The Big Picture of Financial Statements
The three Financial Statements: Balance Sheet, Income Statement, and Cash Flow Statement, are interconnected and the accounting numbers flow through them. They are the measure of a company’s performance and health.
The basic interconnection starts with a Balance Sheet showing the financial position at the beginning of the period (usually a year); next you have the Income Statement that shows the operations during the year period, and then a balance Sheet at the end of the year.
The Cash Flow is necessary to reconcile the cash position starting from the Net Income number at the bottom of the Income Statement. The cash number calculated from the Cash Flow Statement is added to the cash reported on the beginning Balance Sheet. This number needs to match the actual cash in the bank at the end of the period and is used as the Cash account balance at the top right (Asset column) of the end of year (EOY) Balance Sheet.
The Net Income number from the Income Statement is then added to the Retained Earnings number in the Equity section (lower left hand side) of the end of year (EOY) Balance Sheet.
Changes in non-cash accounts like Accounts Receivable and Accounts Payable and Depreciation and Amortization will make up the difference between the Cash Flow number added on the right side of the Balance Sheet and the Net Income number added on the left hand side.
When this is done correctly, all the numbers should reconcile and the Assets will be equal to the Liabilities and Equity (remember the Accounting Equation A = L + E) of the EOY Balance Sheet.
Financial Statement Interconnections and Flow
Think of it as a system of two Balance Sheets acting as bookends for the Income Statement. And the Cash Flow Statement used to reconcile the Net Income (or Loss) at the bottom of the Income Statement with the amount of cash actually in the bank. This process accounts for every penny that has come in, gone through, and gone out of a company during the period.
Understanding these three financial statements and how they knit together will allow you to assess the financial health, viability and prospects of any company, and help you make rational fact-based investment decisions. This is how Warren Buffett does it.
This post ties together the functionality of the financial statements. I hope this might be an “aha” moment for you. It was for me when I finally realized how this all fit and worked together. This is the basis of Financial Literacy and Capitalism. Understanding this conceptual big picture of accounting will provide a context to keep you from ever getting lost in the details.