Income Statements and Balance Sheets and Statements of Cash Flows! Oh My!

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A layman’s guide to the 3 most important corporate financial indicators

Accounting isn’t easy.

Rules, transactions, the basic concept that debits must equal credits…it’s all very soothing after a day of dealing with the relatively flexible nature and amphibious rules of writing, even business writing.

Still, not easy.

Especially for someone who, until recently, struggled with math her entire life. Until my requisite Corporate Finance and Corporate Accounting MBA classes, Math and I were NOT friends.

Of the two, Corporate Accounting was the most useful. It was absolutely the one that finally dispelled all my arithmetic fears. Seven weeks of living and breathing Excel worksheets in tandem with a mechanical calculator will do that.

So did completing a financial statement workbook assignment every other week led me and my classmates through creating and revising general journal entries, T-accounts, trial balances, and, finally, the income statement, balance sheet, foundation of a business’s income statement, and overall balance sheet, statement of cash flows, and, finally, statement of changes in shareholder’s equity.

In short, we completed an organization’s periodic (annual, semi-annual, quarterly, etc.) audit and accounting (A&A) process, reviewing and analyzing the primary financial statements that sustain a business long-term by making it fiscally stable and profitable.

It turned out the math part of the whole process was easy. So was the analysis.

Income statements and balance sheets in a nutshell

The importance of income statements and balance sheets better than I could with just one line from Kemp and Waybright’s Financial Accounting:

“We know we’ve made net income…”

• The income statement tells us whether or not a company operates at a profit or a loss, aka, can this company make me, the investor, money?
• The balance sheet tells us at a glance what a company’s overall assets and liabilities are, or, do the company’s liabilities at least equal its assets?

The next part of that sentence summarizes the importance of Statements of Cash Flows (SCFs):

…but what about cash? Do we have enough cash to…operate the brewery this year, to buy the equipment we need to expand the business and to pay off the bank loans that are coming due?”

The Statement of Cash Flows offers a snapshot of a company's operations and hints at its longevity by showing where money is spent and where cash comes into the organization. It is literally the flow of money through a business.

How? The SCF lists all a company’s accounts under three broad categories:

• Operating: revenue and expenses, i.e., sales revenue and basic office supplies.
• Investing: long-term asset management, i.e., buying a new printer for the copy center or selling a building.
• Financing: cash-generating activities, i.e., selling additional stock or paying dividends.

Each statement answers one or more of the five key questions a potential investor asks themselves when deciding to buy stock or purchase part of, or loan money to, a company:

“1. Is the business a going concern?

2. How is the business earning a net profit or loss?

3. Where is the business getting its money and can it pay its debt obligations?

4. How is the business investing its money and is it using its assets efficiently?

5. Is the business generating enough net income to reward the stockholders for the use of their money?”

(Kemp, R., et al., 2019)

Each statement presents one or more of the key ratios (more on those later) investors use to answer those questions and perform that valuation.

Allowing for the individual risk tolerance of the investor, which is determined by their purpose in investing and how close they are to retirement (among other factors), someone considering buying stock in a company wants to see a steady income with enough assets to cover their liabilities and enough cash flow to remain liquid, or, pay off investors in addition to the company’s debt if it ends up going bankrupt.

But I’m not an accountant! How is this relevant?

I hate to say it, but accounting — like the “evil” math it’s based on — permeates every part of our adult lives, even when we don’t want it to.

An everyday example of a statement of cash flows is your checking account. If I log onto my bank, I tell at a glance which stores I’ve spent money at, which bills I’ve paid, and what income sources I’m using, i.e., a weekly paycheck, cash from selling something online, my ex reimbursing me for our son’s gym membership, etc., etc.

A simple example of an income statement is your handy dandy tax return, whose deadline is coming ominously into view (unless you’re the spouse of a CPA, in which case April 15th can’t come soon enough). Your 1040 lists your income divided into basic categories such as salary, social security benefits, etc., and your liabilities, such as the income tax automatically deducted from your paycheck, and how much your refund is (or how much you owe the IRS this year) after subtracting the two.

Finally, a balance sheet is your written budget. It lists all of your liabilities, including your credit cards and any outstanding balances, and your assets, such as your car, house, salary, etc., and, hopefully, when you add the columns together and then subtract them from one another, the money you can put to savings.

Now that I think about it…

Ok, given how utterly integrated accounting is into my everyday life, maybe Math and I haven’t been lifelong enemies. Maybe we’ve only been frenemies all these years.

Well done, arithmetic! Well done!

Cheers,

Cris

References:

Kemp, R., Waybright, J. (2019). Financial Accounting 5th Edition. Pearson Education, Inc.