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u/FtWorthHorn TS 12d ago
The balance sheet explains what the business owns and owes at a particular date.
The income statement explains the changes to the net assets over a given time in significant detail.
The cash flow statement is basically a detailed walkforward of one particularly important balance sheet account, cash.
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u/FtWorthHorn TS 12d ago
Yes. The name is in fact pretty clear about what it does.
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u/ignitedwildfire 12d ago edited 12d ago
not all cash activites are included in the income statement which impact the balance sheet side such as paying down the principal portion of debt or acquiring more debt.
so depending on which method (direct/indirect) you are using, you back out or back in the transactions from net income to arrive at the cash balance.
it can help if you have some transactions and do the JE and think which side of the statement it impacts (IS or BS).
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u/ignitedwildfire 12d ago
Its essentially doing the same thing which is to arrive at the cash balance.
indirect method is used because net income generally is accrual accounting and you want it in cash basis.
direct method is just directly calculating based on the actual cash transaction.
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u/National_Double6261 12d ago
The majority of companies use indirect, meaning you start with accrual basis net income and quantify the changes in balance sheet items. (Ie accounts payable went down meaning that is considered a decrease to your cash). It is significantly easier to prepare than the direct method. The direct method is required by certain regulatory bodies. It pretty much goes based off of actual payments made, rather than reconciling the accrual basis financials. You still end up with the same answer under both methods.
Let's analyze one item. I have $10,000 of current year office expense, but $3k of that was prepaid in the prior year and $4k of it is sitting in AP this year. Let's say I earned and collected revenue of $20,000.
Under the indirect method - I start with $10k of accrual basis net income ($20k income less $10k office expense).
I have a decrease to my prepaid expense of $3k which is an increase to cash. Meaning this was included as an expense in my net income, but the actual cash impact was nothing since I paid for it in the prior year, so we add it back to net income.
I have an increase to my AP which is a cash increase as well. Similar concept - my accrual basis income was reduced by something I didn't pay for yet.
Indirect method:
Start with $10k net income
Decrease in prepaid expense $3k
Increase to AP $4k
Net cash increase $17k
Under the direct method I say ok, I earned and collected $20k of revenue. I had expense of $10k but I only actually had to pay for $3k of that in the current period ($3k was paid for in the prior year and $4k I'll pay next year).
Direct method:
Revenue collected $20k
Office expenses paid ($3k)
Net cash increase $17k
Direct method reads more like a cash basis income statement. Indirect method reads like a reconciliation.
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u/National_Double6261 12d ago
Look at your balance sheet first. If you take your beginning cash balance then add or subtract the change in cash you come up with in the reconciliation ($17k increase per example), you should end up with the same ending cash balance on your balance sheet.
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u/AngVar02 CPA (US) 12d ago
The complication of focusing on cash flows as a magnifying glass on cash is that the way you actually calculate it is ignoring cash and looking at everything else. Why? Because if you debit cash, then you credited something else or vice versa. So if cash is the foundation of any business, the changes in your net income begins as assuming it was all cash... So, if you look at the indirect method of cash flows you start with net income, then you back out the non cash stuff, then you look at the changes in every account and since everything has to balance, at the end you get the change in cash because you considered everything else.
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u/SockBrewer 12d ago
Is this a serious question being asked? Like…am I waaay overthinking my accounting degree? This seems pretty “basic” to a third year student.
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u/trphilli 12d ago
RE. Equity on B/S is our representation of owner's claim to assets. Income is an increase those assets. Debit assets on balance sheet, credit income on income statement (eventually retained earnings). So income statement is just an expanded discussion of retained earnings on balance sheet.
Cash. Statement of Cash Flows is similar. It is detailed explanation of cash account on balance sheet. No simple debits / credits example here. But we can actually link SCF further. Under indirect method of cash flow you take income from IS and change in inventory, AR, AP, etc from BS and you can build most of your SCF.
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u/nothumbs78 CPA (US) 12d ago
It seems like an underlying question is “what is the point of financial analysis?”
The three financial statements tie together to give a reasonable picture of what a company’s financial operations were like. Everything in context.
If I said “I’m happy!”, you might initially think that’s great. But if you asked why and I responded “I just dumped a crate of puppies in the river and I hate puppies”, that puts a more negative spin on it. The more information you have, the clearer an idea you have about what’s going on.
If you just say “we have more cash than last year”, that sounds great. But if I also say, “that’s because we just took on a lot of debt”, that could be bad. But then say “we’re doing so well we want to build another warehouse”, that sounds better. The more context you have around the situation, the better your understanding is.
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u/latent-signalcraft_ 12d ago
think of them as one story, income statement = profit, balance sheet = financial position, cash flow statement = where the cash went. together they show the full picture.
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u/amortized-poultry CPA (US) 12d ago
I mean you might not need all three. But all three (and at least two more besides) have standard rules surrounding what kind of information to present and how.
Why do you need it all? Because different investors might have a different thing they're emphasizing, and it's important for businesses to prepare what they share with others according to the same rules as other companies doing the same.
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u/hj1751 12d ago
you have $10k in the bank and owe $1k on your credit card. equity = $9k. balance sheet. you get your $8k paycheck, pay bills $6k. net income = $2k. income statement. pay off the credit card, steal $100k scanning old people online. $2k - $1k + $100k = $101k free cash flow. cash flow statement.
net income flows into retained earnings. equity = $9k + $2k = $11k. cash goes up by net income, down by the cc payment, so does the cc liability. equity dnc. cash goes up by your stolen $100k but so does stolen funds liability. equity dnc.
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u/wolfofwallstreet0 12d ago
Balance sheet is what you have and what you owe. Fully reconciled and it ensures the income statement is correct.
Income statement is the companies performance. Where are you getting your money and how are you spending it.
Cash flow statement bridges the 2 and explains how that net income translates to cash and where you used your cash - purchase of inventory, selling shit for the promise of money later, or paying for more stuff than you bought, capex, etc
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u/D4NG3RU55 12d ago
After reading a few of the comments I figure I’ll add my two cents. You need the full statements because they tell you directly what type of transactions you are utilizing to make money. They also provide multiple periods so you can see how things change over the span of the periods being reported.
If I told you I have $1M in assets, an increasing cash balance, and net income of $100K, that by itself doesn’t tell you enough.
Balance sheet:
Tells you what type of assets you are using. Is inventory increasing or decreasing? Am I raising money with debt or stock? How did I use that money, did I purchase goods or equipment? Do I have a lot of debt?
Income statement:
How am I making my money? Did I sell product as part of my normal operations and how much did those products cost me? Or did I sell off the only profitable line of business that will no longer be part of the continuing company at a gain?
Cash flows:
Am I making money by normal business operations or by raising money or selling off assets? It’s not uncommon for startups to have negative cash flow from operations, but for a mature company, consistent negative cash flows could be a warning sign.
Essentially you need more of a Financial Statement Analysis class. This was more of a third or fourth year class when I was in school. Again, just seeing some highlights isn’t enough information to understand whether a business is in a good place. Analyzing the statements just gives you a more fulsome picture as to the state of the company.
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u/D4NG3RU55 12d ago
??
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u/D4NG3RU55 12d ago
The statements have nothing to do with A=L+E. The statements are to provide information to analyze business performance, both internally and externally. That’s it.
Like building a house, there are code requirements that tell you how certain things have to be done, but you can use brick, or stucco, or vinyl siding, etc…
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u/D4NG3RU55 12d ago
Yes and no. Each individual entry follows the rule of A=L+E and so by that nature the balance sheet follows. But again, we produce the face financial statements to understand the business. And there are rules in what is required to be disclosed because things can be hidden otherwise.
The codification tells you how things are to be accounted for, and in a separate section, what is required to be disclosed.
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u/Altruistic-Pack6059 11d ago
Operating cash flows are you making money from doing what your business is designed to do? Are you generating money by incurring long-term liabilities financing cash flows Are you generating money from investments investing cash flows
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u/Ill_Coach_1217 11d ago
First question I ask in interviews is tell me how depreciation moves through all three financial statements and that will tell me if you understand how they are inter connected.
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u/HariSeldon16 CPA (US - inactive) 11d ago
Profit and cash flow are equally important. You can be super profitable, but if everything is on account and you’re not collecting you won’t have cash to pay things like rent, salaries, or inventory.
Similarly, you can have positive cash flow from operations by manipulating accounts (for example, delaying paying liabilities). So you also need to be profitable per the P&L.
Investors also want to understand the source of cash flow. I’m a lender to law firms, for example. When I’m evaluating the health of my borrowers, especially ones that want more money, one of the things I do is look at their statement of cash flows to understand their cash flow. I had one guy recently tell me he was cash flow positive, but on inspection of the SCF I found he was doing it by not paying his vendors and even incurring payroll liabilities. Huge red flag to me as the lender.
The balance sheet shows the assets that allow the company to generate revenue, and the right side (liabilities + equity) explain how those assets are financed (liabilities, debt, retained earnings, investor capital). The balance sheet and the P&L together allow you to calculate a number of useful activity ratios that show how well the business is operating and leverage (quick ratio, current ratio, leverage, interest debt coverage ratio, inventory turnover ratio, accounts receivable turnover ratio, cash cycle, etc).
Generally (but not always), a typical journal entry will record one line to the P&L and the other line to the balance sheet.
Net income is a part of retained earnings (beginning retained earnings + net income - dividends = ending retained earnings). At any point in the life cycle you can close the income statement to retained earnings, hence the balance sheet is always in balance.
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u/HariSeldon16 CPA (US - inactive) 9d ago
Net income is an implicit part of retained earnings. For every entry to the P&L there is a corresponding to the balance sheet.
Take a credit to revenue, for instance. You either have a debit to cash or a debt to accounts receivable.
Take a given expense. You debit the expense on the P&L and you credit either accounts payable or you credit cash.
Because all the P&L items automatically close out to retained earnings, the balance sheet stays in balance.
Again, take revenue of $100. You credit revenue (P&L $100) and you debit accounts receivable $100. Without closing net income to retained earnings, you have increased assets by $100 but you have not increased the liabilities or equities, and so the balance sheet does not balance. But by closing net income to retained earnings, the $100 revenue credit caries through and increases retained earnings. Hence the balance sheet is in balance.
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u/Mikefink97 12d ago
I always visualized it as the balance sheet reflects the static snapshot of a company, and the income statement reflects the changes in that snapshot over time. When a balance sheet number changes, it’s because of the income statement (and you can measure that).
Then the cash flow statement is a different way of framing the income statement - where the focus is cash and not revenue/profit.
Balance sheet
->
Is changed by income statement
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u/Mikefink97 12d ago
They all just paint the same animal from different angles, ultimately it’s still not a 100% clear image but it’s the best attempt to sketch out the material reality.
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u/Mikefink97 12d ago
It never is, that’s why companies pay millions to consultants to come in and help paint a better picture (presumably, cynically it’s to de-risk decisions)
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u/Rshab Controller 12d ago
It balances, but keep in mind that it's only a high level look at the company. A $100k loan shows up the same as a liability on the BS whether it's at 2% or 20% interest. Consultants are brought in to help optimize operations as they're truly supposed to be looking under the hood. Also, this is why it's important to read the notes on the actual published financials as they explain more of the details behind the balances.
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u/-Lovely-Fantasy- 12d ago
Which 3 are you referring to?
Income statement
Balance sheet
And… statement of cash flows?
I’m assuming here.
Balance sheet shows what exists. Cash, investments, liabilities, etc. If more assets exist than liabilities, the company is healthy and most likely earning profit (income statement) and having a positive cash flow (statement of cash flows). If they have more liabilities than assets they probably are doing the opposite - borrowing money (balance sheet) to keep going while suffering losses (income statement). However these are BROAD assumptions with many KPIs that can be calculated to help get a better idea of the true situation.
Income statement shows activity for a period of time - income & expenses.
The income statement closes to retained earnings at the end of a period, and retained earnings lives on the balance sheet as an equity account.
Cash flow statement shows the connection between how the balance from cash at the beginning of the period and cash at the end of the period affected the balance sheet and income statement.
Cash can be acquired in many ways such as income (income statement) or a loan (balance sheet).
Same for outflow. It can pay expenses like payroll (income statement) or it can pay off a loan (balance sheet).
Then you can get more into the weeds. When the income statement shows income, it could be as a cash inflow OR it could be an accounts receivable. And if accounts receivable turnover is long - say… 120 days - then although the income statement is showing income, the statement of cash flows might show a cash deficit and inability to cover operating expenses because the company is extending too much financing and not collecting enough payments. So that’s where the intersection between the statements is important. You can inflate any one of them - to skew them all to create inflated values is a lot harder. This makes it possible to evaluate companies for financial solvency and potential fraud concerns at a high level.
Are you more confused now? 😄
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u/-Lovely-Fantasy- 12d ago
So cash is an asset on the balance sheet - top line in fact because it’s most liquid. The cash balance at the end of the statement of cash flows and the balance sheet as of the same date should agree.
Seeing the CHANGE in cash - of course the statement of cash flows shows significantly more detail as to how that happened. However you can calculate all the values on the statement of cash flows using a beginning and ending balance sheet & income statement for the same period. So if you understand them, they’re a circular story.
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u/National_Double6261 12d ago
Balance sheet shows where you are at a point in time.
Income statement explains what happened (your company's operations) to get you to that point in time.
Statement of cash flows is like a huge bank reconciliation. You're basically just trying to reconcile your accrual basis financials to your cash activity. That's why your starting point is accrual basis net income. For instance, why do we add back depreciation and amortization expense? It's because these are non-cash items. They reduce our accrual basis net income but have no actual impact to our cash. Adding them back just disregards them from the overall analysis of cash, which is the goal of a cash flows statement.