’ Equity: The leftover value after liabilities are subtracted from assets (ownership value).

Importance:

• Reveals how a business is financed (debt vs. equity).

• Helps assess financial stability by comparing ratios over time and across competitors.

Example:

If a business takes out a loan, it gains cash (asset) but also increases liabilities. This maintains the balance.

3. Statement of Cash Flows

• Expression: "Cash is King."

• Focuses on cash’s liquidity (how easily it can be used).

Categories:

1. Operating Activities: Cash generated from core business operations.

2. Investing Activities: Cash used for investments (e.g., purchasing equipment).

3. Financing Activities: Cash flows from loans or issuing equity.

Key Points:

• Liquidity ensures the business can pay bills, manage emergencies, and invest.

• Cash flows in some categories (e.g., investing) can be negative but still healthy.

• Strong cash management is critical for financial stability, especially during crises.

4. Retained Earnings Statement

• Simplest Statement: Tracks net income distribution.

Purpose:

• Ties together data from other financial statements:

  • Net Income (from Income Statement).

  • Dividends Paid (amount distributed to shareholders).

  • Retained Earnings (remaining balance reinvested in the business).

Other Elements of an Annual Report

Publicly traded companies in the U.S. must provide annual reports, which include:

1. Management Discussion and Analysis (MD&A):

• A "post-game analysis" by management, addressing:

  • Ability to meet near-term obligations.

  • Operational results and trends.

  • Future expectations and uncertainties.

2. Notes to the Financial Statements:

• Provides detailed explanations of how values were calculated.

• Discloses methods (e.g., inventory valuation) and other key details not included in the primary statements.

3. Auditor’s Report:

• An independent examination of the financial statements for:

  1. Stability to avoid bankruptcy.

  2. Fair presentation of financial data.

• Unqualified Opinion: Indicates trustworthiness.

• Qualified Opinion: Raises concerns about reliability or "going concern" (ability to continue operations).

Summary

The four primary financial statements provide a detailed and interconnected view of a business’s financial health. Understanding how these statements interrelate, along with additional elements in an annual report, equips stakeholders to assess performance, stability, and future prospects.