Understanding Financial Statements

Banish confusion and head scratching for ever

Understanding financial statements is straightforward when you use your imagination and a few familiar concepts to assist you in understanding the role of each of them.

The are three main types of financial statement, each with their own story to tell about any particular business.

These are:

• The Balance Sheet

• The Income Statement

• The Cash Flow Statement

Understanding the Balance Sheet

Let's take the balance sheet first. Think of the balance sheet as a still photograph of that great movie "life of a business" - more exciting than you might think :-D Instead of light and shade we have numbers. The difference between the numbers gives you the contrast. Instead of foreground and background we have balance sheet categories.

If you take one balance sheet photograph now, and another in a year from now, then you will have two photographs of the same business but a bit like a photo of a person the second one will look slightly older, or have a different style of clothes on. You can't tell until you look a bit closer.

Understanding financial statements is the story of what has happened in the intervening period between the two balance sheet photographs. You have two choices. You can view the income statement movie, full of subtle sub plots and asides, or you can watch the cash flow statement movie. A bit like an action thriller, shorter snappier and to the point.

If you would like to learn more, then have a look at creating a balance sheet

Understanding the Income Statement

The income statement differs from the cash flow statement due to something called the matching concept. This is an accounting idea that means that as items are used or consumed, then the cost of those items is recognised.

For example, let us say we make a sale today. In an income statement movie the sales value, and the associated costs of producing the product, and the costs of getting the products to the customer, would all be recognised in the income statement at the same time. They would all be matched into the same period, and this is the matching concept.

Understanding the Cash Flow Statement

The same transaction in a cash flow statement could look considerably different (though not necessarily, depending upon the nature of the business). When we pay for or receive cash, is when we recognise it in a cash flow statement.

Let's use the same example sale as the income statement example above, but consider it from a cash flow statement view.

If you bought the raw materials to make the product you just sold today, last month, but granted credit terms to the customer of 30 days, then your income statement and cash flow statement would reflect the situation as per the diagram above.

The income statement shows you in the period of despatch to your customer, the result of your labours by attaching the appropriate costs to the appropriate revenues in the same accounting period.

The cash flow statement shows you how your payments stagger across time and do not necessarily tie in with your sales activities.

The balance sheets show you a static picture of the financial situation at each point in time, between a determined period, and to assist you and understanding financial statements, the income statement and cash flow statement explain the financial stories of what happened between those two balance sheets.

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