The Ultimate Guide to Financial Statements

[0:00]Hello, I'm James, you're watching Accounting stuff, and today we're doing a deep dive into financial statements. This is a special compilation video that I've split into four parts. First, I'll explain what financial statements are and introduce you to the main ones: the balance sheet, the income statement, and the cash flow statement. Then we'll explore each one in a bit more detail. We'll build each statement from scratch using a trial balance. Stick with me to the end and you'll be an expert on financial statements in no time at all. Let's do this. What are financial statements? Financial statements are reports that summarize the activities and financial performance of a business. They're prepared at the end of each accounting period and they're designed to give investors and lenders a feel for a business's financial health. The three main financial statements are the balance sheet, the income statement and the cash flow statement. Now I'll explain how each of these work with an example. Tea-licious is a family-run business that produces a popular blend of black tea. Their financial year has come to a close and they finished putting together their financial statements. So let's look at them. We'll start with the balance sheet. What is a balance sheet? The balance sheet is a financial statement that gives us a snapshot of a business's assets, liabilities and equity at a single point in time. The balance sheet is also called the statement of financial position, and it looks like this. In the header, we have the business's name, followed by the name of the financial statement, and directly below that, we have the point in time that we're looking at, a snapshot of December 31st. On the left-hand side of the balance sheet, we have a list of everything the business owns, its assets. And on the right, we have everything the business owes, its liabilities and equity. Tea-licious owes liabilities to third parties like its suppliers, its employees, and the tax office. But it also owes equity back to the owners of the business. This includes their original capital contributions, which is the cash the owners injected into the business, and retained earnings, which are the cumulative profits that the business has held onto. If we collapse the balance sheet down into its core components, then we can see that Tea-licious has total equity of 129.5 million dollars. What does this mean? Well, if the business were to suddenly sell off all of its assets and pay off all of its debts, then in theory, this is how much money the owners would get. At the bottom of the balance sheet, Tea-licious has total assets of 169 million dollars and total liabilities and equity of 169 million dollars. The stuff it owns is equal to the stuff it owes. So, the balance sheet is in balance. Which is fantastic news because a balance sheet always has to balance. Why? Because it says so in the accounting equation. Assets shall always equal liabilities plus equity, or the stuff that a business owns is equal to the stuff that a business owes. What is an income statement? An income statement is a financial statement that summarizes a business's revenues and expenses over a period of time. If the balance sheet is a snapshot of a point in time, then the income statement is more like a video or a boomerang covering a range of time. The income statement looks like this. As you can see, in the header, the income statement covers a period of time, the year ended December 31st. And in the body of the report, we have a summary of revenue earned and expenses incurred. If we collapse it, then we find that the income statement is really showing us three things. Firstly, Tea-licious made 255 million dollars in revenue, which is their top-line income that it earned from selling products during the year. Secondly, it incurred 248 million dollars in expenses. This includes the direct and indirect costs of running the business. And finally, when we subtract expenses from revenue, we see that Tea-licious generated 7 million dollars in net profit on the bottom line. Profitability is key to the income statement, which is why it's also called the statement of profit and loss. It tells us how much profit the business earned over a period of time. But be careful here because profit doesn't necessarily translate to cash flow, which is why businesses also need a cash flow statement. What is a cash flow statement? A cash flow statement is a financial statement that shows a business's cash inflows and outflows over a period of time. Businesses need to make a cash flow statement if they are using accrual accounting. You see, there are two methods of accounting. We have the cash method and the accrual method. The cash method of accounting is often used by smaller businesses. It says that revenue is recognized when cash is received and expenses are recorded when cash is paid out. Under the cash method, the income statement and the cash flow statement are equivalent to one another. If cash comes in, we record revenue, and if cash goes out, we record an expense. It's nice and simple, but it has its limitations. What if Tea-licious makes a large sale, but the customer doesn't pay the invoice until the following accounting period? Their revenue could be understated in the period that they made the sale and overstated in the following period when they received the cash. There has to be a better way. And thankfully, there is. The accrual method says that we should recognize revenue as it's earned and record expenses as they are incurred, when the substance of the transaction takes place. This means that cash inflows and outflows aren't equivalent to revenues and expenses. They need to be tracked separately in the cash flow statement. A cash flow statement looks like this. In the header, we have the period of time that it relates to, just like we had in the income statement, and in the body, we have two main sections. At the bottom, we have the opening and closing cash balances for the financial year. We get these numbers from the balance sheet. Tea-licious started out with 11 million dollars and finished up with 12 million dollars. So, overall, that's a net increase in cash of 1 million dollars. But how did this come about? This is where the top section comes in. We work out the cash flow from operating activities, investing activities, and the financing activities. Cash flow from operating activities covers regular business activities. How much cash Tea-licious brought in and spent whilst selling tea? Tea-licious is using the direct method so this section mirrors an income statement prepared under the cash method of accounting. Cash flow from investing activities looks outside of the core operations of the business. These are the cash inflows and outflows from investments and buying or selling property and equipment. Cash flow from financing activities is all about funding the business, either through loans from banks or equity from the owners of the business. If we collapse this all down, then the net cash flow on the top should match up with the net cash flow on the bottom. It does here, which means the cash flow statement is reconciled. Let's do a quick recap. The balance sheet gives us a snapshot of a business's assets, liabilities and equity at a single point in time. It shows us what a business owns and what it owes. It also tells us how much the business is worth to its owners. And then we have the income statement, which shows us a business's revenues and expenses over a period of time. When we take the difference, we can see if it made a profit or a loss. The cash flow statement reveals a business's cash inflows and outflows over a period of time. These are reconciled back to the movement in cash in the balance sheet. Woo yeah! Before we go any further, you should know that I've put together cheat sheets covering all of these financial statements. I'll leave links to them down in the description. Okay, now that you've got a feel for financial statements, let's take a closer look at them one by one. We'll start with the balance sheet. A balance sheet, or a statement of financial position, is a financial report that gives us a snapshot of a business's assets, liabilities and equity at a single point in time. Now if you've watched my videos before, then you've probably heard this one. The stuff that a business owns is equal to the stuff that a business owes. In other words, a business owns assets, and it owes liabilities to third parties. The difference between the two is called equity, which is what the business owes back to its owners. And so we have the accounting equation: assets are equal to liabilities plus equity. When we take a snapshot of this accounting equation at a single point in time, we're looking at a balance sheet. We'll call this one the basic balance sheet, and as its name suggests, it's got to balance. That means that total assets must always equal total liabilities and equity. A detailed balance sheet will look something like this. We expand out assets into current and non-current. Current assets are short-term assets, things like receivables and prepaid expenses. On the other hand, non-current assets are long-term assets. There are two main types, the ones that you can touch and the ones that you can't touch. We do the same thing with liabilities. Current liabilities are short-term liabilities, payables, accrued expenses, and deferred revenue, and non-current liabilities are long-term liabilities, stuff like long-term loans. Equity, on the other hand, is a different kettle of fish. First, we have capital contributions, which is the money invested into the business by its owners. For a company with shareholders, we might call this common stock, and then we have the business's retained earnings, which are its accumulated profits held for future use. I do have a balance sheet cheat sheet that summarizes all of this, the links in the description. Anyways, how do you make a basic balance sheet? First, you need another accounting report called the trial balance. This shows us the closing balances for every general ledger account at a point in time. Here's a trial balance for a dating app called Tumble. It was run at the end of Tumble's financial year, December 31st, and it's an adjusted trial balance because all adjusting entries have already been posted. We can see all of Tumble's accounts and balances. Debits are on the left and credits are on the right. At the bottom, we can see that the debits total to 87,700,000, which matches the total credits exactly. This means that Tumble's trial balance is in balance, which is very important because if the trial balance is in balance, then the balance sheet also has to balance. Don't think I've ever said balance so much in my life. Accounts in a trial balance are usually arranged in a pattern. Above this line, we have the stuff that Tumble owns, its assets. And below the line, we have the stuff that Tumble owes, its liabilities and equity. We also have its revenue and expense accounts, which we use last time to make the income statement. So, how do we make a balance sheet? We'll start with the wrong way, because this is a really easy mistake to make. And it goes something like this. We take all of Tumble's assets, liabilities, and equity accounts, and we pop them in their sections of the balance sheet. In theory, it's the right thing to do, but check this out. Total assets add up to 36,350,000 and total liabilities plus equity add up to 25,650,000. That's a difference of 10,700,000. So this balance sheet doesn't balance. What went wrong? We forgot to include Tumble's revenue and expenses. These are part of Tumble's retained earnings, its profits held for future use, which also sit in the equity section of its balance sheet. When we include them, total liabilities plus equity also add up to 36,350,000. So Tumble's basic balance sheet is in balance. Remember, the balance sheet is a snapshot of a business's assets, liabilities and equity at a single point in time. On the left side, we can see what the business owns, and on the right side, we can see what it owes to third parties and its owners. How do we make a detailed balance sheet? We follow the same process, but first, we need to divide Tumble's assets and liabilities into current and non-current. Cash, accounts receivable, other receivables, and prepaid expenses are all current assets. Property, plant and equipment, and intangible assets are non-current assets. Accounts payable, taxes payable, accrued expenses, and deferred revenue are all current liabilities. And long-term loans is a non-current liability. In the equity section, common stock is a type of capital contribution, and everything below that is retained earnings, Tumble's profits held for future use. And that's it. We can pick up all these numbers and put them in our detailed balance sheet. So we've got current assets, 31,050,000 and 5.3 million in non-current assets. Current liabilities are 14.4 million dollars, and non-current liabilities of 1.2 million dollars. Then we have 1,050,000 in common stock, which is a type of capital contribution, and finally, 19,700,000 in retained earnings, or profits held for future use. Total assets are equal to total liabilities plus equity, so this balance sheet is in balance. Oh yeah! Congratulations, you are now officially an expert on financial statements. I've just decided. The next step is to learn how to read and analyze them, and boy, do I have the video for you! It's right here, and yes, it's on financial ratios. Why not give it a watch? I'll see you there.