Fundamentals of the Big Three Financial Statements

The Final Blog in a Series on Budgeting and Finance for the Non-Financial Manager

The Income Statement

Revenues, expenses, the matching principal and accrual-based accounting from Blog#1 come into play in the Income Statement. It measures whether the products or services that your company provides are profitable when everything is taken into account. A Pro Forma Income Statement indicates it’s either: 1) projected; or 2) it excludes any unusual or one-time write-offs.
Income Statement equations:

• Total your Sales and subtract the Cost of Goods Sold = Gross Profit
• Gross Profit minus Operating and Depreciation Expenses = Operating Profits
• Operating Profit minus Interest and Taxes = Net Profit

Operating Profit shows whether the core of the business is functioning at a profit or loss. It is possible for a company to have a high Gross Profit (25-50%), but have a relatively low Operating Profit due to marketing the product and/or managing the company. Think of Operating Profit as a measure of how efficient management is at generating revenues and controlling expenses.

The Balance Sheet

The Balance Sheet indicates on a given day what the company owns (assets), what the company owes (liabilities) and how much it is worth (equity). The Balance Sheet illustrates the fundamental accounting equation: Assets = Liabilities + Owners Equity. It indicates how efficiently a company is utilizing its assets and managing its liabilities, and is critical because it indicates a company’s net worth.
Balance Sheet equations:

• Total your Assets (Current and Fixed) and subtract Total Liabilities (Current and Long-Term) = Stockholders Equity
• Stockholders Equity minus Preferred Stock = Net Worth or Book Value of the company

If a company sustains a loss on the Income Statement, the equity on the Balance Sheet will decrease. Conversely, if the P&L shows an increase, the equity section on the Balance Sheet shows the accumulation. A company’s goal is to increase profits both on the Income Statement and Balance Sheet.

The Statement of Cash Flows

This financial tool demonstrates how cash came in and how it was used. There are a lot of in’s (adds) and out’s (subtracts) to the Statement of Cash Flows, so I thought it best to illustrate it via the following flow chart:

As we’ve discussed before, the Income Statement is about accounting profitability, not cash profitability. That’s where the Statement of Cash Flow comes in – it translates the actions taken in the income statement and balance sheet (i.e., company purchases, sales, etc.) into cash flow. In this economy, cash is king, and this is an important tool to understand where the company’s money is going.

Next Steps

This blog is the 30,000 foot view of the big three financial statements. There is a WEALTH of detailed information on the subject. One book I have found particularly useful is Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Mean by Karen Berman and Joe Knight, © 2006. It is an excellent reference, and won’t overwhelm you with accounting equations!

Stay tuned as next week we begin a three-part series on how to blog. If you’ve been thinking about starting your own company blog (or a personal blog for that matter), you won’t want to miss insights from Carrie Roberts, Project Manager at Val Grubb & Associates, Ltd. on how to set-up, market and create content for your blog.