The Three Types of Financial Statements

Warren Buffett has called accounting “the language of business.” If you want to invest like he does, you must learn the nuances of accounting.

Investors need to understand how financial statements work.

Every investor needs to be able to read and analyze the three financial statements companies provide to their shareholders:

1. Income Statement
2. Balance Sheet
3. Cash Flow Statement

Not only do investors need to be able to read these statements, they also need to understand how they are all related. Indeed, each financial statement provides key inputs and outputs for the others.

What is the balance sheet?

The balance sheet tells what a company "owns" and what it "owes."

Like your net worth, balance sheets are only for a specific time; they're a snapshot of a company’s net worth.

What the company owns are considered assets (e.g., cash, property).

Assets are ordered, from top to bottom, in order of liquidity. In simple terms, that means how quickly something can turn into cash.

A company's liabilities are the amounts it owes. This includes what it owes vendors, banks, and bondholders.

Liabilities are similarly ordered from top to bottom regarding how soon the debt is due.

Lastly, a balance sheet shows shareholders’ equity. This is the net value of the owner’s claim, essentially a company’s net worth.

A balance sheet "balances" because the following formula is always true;

Assets = Liabilities + Shareholders Equity

What is the income statement?

The income statement details the results of a company's operations over a period of time.

The income statement has a specific beginning and end date, typically measuring a company's quarter or year.

The purpose of the income statement is to reveal whether a company is profitable. It provides three crucial figures for investors:

1. Revenue: Total sales
2. Expenditures: Total costs and expenses
3. Income: How much profit was generated

There are many similarities between an income statement and your household's budget. If I looked at your monthly budget, I would see how much money you make from your job or other sources. I would see all of your monthly expenses. What's left would be your savings.

With a company, the income statement follows a similar model.

A company's revenue, or sales, is all the money it makes by selling its products and services.

The company's expenditures, such as supplier costs and employee salaries, are then subtracted.

The result is a company's profit (if a surplus amount is left over) or loss (if its expenses exceed its sales).

Both the income statement and balance sheet use accrual accounting, which records revenue and expenses as transactions occur, not when the payment is received or made.

What is the cash flow statement?

Lastly, the cash flow statement rounds out our key financial statements.

Its purpose is solely to track cash movements. In this way, it is like your personal checking account, which only cares about when money comes in and goes out.

Like the income statement, the cash flow statement tells investors what happened over a period of time, such as a quarter or year.

The cash flow statement is typically divided into three key sections: operating activities, investing activities, and financing activities.

Operating activities are the cash entering and exiting the company’s coffers through normal business operations. It can be helpful to think of this as the money needed to run your household, such as your grocery or utility bills.

Investing activities are the cash companies use to invest in and maintain their business, including capital expenditure and acquisitions. Think of this as the money required to remodel your kitchen.

Finally, financing activities are how a company’s cash flow changes based on its actions with its bank. This includes borrowing money, paying off loans, and equity investments.

Unlike the income statement or balance sheet, the cash flow statement uses cash accounting, not accrual accounting. Cash accounting records sales when the money is received, and expenses are recorded as paid.

How the financial statements are connected

So, how are all the financial statements related?

First, the bottom line of the income statement, net income, becomes the top line of the cash flow statement.

Net income is also added to the retained earnings on the balance sheet.

Finally, the bottom line of the cash flow statement, cash end of period, becomes the top line of the balance sheet.

Key Takeaway

Understanding the three core financial statements—the income statement, balance sheet, and cash flow statement—is essential for any investor looking to navigate the complexities of the business world.

Each statement provides unique insights while also interconnecting to paint a comprehensive picture of a company’s financial health. By mastering these relationships, investors can make more informed decisions and develop a deeper understanding of a company's overall performance and stability.