Question

Banks are concerned with debt to income and leverage. You have to fall within key areas to meet their requirements. Managers in your company must understand financial statements. The devil is in the details. A financial manager must also be concerned with the presentation of the financial statements as well. Why is it essential to understand the relationship between each of the financial statements (income, cash flow, balance sheet)?

Answer 1

It is necessary to understand the relation between each of the financial statements:

The Income Statement:

The income statement (statement of profit and loss) shows how profitable the firm is. A positive net income means the firm is making money. A negative net income means the firm is losing money. The income statement is developed from the accounting entries for revenues and expenses over the accounting period.

The Statement of Retained Earnings:

The statement of retained earnings is developed after the Income Statement because it uses data from the Income Statement. The net income from the income statement is either retained by the firm or paid out as dividends or a combination of both.

The Balance Sheet and the Accounting Equation:

The business firm's balance sheet shows the firm's net worth, separated into assets and liabilities or equity. Balance sheet items are separated into two sides that have to balance since every asset has to be purchased with a liability, like a bank loan, or owners' equity, such as a portion of the retained earnings.

The balance sheet is an indicator of net worth while the income statement or statement of profit and loss is an indicator of profitability.

The Statement of Cash Flows:

The statement of cash flows uses data from both the income statement and balance sheet, making it the last financial statement to be developed. This statement tracks how cash is coming into the firm and how it is being spent in the areas of day-to-day operations, financing, and investments.

Financial statements are written records that convey the business activities and the financial performance of a company. Financial statements are often audited by government agencies, accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes.

Thus to understand the three financial statements are essential because:

• Financial statements are written records that convey the business activities and the financial performance of a company.
• The balance sheet provides an overview of assets, liabilities, and stockholders' equity as a snapshot in time.
• The income statement primarily focuses on a company’s revenues and expenses during a particular period. Once expenses are subtracted from revenues, the statement produces a company's profit figure called net income.
• The cash flow statement (CFS) measures how well a company generates cash to pay its debt obligations, fund its operating expenses, and fund investments.