Question

The structure of Financial Statements and how they interact with each other.

Answer 1

The four main types of financial statements are:

1. Balance Sheet: It presents the financial position of an entity at a given date. It is comprised of the following three elements:

• Assets: Something a business owns or controls (e.g. cash, inventory, plant and machinery, etc)
• Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)
• Equity: What the business owes to its owners. This represents the amount of capital that remains in the business after its assets are used to pay off its outstanding liabilities. Equity therefore represents the difference between the assets and liabilities.

2. Income Statement: It is also known as the Profit and Loss Statement, reports the company's financial performance in terms of net profit or loss over a specified period. Income Statement is composed of the following two elements:

• Income: What the business has earned over a period (e.g. sales revenue, dividend income, etc)
• Expense: The cost incurred by the business over a period (e.g. salaries and wages, depreciation, rental charges, etc)

Net profit or loss is arrived by deducting expenses from income.

3. Cash Flow Statement: It presents the movement in cash and bank balances over a period. The movement in cash flows is classified into the following segments:

• Operating Activities: Represents the cash flow from primary activities of a business.
• Investing Activities: Represents cash flow from the purchase and sale of assets other than inventories (e.g. purchase of a factory plant)
• Financing Activities: Represents cash flow generated or spent on raising and repaying share capital and debt together with the payments of interest and dividends.

4. Statement of Changes in Equity: It is also known as the Statement of Retained Earnings, details the movement in owners' equity over a period. The movement in owners' equity is derived from the following components:

• Net Profit or loss during the period as reported in the income statement
• Share capital issued or repaid during the period
• Dividend payments
• Gains or losses recognized directly in equity (e.g. revaluation surpluses)
• Effects of a change in accounting policy or correction of accounting error

Financial Statements are interlinked in the following way:

The bottom line of the income statement is net income. Net income links to both the balance sheet and cash flow statement.

In terms of the balance sheet, net income flows into stockholder’s equity via retained earnings. Retained earnings is equal to the previous period’s retained earnings plus net income from this period less dividends from this period.

In terms of the cash flow statement, net income is the first line as it is used to calculate cash flows from operations. Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations.

Any balance sheet items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash. The net change in cash on the cash flow statement and cash from the previous period’s balance sheet comprise cash for this period.