The Three Fundamental Financial Statements: A Beginner’s Guide to Corporate Accounting (2024)

Accountants are often stereotyped as number-crunching math nerds who love taxes and spend Saturday nights playing calculator bingo. However, the world of corporate accounting is very important to learn as an aspiring investor because it will help you get an edge with your portfolio management. Investors need to analyze the quantitative information found in financial statements and relevant accounts to base their valuations and investment decisions with specific corporations. But what are these financial statements and what major information can you find on them?

The three standard financial statements — income statement, balance sheet, and cash flow statement — are the foundation of corporate accounting. Besides investors, corporate management, lenders, suppliers, and industry competitors use these statements to evaluate a company’s financial position. Specific information found in these statements can be used to calculate financial ratios, which provide quantitative insight into a company’s performance. While the income statement, balance sheet, and cash flow statement all offer distinct financial details, they are also interconnected, which gives a comprehensive overview of a company’s operating activities. In this article, we’ll dive into the structure and content of these statements, how to analyze them as an investor, and how they all fit together.

A firm’s balance sheet is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders. The balance sheet is divided into two main categories: (1) assets and (2) liabilities and shareholder’s equity.

A firm’s assets indicate how it has invested its funds and what it owns. Within the asset segment, accounts are placed from top-to-bottom in order of liquidity — how easily the asset account can be converted into cash. Consequently, assets are classified as either short-term or long-term assets. Short-term assets can be made liquid within a span of a year. Generally, the order of accounts within current assets is as follows

• Cash and cash equivalents: the most liquid assets and can include hard currency, liquid bank accounts, Treasury bills, short-term government bonds with maturities of less than 90 days. Cash equivalents refer to very short-term investments that are highly liquid, with a maximum investment duration of 3 months.
• Marketable securities: equity and debt securities that have liquid markets
• Accounts receivable: money owed to the business for previous sales
• Inventories

Long-term assets are not very liquid and take longer than one year to be converted into cash. They include the following:

• Fixed assets: land, buildings, machinery, equipment, and other capital-intensive assets.
• Intangible assets: non-physical assets like intellectual property

Liabilities represent the amount the amount owed to creditors or suppliers, and are classified as current (short-term) or long-term liabilities. Current liabilities are those that are due within one year and are listed in order of their due date. Long-term liabilities are due at any point after one year.

Current liabilities may consist of:

• Current balances of long-term debt
• Interest payable on long-term debt
• Rent, tax, utilities
• Accounts payable: amounts due to vendors or suppliers for goods or services received that have not yet been paid for
• Wages payable
• Dividends payable

Long-term liabilities include:

• Long-term debt
• Pension fund liability: the money a company is required to pay into its employees’ retirement accounts
• Deferred tax liability: taxes that have been accrued but will not be paid for another year

See Also

Analysis of Financial Statements

Also known as “net assets”, shareholder’s equity is the money that is attributable to a business’ owners. If all the assets of a company were liquidated and all of its liabilities were paid off, the resultant amount would be the shareholders’ equity.

Below, there is an example balance sheet for Amazon Inc. You may recognize the structure and the labels, but the most important aspect of reading a balance sheet is knowing the fundamental accounting equation:

Assets = Liabilities + Shareholders’ Equity

Since a firm has to pay for everything it owns (its assets), it will either take on debt (liabilities) or take funds from investors (issuing stock or shareholders’ equity). Shareholders equity is found by subtracting liabilities from assets, which is ultimately what the company is worth from a book value perspective.

Let’s say Amazon took a long-term loan of $4 million from a commercial bank in 2017. As a result of this loan, Amazon’s assets increased by $4 million, specifically in its cash account (“cash and cash equivalents”). Its long-term debt also increased by $4 million because the loan is ultimately a liability that will be paid over the long term (> 1 year).

Any amount that a company takes from its investors through stock is recorded in its assets and shareholder’s equity. Furthermore, all revenues the company generates in excess of its liabilities will go into the shareholders’ equity account, representing the net assets held by the owners. These revenues balance themselves out on the assets side, appearing as cash, investments, inventory, or another asset because profits are usually used for investments or set aside in the cash account.

Retained earnings is the amount of net income left over for the business after it has paid out dividends to its shareholders. When a business reports profits, a portion of its long-term shareholders may expect higher dividend payments as a reward for putting their money in the company. However, this surplus of money can be used in various different ways that are deemed fit by the company’s management. Net income could be used to pay off debt or investing in expansion projects like launching new products or increasing production capacity.

When dividends are distributed, the cash payment to investors reduces a corporation’s liquid assets and retained earnings because of the cash outflow. Smaller and growth-focused companies may not pay dividends at all, or pay very small amounts. They may opt to utilize their retained earnings to finance operational or expansion activities like research and development, marketing, working capital requirements, and acquisitions. A high RE is common for such companies, and can be one indicator of general growth. With blue-chip stocks — large and mature companies that offer higher dividends due to less capital growth — such companies may not have options for high-risk projects and may prefer to hand out dividends to further incentivise investors.

Because the balance sheet is just a snapshot of a company’s finances at a particular point in time, an analyst can only use the difference between one point in time and another single point in the past. Many financial ratios draw statistics from the balance sheet and the more long-term data found in both the income statement and cash flow statement. That’s why understanding all of these statements and how they connect is an invaluable skill.

Sometimes referred to as the profit and loss statement, the income statement deals with revenue and expenses over a certain period, to determine gains or losses. It provides great detail on the overall operating activities of a company. Essentially, the income statement reports the direct, indirect, and capital expenses that a company incurs. The basic equation for this statement is:

Net Income = (Total Revenue + Gains) — (Total Expenses + Losses)

Total revenue is the sum of both operating and non-operating revenues.

Operating revenues are revenues realized through primary activities. For a company manufacturing a product, or a distributor, wholesaler or retailer, the sale of the product is a primary revenue stream. For companies offering services, revenue from primary activities refers to the revenue or fees earned in exchange for providing those services.

Non-operating revenues are realized through non-core business activities, outside the sale of a good or service. This includes interest earned on business capital lying in the bank, rental income from business property, or income from an advertisem*nt display placed on business property.

Gains, another source of income, indicates the net amount earned from the sale of long-term assets like property, equipment, or even a subsidiary.

An expense is the cost for a business to operate and turn a profit. The two categories of expenses are primary and secondary activity expenses. In the Amazon income statement, these are referred to as operating and non-operating expenses.

Primary activity expenses are incurred through earning normal operating revenue and are linked to the primary operational activities. Some examples include:

• Cost of goods sold (COGS)
• Selling, general and administrative expenses (SG&A
• Depreciation or amortization
• Marketing costs

Secondary activity expenses are all expenses linked to non-core business activities, like interest paid on loan money or tax expenses. Refer to the “Interest expense” and “Provision for income tax” on Amazon’s income statement as examples.

Net income represents total revenue minus total expenses. On the balance sheet, the net income feeds into retained earnings. As mentioned previously, retained earnings the portion of earnings that are not distributed as dividends and are instead internally invested by the company. Therefore, the amount paid for dividends is equal to net income minus the change in retained earnings for any period of time.

Depreciation is another way that the balance sheet with the income statement are linked. Depreciation has two meanings: (1) the decrease of fair value in an asset like factory equipment, and (2) the allocation in accounting statements of the original cost of assets to periods in which the assets are used. Used as an income tax deduction, calculating depreciation gives businesses an annual allowance for the use and deterioration of their assets.

Imagine that Amazon bought a new warehouse for $10 million that was to last 25 years, with a salvage value of about $5 million after that. Rather than treating this $10 million as a current expense, Amazon would treat it as a depreciable asset. To calculate depreciation using the “Straight-Line Method”, the cost would be subtracted from the salvage value and divide $5 million into equal portions paid each year over the span of its useful life. Every year until 25 years in the future, Amazon would record this depreciation cost on its income statement.

In accounting, earnings means net profit. Investors and analysts often look at changes in the earnings per share (earnings / number of outstanding shares). You can think of EPS as a per-capita way of describing earnings. However, share prices may not always reflect changes in earnings. Sometimes a company with a rocketing stock price might not be reporting significant increases in net-income, but the rising price means that investors are hoping that the company will be very profitable in the future. Of course, the future is never certain and there is no guarantee that the company will fulfill its investor’s expectations.

Real-world companies that operate on a global scale usually have distinct business segments that have different revenue structures and expenses. Especially when a business is involved in mergers, acquisitions, and strategic partnerships, the requirements of reporting in a standard format in compliance with GAAP (Generally Accepted Accounting Practices) or IFRS (International Financial Reporting Standards) leads to multiple and complex accounting entries in the income statement.

Publicly listed companies follow the Multiple-Step Income Statement which segregates the operating revenues, operating expenses, and gains from the non-operating revenues, non-operating expenses, and losses, and offer many more details through the income statement. Amazon’s income statement follows this format exactly, and as an investor, you may see this structure used very commonly.

The statement of cash flows summarizes the amount of cash and cash equivalents entering and leaving the business over a given period. It measures how well a company can generate cash to pay debt obligations and funds it operations. The CFS is crucial because it tells investors a company’s liquidity (how much cash it has on hand) to fund its current liabilities and expenses.

One key distinction to make with the CFS is that “cash” is different from “earnings” or “net income”. While the income statement accounts for future incoming cash as credit sales with revenue, the CFS does not include the amount of future incoming and outgoing cash that has been recorded on credit.

The four main components of the CFS are:

1. Cash from operating activities
2. Cash from investing activities
3. Cash from financing activities
4. Disclosure of non-cash activities (not extremely relevant, but good to understand how it differs between companies and industries)

As mentioned before, cash from operating activities is how much cash is generated from the business’s core functions. These operating activities are:

• Receipts from sales of goods and services
• Interest payments
• Income tax payments
• Supplier purchases
• Salaries and wages
• Rent payments
• Any other expenses involved with operating

Cash flow from operations begins with net income (from the income statement), and then reconciles all non-cash items to cash items related to operational activities. This is the ‘cash-version’ of net-income on the CFS. Basically, if a firm doesn’t have sufficient positive cash flow for operational purposes, this suggests that they need to secure financing for external growth.

The second section of the CFS, investing activities measures investment gains and losses. This category includes cash spent on property, equipment, etc, and is where analysts look for changes in “capital expenditures” (CapEx).

When CapEx increases, there is an overall decrease in cash flow, which can indicate that the firm is investing in future growth. High capex is also correlated with smaller growth companies. With positive cash flows with investing activities can be good for long-term expansion, investors generally find higher cash flows from business activities as more desirable in the short-term. Companies can generate cash flow in this section through selling their assets and investments.

The last section of the CFS, cash flows from financing provides an overview of cash used in business financing. It measures cash flow from both debt and equity sources (creditors and owners). The information given here helps determine how a company raises cash for its operations. When cash flow from financing is positive, that means that more money is flowing in than out. Conversely, when it is negative, that means the firm is paying back its debt or making dividend payments/stock buybacks.

Changes in accounts receivable from one period to another must be reported on the CFS. If AR is reduced, this suggests that more cash has entered the company from customers because they have paid their obligations. The amount by which AR has decreased is added to net sales. If AR rises over the next period, the increase must be subtracted from the net sales. Despite AR being included in revenue, it isn’t cash, resulting in this change in net sales.

As stated earlier, depreciation is an expense on the income statement. The higher the recorded depreciation expense, the less a company’s net profit will be.

On the balance sheet, accumulated depreciation is shown on the asset side. If Amazon’s distribution center has completely depreciated, the net asset value would be zero — the cost of the asset minus the value of its accumulated depreciation. Instead of showing that Amazon does not own this asset anymore, the accumulated depreciation account entry let’s you see that Amazon actually does own a distribution center, but that this asset has been fully depreciated. This information is helpful since what Amazon actually owns and what assets are reaching the end of their useful life.

In accounting terms, depreciation is a non-cash expense because there is no outflow of cash every time a depreciation expense is recorded. Nonetheless, when preparing a tax return, Amazon would list depreciation as an expense to reduce its taxable income. Thus, depreciation indirectly affects the cash flow statement by decreasing the amount of cash used to pay taxes.

The change in net cash flow over one year should reflect the change in the cash account over the same period for the balance sheet.

Net earnings from the income statement is the first item on the cash flow statement, which is adjusted for all non-cash items to cash items involving operational activities.

In addition, many of the accounts on each statement are transferable to another statement.

Hopefully this article helped you grasps some basic accounting concepts and how to analyze the three fundamental financial statements to make better informed investing decisions. In future articles, you can learn about financial ratios and how they all come together in fundamental analysis, a key method of evaluating a company.

Be sure to review key takeaways and take a look at some next steps you can take to support us and further your learning!

1. The two components of the balance sheet are: (1) assets, and (2) liabilities and shareholders’ equity
2. The fundamental accounting equation is: Assets = Liabilities + Shareholders’ Equity
3. High retained earnings are common for small cap stocks that are growing much quicker than blue chip stocks, which focus more on dividend payments
4. The basic equation for the income statement is: Net Income = (Total Revenue + Gains) — (Total Expenses + Losses)
5. The two parts of the income statement are “Revenues and Gains” and “Expenses and Losses”
6. Operational activities are the core business activities — selling products and/or services
7. Non-operational activities are outside the sale of a good or service (ex. Income from property rental)
8. Net income feeds into retained earnings
9. Depreciation has two meanings: (1) the decrease of fair value in an asset like factory equipment, and (2) the allocation in accounting statements of the original cost of assets to periods in which the assets are used.
10. The Multiple-Step Income Statement is the general format you will see with public companies
11. The Cash Flow Statement summarizes the cash inflows and outflows over a given period
12. The four main components of the CFS are cash from operating activities, cash from investing activities, and cash from financing activities
13. CapEx has a negative correlation with net cash flows
14. If Accounts Receivable decreases, net sales rise, but if AR rises, net sales is reduced by the amount of change
15. The change in net cash flow directly affects “cash and cash equivalents” on the balance sheet
16. Net earnings is adjusted for non-cash items and is the top item on the CFS

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