The Financial Statements & their Relationship / Connection | Explained with Examples

Summary

This 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

00:00

📊 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.

05:00

🌐 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.

10:02

📈 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.

15:03

🔗 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.

Keywords

💡Financial Statements

Financial statements are formal records of a company's financial activities, including balance sheets, income statements, and cash flow statements. They provide a comprehensive overview of a company's financial health. In the video, the instructor focuses on explaining the relationship between different financial statements and their significance in assessing a company's performance and financial position.

💡Income Statement

The income statement, also known as the statement of comprehensive income, details a company's financial performance over a specific period. It shows revenues, expenses, and the resulting profit or loss. The video script emphasizes the income statement's role in reflecting the financial performance by highlighting income earned and expenses incurred, such as 'income earned and expenses incurred' being crucial for understanding the company's operations over a year.

💡Balance Sheet

The balance sheet, or statement of financial position, provides a snapshot of a company's financial standing at a specific point in time, showing assets, liabilities, and equity. The video explains that the balance sheet differs from the income statement as it captures the financial state at a moment, not over a period, and is connected to the income statement through elements like depreciation and retained earnings.

💡Statement of Cash Flows

The statement of cash flows illustrates the inflows and outflows of cash within a company over a specific period. Unlike the income statement, it focuses solely on cash transactions, ignoring non-cash items. The video script describes how the cash flow statement is prepared using the indirect method, starting with net profit and adjusting for non-cash items to determine the actual cash generated during the period.

💡Accrual Principle

The accrual principle is an accounting concept where revenues and expenses are recorded when they are earned or incurred, not when cash is received or paid. This principle is fundamental to preparing financial statements like the income statement and balance sheet. The video script mentions that profits computed under the accrual principle may not match the cash balance, reflecting the timing differences between earning income and receiving cash.

💡Equity

Equity, in the context of financial statements, refers to the ownership interest of shareholders in a company, representing the residual interest in assets after deducting liabilities. The video script explains how net profit from the income statement is transferred to the equity section of the balance sheet, affecting retained earnings and reflecting the company's change in net assets.

💡Depreciation

Depreciation is the allocation of the cost of a tangible asset over its useful life and is used in the income statement to spread out the expense of assets. The video script connects depreciation as a non-cash item that affects both the income statement and the balance sheet, where it accumulates in the accumulated depreciation account, reducing the carrying amount of non-current assets.

💡Retained Earnings

Retained earnings represent the cumulative earnings of a company that have not been distributed as dividends. They are a component of equity found on the balance sheet. The video script illustrates that retained earnings are impacted by net profit from the income statement, showing how profits are either distributed or retained to finance future operations.

💡Working Capital

Working capital is a measure of liquidity that is calculated as current assets minus current liabilities. It indicates a company's ability to meet its short-term obligations. The video script discusses how changes in working capital are derived from the balance sheet and are crucial for the cash flow statement, reflecting the operational efficiency of managing day-to-day financial requirements.

💡Indirect Method

The indirect method is a technique used to prepare the cash flow statement, starting with net income from the income statement and adjusting for non-cash items and changes in working capital to determine cash generated from operations. The video script provides an example of using the indirect method, highlighting the process of adjusting net profit for items like depreciation to align with actual cash movements.

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

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Cheers