The Financial Statements & their Relationship / Connection | Explained with Examples
Summary
TLDRThis lesson delves into the intricacies of financial statements, highlighting their interconnections. It explains the income statement, which reflects a company's financial performance over a period, the balance sheet, offering a snapshot of the company's financial position at a specific time, and the cash flow statement, detailing cash movements. The lesson clarifies how net profit from the income statement impacts equity on the balance sheet and how non-cash items like depreciation link the two. It also illustrates how the cash flow statement reconciles cash movements with the other financial statements, providing a comprehensive understanding of financial reporting.
Takeaways
- 📊 The income statement (statement of comprehensive income) shows a company's financial performance over a specific period, detailing income earned and expenses incurred.
- 💼 The balance sheet (statement of financial position) provides a snapshot of an entity's financial position at a given point in time, including assets, equity, and liabilities.
- 💧 The cash flow statement (statement of cash flows) illustrates the movement of cash within an entity over a specific period, focusing solely on cash transactions.
- 🔗 There is a direct relationship between the income statement and the balance sheet, where net profit affects equity and expenses and income that are not yet paid or received appear as liabilities or assets respectively.
- ⏱ The balance sheet and income statement are based on the accrual principle, recognizing income and expenses when they are earned or incurred, not necessarily when cash is exchanged.
- 💹 The cash flow statement is prepared to reconcile the accrual-basis net profit with actual cash movements, taking into account non-cash items and changes in working capital.
- 📈 The preparation of financial statements can vary between entities, with some differences in how items like depreciation or finance costs are categorized.
- 🌐 The indirect method of cash flow statement preparation starts with net profit from the income statement and adjusts for non-cash items and changes in working capital to determine cash generated.
- 🏦 The cash or bank balance on the balance sheet corresponds to the final cash balance calculated in the cash flow statement, reflecting the entity's cash position at a specific date.
- 🔄 Changes in working capital, such as inventory, receivables, and payables, are derived from the balance sheet and are crucial in the indirect method of preparing the cash flow statement.
Q & A
What is the primary purpose of the income statement?
-The income statement, also known as the statement of comprehensive income, shows the financial performance of a company over a specific period and includes income earned and expenses incurred.
How does the balance sheet differ from the income statement?
-The balance sheet, or statement of financial position, provides a snapshot of an entity's financial position at a specific point in time, showing assets, equity, and liabilities, unlike the income statement which covers a period.
What does the statement of cash flows represent?
-The statement of cash flows illustrates the movement of cash within an entity over a specific period, focusing solely on cash transactions and excluding non-cash items.
Why might the net profit not match the cash balance in the balance sheet?
-The net profit might not match the cash balance because the income statement and balance sheet are prepared on the accrual basis, which recognizes income and expenses when they are earned and incurred, not necessarily when cash is exchanged.
What is the accrual principle and how does it affect financial statements?
-The accrual principle recognizes income and expenses when they are earned and incurred, respectively, rather than when cash is received or paid. This principle affects the income statement and balance sheet by recognizing revenue and expenses even if there is no immediate cash movement.
How is depreciation accounted for in both the income statement and balance sheet?
-Depreciation is an expense recognized in the income statement that reduces net income. It is also recorded in the balance sheet as a reduction in the carrying value of the related non-current assets, shown as accumulated depreciation.
What is the relationship between the net profit on the income statement and the equity section of the balance sheet?
-The net profit from the income statement is transferred to the retained earnings or accumulated profits in the equity section of the balance sheet, reflecting the change in net assets of the company.
How does the statement of cash flows connect with the income statement and balance sheet?
-The statement of cash flows starts with the net profit from the income statement and adjusts for non-cash items like depreciation. It also considers changes in current assets and liabilities from the balance sheet to determine the actual cash generated or used during the period.
Why is the indirect method used to prepare the cash flow statement?
-The indirect method starts with net profit and adjusts for non-cash items and changes in working capital to arrive at cash generated from operations. This method shows how operating activities affect cash flow and is useful for analyzing a company's liquidity.
What are working capital changes and how do they appear in the cash flow statement?
-Changes in working capital include modifications in current assets and current liabilities that affect cash. These changes are derived from the balance sheet and are included in the cash flow statement to show the impact on cash flows from operating activities.
How is the final cash balance on the cash flow statement related to the balance sheet?
-The final cash balance on the cash flow statement, which results from the addition of cash generated during the year and the beginning cash balance, is carried forward to the balance sheet as either cash or bank under current assets.
Outlines
📊 Introduction to Financial Statements
This paragraph introduces the topic of financial statements, emphasizing the importance of understanding the relationship between the income statement, balance sheet, and cash flow statement. The income statement reflects a company's financial performance over a specific period, showing income earned and expenses incurred. The balance sheet, on the other hand, provides a snapshot of the company's financial position at a given point in time, detailing assets, equity, and liabilities. The cash flow statement tracks the movement of cash within the company over a specific period. The paragraph sets the stage for a deeper exploration of these statements and their interconnections.
🌐 The Accrual Principle and Its Impact
This section delves into the accrual principle, which is fundamental to the preparation of the income statement and balance sheet. It explains that income and expenses are recognized when they are earned and incurred, not necessarily when cash is exchanged. This principle leads to a distinction between net profit and cash balance, as the income statement may recognize income before cash is received, and the balance sheet reflects this as a receivable. The cash flow statement is introduced as a tool to reconcile the accrual-based net profit with actual cash movements, focusing on the changes in cash position over time.
📈 Detailed Breakdown of Financial Statements
The paragraph provides a detailed examination of the components of the income statement, balance sheet, and cash flow statement. It outlines the typical sections found in each statement, such as revenues, costs, gross profits, operating expenses, and net profit for the income statement. The balance sheet is described with sections for assets, equity, and liabilities. The cash flow statement is highlighted with its focus on cash movements, including operating, investing, and financing activities. The paragraph emphasizes the importance of understanding how each element of these statements contributes to the overall financial picture of a company.
🔗 Connecting the Financial Statements
This final paragraph explores the interconnections between the financial statements. It explains how the net profit from the income statement is transferred to the equity section of the balance sheet, reflecting the change in net assets. Depreciation is highlighted as an example of how expenses from the income statement affect non-current assets on the balance sheet. The paragraph also discusses how unpaid expenses and uncollected income appear on the balance sheet as liabilities and assets, respectively. The relationship between the income statement and the cash flow statement is clarified, with net profit serving as the starting point for the cash flow statement. Lastly, the connection between the balance sheet's cash balance and the cash flow statement is established, showing how the ending cash balance is derived from the cash flow statement.
Mindmap
Keywords
💡Financial Statements
💡Income Statement
💡Balance Sheet
💡Statement of Cash Flows
💡Accrual Principle
💡Equity
💡Depreciation
💡Retained Earnings
💡Working Capital
💡Indirect Method
Highlights
Introduction to financial statements and their interrelations.
Explanation of the income statement and its focus on financial performance over a period.
Income statement shows income earned and expenses incurred.
Balance sheet provides a snapshot of an entity's financial position at a specific point in time.
Differences between the income statement and balance sheet are highlighted.
Statement of cash flows shows the movement of cash over a specific period.
Income statement and balance sheet are based on the accrual principle.
Cash flow statement is prepared to reconcile cash movements with income and expenses.
The format of the income statement includes revenues, costs, and profits.
Balance sheet format shows assets, equity, and liabilities at a specific date.
Cash flow statement details cash movements from profits, including non-cash items.
Net profit from the income statement is transferred to the equity section of the balance sheet.
Depreciation from the income statement affects non-current assets in the balance sheet.
Unpaid expenses and uncollected income appear in the balance sheet due to the accrual basis.
Net profit from the income statement is the starting point of the cash flow statement.
Changes in working capital are derived from the balance sheet for the cash flow statement.
Final cash balance from the cash flow statement matches the cash or bank balance in the balance sheet.
Encouragement to subscribe, like, and share the video for those who might benefit.
Transcripts
welcome to counters in this lesson we're
going to be looking at the financial
statements going to be looking at the
relationship between the financial
statements going to focus on the income
statement otherwise known as the
statement of comprehensive income the
balance sheet otherwise known as the
statement of financial position and the
statement of cash flows or the cash flow
statement going to be looking at them
and I'll show you an example of how they
look the formats as well as the
relationship between all these financial
statements and it will help you
thoroughly understand how the financial
statements work and also help you in
advancing how you prepare these
financial statements and how they relate
to one another when you're preparing
them so what are these financial
statements and what do they mean well
the statement of comprehensive income
though as known as the income statement
is a statement that shows the change in
the net assets or the equity of the
entity shows you that it shows the
financial performance of the company
over a specific period and that is
income earned and expenses incurred so
we know this when you look at the income
statement we see what the income is and
what the expenses are I highlighted in
red here the financial performance of
the company over a specific period so
you're looking at how the company
performed all the entity performed over
a specific period of time usually in 12
months time how it performed okay over a
year's time but you can do this even if
I shot up here of time so there is the
statement of comprehensive income and
here I also wrote income earned and
expenses incurred very important for us
to take note of this it's income earned
and expenses incurred so it's not is not
just any income the one we just earned
and the one which is incurred the second
one is the statement of financial
position or the balance sheet which is a
statement that shows an entity's
financial position at a given point in
time and what I wrote the in practice is
it says snapshot it gives you a picture
at a specific point in time
what it looks like and what do you see
in the statement of financial position
or the balance sheet we see what the
assets are the equity and the
liabilities of the entity okay so we are
able to see that at a specific point in
time now you can see the differences
between the income statement and the
balance sheet okay and you can see I've
highlighted them
in red the income statement is the
financial performance of a specific
period okay over a period of time the
balance sheet or the statement of
financial position is a snapshot okay
the financial position at the given
point in time so usually when you see
the statement of financial position for
the year and that let's say 28 February
2020 what you're seeing there is that
what the assets the company has what
they you could see the company has and
what the liabilities the company has a
bad specific point in time at the 28th
of February 2020 like I gave the example
but when you look at the statement of
comprehensive income for the same period
at the S at the end of 28 February 2020
you are looking at 12 months preceding
that period okay so you're looking from
the 1st of March 2019 to the 28th of
February 2020 okay and there is the
difference between that through the
income statement gives you a very
specific period of time the statement of
financial position gives you at that
specific point in time what the assets
equity and liabilities of the company
are so if there's something you remember
between these two statements or between
the income statement and the balance
sheets you remember that they statement
of comprehensive income shows you the
pion financial performance over a
specific period okay but the balance
sheet gives you a snapshot gives you the
financial position of the entity at the
specific period okay at a specific
period it's not over a period of time
but at a specific period the last one
we're looking at here is a statement of
cash flows or the cash flow statement
this is a statement that shows an
entity's movement in cash over a
specific period in time okay
it shows you the movement in cash in the
entity of a specific period of time
now here the statement of cash flows
strictly looks at the cash movement it
does not deal with other aspects of the
statements okay does not deal with what
the income statement will have non-cash
items for instance does not look at what
the statement of financial position
which would have which is non-cash items
as well like the receivables accounts
receivables or debtors
okay the amount that you are old by the
data or the people that you sold to one
credit doesn't look at that it looks at
what is the cash why
- did we have at the beginning and what
cash do we have now at the end what are
the movement what caused the cash that
moved from the beginning so now what we
have at the end okay how did we come
from what we have at the beginning and
not we have at the end so it's looking
at the cash movement of a specific
period of time so just like the income
statement gives you the financial
performance of the company over a
specific period of time the statement of
cash flow shows you the movement of cash
over a specific period of time now let's
continue with this one here let's
highlight it even further the statement
of financial position on the balance
sheet and the statement of comprehensive
income or the income statement are
completed based on the accrual principle
which means that income and expenses
from which profits are computed are
recognized when they are earned and
incurred respectively okay and there is
what we mentioned the statement of
financial position and the statement of
comprehensive income are completed based
on that cool principle now we've looked
at that cruel principle you know other
lessons where we showed you how our crew
worlds work how it affects that
statement of financial position as well
as how it affects the statement of
comprehensive income we look at them
when we are completing these two
statements in great detail and we'll
leave the links to those lessons in the
description below but what we're saying
here is that it's completed based on
their qual pieces okay when income is
earned and when expenses I incur okay
and income can be earned but there's no
movement of cash okay I can earn an
income from my customer but he has not
paid me yet okay but the income
statement or the statement of
comprehensive income will recognize that
income and if I have not been paid the
statement of financial position will
recognize that I have not been paid that
income as well okay so they work on the
accrual principle therefore it is rare
that the net profit that you find in the
statement of comprehensive income is the
same as the cash balance as reflected in
the statement of financial position okay
and remember in the statement of
financial position we have a cash
balance auditors at the specific period
of time which is usually at the end of
the period okay so the net profit that
you have they is not necessarily the
cash that the company has extremely rare
for you to find that because of their
cool issues and also
- elements that are affected in the
statement of comprehensive income in the
statement of financial position it is
for these couples that the cash flow
statement is prepared it is prepared by
taking the latest - statement of
financial position which is the
currently and the priority of the
statement of financial position and the
statement of comprehensive income that
covers that period now we have completed
the statement of cash flows before we
have done that and we showed you how we
take the statement of comprehensive
income and the statement of financial
position to complete the statement of
cash flows but that's what we are saying
when we're completing the statement of
cash flows we are looking at the
statement of financial position for the
prior year and for this year and the
statement of comprehensive income for
this year okay we are looking at them
and we are now trying to reconcile how
cash is affected with these two accounts
to come and see how much cash did we
have at the beginning and how much cash
do we have now and what were their
movements okay to reconcile there - now
let's look at this the format of the
three statements that you've been
looking at the statement of
comprehensive income the statement of
financial position and the statement of
cash flows the first only looking at
here is a statement of comprehensive
income you can see here this is a
completed statement of comprehensive
income you have revenues or sales you
have direct costs or what is otherwise
known as the cost of goods sold or the
cost of sales and then you have gross
profits you have profit on sale of
assets then you have operating expenses
and it's all detailed down here and then
you have operating profit down here and
then you have depreciation your finance
cost you have profit before tax or EBT
which is earnings before tax as well
then you have the income tax expense and
then you have net profits at the end
obviously the preparation of the
statement of comprehensive income might
be different from one entity to another
okay
others may put the depreciation together
the operating expenses or they might put
the finance cost together with the
operating expenses okay and we have
explained about those details before get
the difference between the earnings
before interest and tax and operating
profit and such and such details but
what I want you to focus on here is that
your statement of comprehensive income
details all your incomes
like your revenues like your profit on
the sale of an asset like your interest
income
if you have and it also details all your
expenses and remember it must be
expenses which are incurred and it must
be income which is and this is the
segment of comprehensive income and
another one here is a statement of
financial position which is pretty
standard for most companies ok most of
them would look more similar than the
statement of comprehensive income ok
statement of financial position like we
said it shows you what the assets of the
company are okay
what they equity of the company are and
then what the liabilities of the company
okay it shows you at a specific point in
time and you can see it's written
statement of financial position for the
year and at 28 February 2018 it's
showing you that assets the equity and
the liabilities of the company at this
specific date we need February 2018 so
it's just a snapshot showing you what
assets what equity and what liabilities
but the company has and the last one
here the statement of cash flows which
now details the movement from the
profits that we have in the profits that
are detailed in the statement of
comprehensive income and we take into
account all they have a non-cash item as
well as there are calls and we take that
into account and we're trying to see
what is the actual movement in cash and
strictly cash and loan and this
statement of cash flows is prepared in
the indirect method ok we've done that
you'll find the link in the description
below you can do it that direct matter
method and the indirect method but here
this one is indirect you can see we're
taking the profits of the company the
net profit 2736 and we are making
adjustments for non-cash items and we
know that depreciation is a non-cash
item profit on sale of assets is a
non-cash item and we are also taking
into account other elements but one
arrive at the cash the cash that was
generated this year the cash that we had
at the beginning and the balance that we
have at the end now let's look at the
relationship between the three financial
statements the statement of cash flows a
statement of financial position and the
statement of comprehensive income let's
first look at the connection between the
statement of comprehensive income and
the statement of financial position here
what do you note as the relationship
between the two well the first thing
that you note here is that the net
profit in simplistic terms will be
taken to the equity section of the
statement of financial position and that
is what we said it's the change in the
net assets of the company okay in the
net assets of the company so what does
it mean we just take the net profit and
we take it to retained earnings or
accumulated profits or loss for the
company and you can see the same amount
goes into the statement of financial
position
okay the amount from the income
statement goes into the statement of
financial position obviously there may
be other elements when you're doing an
advance statement of comprehensive
income for instance so for a real
company you'll see that it doesn't end
with net profit the first pay like
preference dividends and they will pay
the ordinary dividends and then whatever
cash they decide to retain in the
company they take it to the equity
section of the statement of financial
position so I'm just showing you the
connection between the statement of
comprehensive income and the statement
of financial position another connection
that we see here is the depreciation
okay you can see here we have
depreciation in the statement of
comprehensive income and what do we do
that depreciation would take it and in
effect all your non current assets okay
your usual and current assets and I'm
talking about land buildings motor
vehicles furniture and fittings
computers and other assets that you may
have that needs to be depreciated are
usually depreciated obviously land is
not usually depreciated but what does
this mean it means that we take the
depreciation with the specific period
and they did that they reduce our non
current assets like your buildings your
motor vehicles and so forth okay so this
depreciation is added to the
depreciation that we've had before for
these specific items and it becomes
accumulated depreciation okay we're
adding the depreciation we take the
depreciation for them from the income
statement and taking to the statement of
financial position there is the
connection between the income statement
and the balance sheet now here's a note
any expense that appears on the
statement of comprehensive income and
not yet paid will appear on the
statement of financial position and that
is why I mentioned the words
income earned and expenses incurred okay
and I say here if an expense that
appears in the statement of
comprehensive income has not been paid
by you yet to whoever you owe it will
appear on the state
a financial position okay it will appear
on your liabilities and the same thing
happens with the income if you have
income that you have not been paid yet
okay you have earned this income but you
have not been paid it will also appear
in the statement of financial position
okay in the assets section so you can
see it can appear in the statement of
comprehensive income and it will also
appear in the statement of financial
position due to accrual basis that we
mentioned and we have done the lessons
on that as well like I said you can find
the lessons on those ones in the links
in the description below now let's look
at the connection between the statement
of comprehensive income or the income
statement and the cash flow statement on
the left we still have our income
statement on the right we have our cash
flow statement okay and what is the
relationship between these two well the
first one that you notice that the net
profit okay and this is the like I said
the indirect method of completing the
cash flow statement okay so you can see
that the net profit that we have in the
income statement goes directly and it's
the first item in the statement of cash
flows okay so we just take the net
profit and you put it in the statement
of cash flows that's the best item now
you can see the connection between the
two and another thing that you see is
the depreciation remember depreciation
is a non-cash item so we take the
depreciation from the income statement
or the statement of comprehensive income
and it goes directly to the statement of
cash flows and we adding it to clean it
as a positive in the statement of cash
flows while in the statement of
comprehensive income of the income
statement it's a negative okay and you
will understand this if you go through
the lessons where we completed a
statement of cash flows and those are
the relationships between the income
statement and the statement of cash
flows now let's look at the last one the
relationship between the statement of
financial position or the balance sheet
with the statement of cash flows or the
cash flow statement what is the
relationship with industry well let's
look at the first one here you can see
that you have your current assets okay
and you can see here changes in working
capital like I again I go and say this
is the indirect method of completing the
cash flow statement you can see that
your current assets the items from your
current assets goes directly and you can
see the changes in working capital goes
from inventory which is found in the
balance sheet your receivables which is
also
the balance sheet and your papers which
is found in the balance sheet but it's
found here in the current liabilities
section okay so you can see the
relationship between the two
you will take items from their statement
of financial position or from your
balance sheet and take it directly to
your cash flow statement for you to
determine what are the changes in
working capital another relationship
that you see here is that the cash that
appears or the bank that appears a bank
balance that appears on the statement of
financial position or the balance sheet
comes directly from the final balance in
your statement of cash flows you can see
here we have cash generated in during
the year you have the balance that you
had at the beginning of the year if you
add the two together it should give you
the balance carried down or the balance
at the end and this balance goes all the
way to the statement of financial
position under the current assets
section it will either be called cash or
it will be called Bank okay and there is
the relationship between your statement
of cash flows and the statement of
financial position I hope this lesson
has made sense I hope you have gained
value from it I hope you are seeing the
connection between the financial
statements the income statement the
balance sheet and the statement of cash
flows as well as understanding what
these statements stand for and how they
look if you have gained value from this
lesson please subscribe to our channel
like this video and share to those who
think it might help till next time
Cheers
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