Financial Statements Overview and Income Statement Notes
Introduction: Why accounting matters
- To make good decisions about a company, you need to understand it from a financial perspective.
- If you’re going to invest, lend, or do business with a company, you’d want to know:
- profitability: how did they perform? were they profitable? what did earnings look like? which answers come from the income statement
- financial position: what the company owns and what it owes? this helps determine financial strength
- cash management: where is cash coming from and where is it going to? is there adequate cash to pay obligations as they come due?
- distributions to owners: do they pay dividends? dividends are a way investors earn a return
- All of this information is found in the company’s financial reports, i.e., the financial statements.
- The four statements together provide a complete picture:
- income statement = profitability
- statement of retained earnings = dividends, changes in retained earnings
- balance sheet = assets, liabilities, stockholders’ equity (financial position)
- statement of cash flows = cash inflows/outflows and beginning/ending cash balances
- Publicly traded companies publish income statements along with the other financial statements on an annual and quarterly basis; many prepare monthly income statements for internal decision making.
- The financial statements are designed to provide relevant information to decision makers.
The four financial statements and their purpose
- Income statement: reports the company’s financial performance or profitability over a period of time.
- Statement of retained earnings: reports changes in retained earnings due to earnings and dividends; retained earnings is a stockholders’ equity account.
- Balance sheet: reports assets, liabilities, and stockholders’ equity as of a specific point in time.
- Statement of cash flows: provides detailed cash inflows and outflows by operating, investing, and financing activities; includes beginning and ending cash balances.
- The statements are connected and reveal the flow of information: net income from the income statement affects retained earnings, which is part of stockholders’ equity on the balance sheet; cash balances on the balance sheet are detailed in the statement of cash flows; cash at the end of the period ties back to the balance sheet.
How the statements are connected to accounts and categories
- In a prior video, the six types of account categories were discussed; these categories underpin the financial statements.
- Balance sheet reports:
- Assets (what the company owns)
- Liabilities (what the company owes)
- Stockholders’ equity (owner’s claim, including retained earnings)
- Income statement reports:
- Revenues (earned by the company)
- Expenses (incurred to earn revenues)
- Net income (or net loss) = Revenues − Expenses
- Statement of retained earnings focuses on:
- Changes in retained earnings over the period, including additions from net income and deductions from dividends paid to investors.
- Retained earnings is a stockholders’ equity account and is also reported on the balance sheet.
- Cash flows statement focuses on:
- Beginning cash balance, cash inflows and outflows during the period, ending cash balance.
- Sections: operating, investing, financing.
- In short, the four statements work together to show profitability, financing decisions, and liquidity/operational efficiency.
- The statements are named and prepared in the following order because of information flow:
1) Income statement (revenues and expenses; profitability)
2) Statement of retained earnings (updates retained earnings with net income and dividends)
3) Balance sheet (assets, liabilities, equity at a point in time; includes retained earnings)
4) Statement of cash flows (cash movements by activity, reconciles to cash balance on the balance sheet) - This flow reflects how results from operations affect equity and cash, ultimately influencing the company’s financial position.
Focus on the income statement (profitability)
- The income statement reports the company’s financial performance or profitability over a period of time.
- Fundamental equation:
\text{Net Income} = \text{Revenues} - \text{Expenses} - It is prepared for a specific period: could be a year, a quarter, or a month.
- Publicly traded companies must publish income statements on an annual and quarterly basis; many prepare monthly income statements for internal decision making.
- Alternate names: the income statement is also called the profit and loss statement or the earnings statement.
- Heading: identifies who, what, and when (company name, title of the statement, time period)
- Example phrasing: "The income statement for Catch and Waves Incorporated for the year ended December 31" (or similar wording for the period).
- Revenues section: reports revenues earned during the period.
- For Catch Waves, both revenue streams are reported:
- Sales revenue (when selling a product to customers)
- Service revenue (for services provided, e.g., surfing lessons)
- If a company has both, both revenues are listed; some companies have only one type (either Sales revenue or Service revenue).
- Expenses section: reports the expenses incurred during the period (e.g., salary, supplies, advertising, office expense).
- There isn’t a strict order for listing expenses, but larger expenses are typically shown first.
- In practice, larger expenses are often listed first; in this example, each expense is listed separately to show detail.
- Some publicly traded companies group expenses when filing with the SEC.
- Calculations:
- Net income (or net loss) is found by subtracting total expenses from total revenues:
- \text{Net Income} = \text{Total Revenues} - \text{Total Expenses}
- Example from transcript:
- Clara’s company made \$2{,}400 during its first year of operations.
- This amount is the bottom line on the income statement and is the figure that flows to the statement of retained earnings.
- Formatting items:
- Currency display: a dollar sign is included on amounts at the top and bottom of the statement to identify currency, e.g., \$2{,}400
- Emphasis on the bottom line: the bottom-line net income is shown with a double underline on the income statement.
Practical example and when this is useful
- The income statement helps answer: Did the company make money in the period? What was the level of profitability? How much did revenues exceed expenses?
- The net income figure is used to inform decisions about dividends, reinvestment, and overall financial strategy.
- The statement of retained earnings will use net income to update retained earnings and show any dividends paid to owners.
Next up: what comes after the income statement
- The video teases the next topic: the statement of retained earnings, which details dividends paid and changes in retained earnings over time.
Key takeaways
- The four financial statements provide a complete view of profitability, cash flow, and financial position.
- The income statement focuses on profitability via the equation \text{Net Income} = \text{Revenues} - \text{Expenses} over a defined period.
- Revenues can be subdivided (e.g., Sales revenue, Service revenue); expenses can be itemized (e.g., salary, supplies, advertising, office expense).
- The bottom-line net income is carried into the statement of retained earnings and influences the equity section of the balance sheet.
- The statement of cash flows adds detail on cash movements across operating, investing, and financing activities, and shows beginning and ending cash balances.
- Financial statements are prepared in a logical order to reflect the flow of information from operations to equity and cash.
- Presentation details, such as currency indicators and a double underline for net income, aid readability and emphasis.
Quick reference: statements in the order prepared
- Income statement
- Statement of retained earnings
- Balance sheet
- Statement of cash flows