The three financial statements are:
Let us now look into each of the financial statements in brief.
I. Income Statement
The income statement is used by analysts to assess the profitability or performance of a company during the accounting period. The accounting period is determined as per the firm’s policies.
It captures two aspects of a business–Revenue & Expenses over a given period (usually 1 year or 1 accounting period) through both operating and non-operating activities. It starts with revenue (also known as “the top line”) and we get the Gross Profit after deducting the Cost of Goods Sold or COGS. COGS is the total producing and selling the goods. Other operating expenses are deducted from the Gross Profit to arrive at the Net Profit (also known as “the bottom line”)
II. Balance Sheet
A Balance Sheet is a summary of a company's assets, liabilities and shareholders' equity at a point in time.
The balance sheet has 2 parts: Assets is one part & the other is Liabilities and Shareholders' Equity. At the period end, the totals of the two parts should tally or balance out and hence this statement is called “Balance Sheet”.
Assets = Liabilities + Shareholders' Equity
III. Cash Flow statement
The Cash flow statement adjusts the net income (taken from the income statement) and adjusts it for any non-cash expenses, for e.g. depreciation. This statement is prepared to analyse the sources and applications of cash, to understand why there is a difference between the net income and the cash balance and also to determine whether the firm has sufficient cash balance to take operating, investing and financing decisions. It shows the impact of a firm's operating, investing and financial activities on cash flows over an accounting period.
• Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities.
• Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
• Financing activities are activities that result in changes in the size and composition of the owners’ capital (including preference share capital in the case of a company) and borrowings of the enterprise
One must note that the cash flow statement shows the changes in cash and cash equivalents. Cash comprises cash on hand and demand deposits with banks and not just hard cash or currency in hand.
Cash equivalents are short term, highly liquid investments that are readily convertible into determinable amounts of cash and are subject to an insignificant risk of changes in value.
There exists an inter linkage in the three financial statements (as represented in the image below).
2. Depreciation for the year is charged as an expense in the income statement, added back in the cash flow statement to arrive at the cash from operations and is also deducted from the relevant asset account in the balance sheet.
3. The net profit in the income is statement is used as a starting point while calculating operating cash flow.