10.5: The Function of Financial Statements

The Three Basic Financial Statements

Since this book is at an introductory level, the focus will remain on the basic financial statements: the income statement, balance sheet, and cash flow statement, even though there are many other types of financial statements. Later in your business studies, when you complete accounting, finance, management and other courses, you will learn more about these concepts.

The three core financial statements include:

• Income Statement: Shows revenues, expenses, and whether the business made a profit over a specific period of time.
• Balance Sheet: Shows assets, liabilities, and equity or the amount invested in a business at a specific point in time.
• Statement of Cash Flows: Shows how much cash is coming in and going out of the business over a specific period of time.

Connor’s Confections

Meet Connor. He operates a business out of his home, “Connor’s Confections”. He loves what he does, and he feels that he’s doing pretty well. In fact, he has an opportunity to take over a nearby store at very reasonable rent, and he can expand by getting a modest bank loan and investing some more of his own money. So, it’s decision time for Connor. He knows that the survival rate for start-ups isn’t very good, and before taking the next step, he’d like to get a better idea of whether he’s actually doing well enough to justify the risk.

Figure 10.3 shows the information Connor will obtain by analyzing the three basic financial statements: the Income statement, balance sheet and statement of cash flows. Connor’s income was better than expected as it grew very fast this past year after he opened the option for customers to order online and have confections shipped to their homes. While the shipping costs could be high, depending on shipping location, Connor opted for customer-paid shipping, and he already had a business website, so he had few additional expenses from opening the online ordering option to customers.

Although Connor is nervous about expansion because he knows that as a sole proprietor, he will be liable for all expenses, he has decided he has enough equity in the business that he can afford the risk of expansion. Go Connor!

 

Toying with a Business Idea

To bring this concept closer to home, let’s assume that you need to earn money while you’re in college and that you’ve decided to start a small business. Your business will involve selling stuff to other college students, and to keep things simple, we’ll assume that you’re going to operate on a “cash” basis: you’ll pay for everything with cash, and everyone who buys something from you will pay in cash.

You may have at least a little cash on you right now—some currency, or paper money, and coins. In accounting, however, the term cash refers to more than just paper money and coins. It also refers to the money that you have in chequing and savings accounts and includes items that you can deposit in these accounts, such as money orders and different types of cheques.

Your first task is to decide exactly what you’re going to sell. You’ve noticed that with homework, exams, social commitments, and the hectic lifestyle of the average college student, you and most of the people you know always seem to be under a lot of stress. Sometimes you wish you could just lie back between meals and bounce a ball off the wall. And that’s when the idea hits you: Maybe you could make some money by selling a product called the “Stress-Buster Play Pack.” Here’s what you have in mind: you’ll buy small toys and other fun stuff—instant stress relievers—at a local dollar store and pack them in a rainbow-colored plastic treasure chest labelled “Stress-Buster.”

And here’s where you stand: You have enough cash to buy a month’s worth of plastic treasure chests and toys. After that, you’ll use the cash generated from sales of Stress-Buster Play Packs to replenish your supply. Each plastic chest will cost $2.00, and you’ll fill each one with a variety of five simple toys, all of which you can buy for $1.00 each.

You plan to sell each Stress-Buster Play Pack for $10 from a rented table stationed outside a major dining hall. Renting the table will cost you $20 a month. In order to make sure you can complete your schoolwork, you decide to hire fellow students to staff the table at peak traffic periods. They’ll be on duty from noon until 2:00 p.m. each weekday except Fridays, and you’ll pay them a generous $17.50 an hour. Wages, therefore, will cost you $560 a month (2 hours × 4 days × 4 weeks = 32 hours × $17.50). Finally, you’ll publish ads in the college newspaper at a monthly cost of $40. Thus, your total monthly costs will amount to $620 ($20 + $560 + $40).

The Income Statement

Let’s say that during your first month, you sell 220 play packs. Not bad, you say to yourself, but did I make a profit? To find out, you prepare an income statement showing revenues, or sales, and expenses—the costs of doing business. You divide your expenses into two categories:

• Cost of goods sold: The total cost of the goods that you’ve sold
• Operating expenses: The costs of operating your business, except for the costs of things that you’ve sold.

Now you need to do some subtracting:

The difference between sales revenue and the cost of goods sold is your gross profit, also known as gross margin. The difference between gross profit and operating expenses is your net income or profit, which is the proverbial “bottom line.”

Your income statement for the first month is shown in Figure 10.4. (Remember that we’ve made things simpler by handling everything in cash.)

Did you make any money? Not in your first month. Many businesses operate at a net loss when they first open.  It takes time to build a customer following and begin to earn profits. Human resources is one of the highest expenses for many companies. If you could run your business without the need to hire others, how much profit would you have made?

What does your income statement tell you? It has provided you with four pieces of valuable information:

• You sold 220 units at $10 each, bringing in revenues or sales of $2,200.
• Each unit that you sold cost you $7, at $2 for the treasure chest plus five toys costing $1 each. So, your cost of goods sold is $1540 (220 units × $7 per unit).
• Your gross profit—the amount left after subtracting the cost of goods sold from sales—is $660 (220 units × $3 each).
• After subtracting operating expenses of $620 – the costs of doing business other than the cost of products sold—you generated a net income of $40.

The Balance Sheet

The balance sheet shows the cumulative effect of the income statement over time.

Companies prepare financial statements on at least a twelve-month basis—that is, for a fiscal year which ends on December 31 or some other logical date, such as June 30 or September 30. Fiscal years can vary because companies generally pick a fiscal-year end date that coincides with the end of a peak selling period; thus, a crabmeat processor might end its fiscal year in October, when the crab supply has dwindled. Most companies also produce financial statements on a quarterly or monthly basis.

A balance sheet reports the following information:

• Assets: The business resources from which it expects to gain some future benefit (what the company owns)
• Liabilities: The business debts that it owes to outside individuals or organizations (what the company owes to others)
• Owner’s equity: The investment the owner(s) made  in the business (the difference between assets and liabilities)

Your income statement tells you how much income you earned over some period of time, but your balance sheet tells you what you have at a specific point in time.

Debits, Credits and Double-Entry Accounting

It’s important to mention that debits and credits are used in a company’s bookkeeping in order for its books to balance. Debits increase asset or expense accounts and decrease liability, revenue or equity accounts. Credits do the reverse of debits, they decrease asset or expense accounts and increase liability, revenue or equity accounts. The individual entries on a balance sheet are referred to as debits and credits. Debits (often represented as DR) record incoming money, while credits (CR) record outgoing money. How these show up on your balance sheet depends on the type of account they correspond to. In double-entry accounting, every transaction is recorded with a debit and credit in two or more accounts, which categorize different types of financial activities in a company’s general ledger. You will put these concepts into practice when you complete your first accounting course.

For Stress-Buster, you’ll want to prepare them monthly to stay on top of how your new business is doing. Let’s prepare a balance sheet at the start and end of your first month in business.

The Accounting Equation

To prepare a balance sheet, one must first understand the fundamental accounting equation:

Assets = Liabilities + Owner’s Equity

This simple but important equation highlights the fact that a company’s assets come from somewhere—either from investments made by the owners (owners’ equity) or from loans (liabilities). This means that the asset section of the balance sheet, on the one hand, and the liability and owner’s equity section, on the other, must be equal, or balanced. Thus, the term balance sheet. The Accounting Coach has a comprehensive online tutorial that you may wish to review.

Let’s prepare the two balance sheets we mentioned—one for the first day you started and one for the end of your first month of business. We’ll assume that when you started Stress-Buster, you borrowed $400 from your parents and put in $200 of your own money. If you refer to Figure 10.5, your business’s first balance sheet, you’ll find that your business has $600 in cash (your assets). Of this total, you borrowed $400 (your liabilities) and invested $200 of your own money (your owner’s equity). So far, so good, your assets section balances with your liabilities and owner’s equity section.

Now let’s see how things have changed on the balance sheet by the end of the month. Recall that the income statement showed a net income of $40 during the month of April (the first month in operation). The $40 gain increases two items on your balance sheet—the assets of the company (its cash) and your investment in it (its owner’s equity). Figure 10.6 shows what your balance sheet will look like on April 30. You now have $640 in cash—$400 that you borrowed, plus a positive amount you invested of $240 (your original $200 investment plus the gain of $40 from the first month of operations).

The Statement of Cash Flows

The statement of cash flows provides valuable information about a company’s expenses and receipts and allows insights into its future income needs in order to be able to meet its future obligations (expenses and receipts). The statement of cash flows reports cash inflows and outflows, and it will identify the amount of cash the company currently holds, which is also reported in the balance sheet.

Typically, the statement of cash flows is reported on a month-to-month basis. However, a statement of cash flow will consolidate the month-to-month cash flow to meet the requirements of the International Financial Reporting Standards.

A statement of cash flow reports cash in three distinct areas of business:

• Cash from Operations
• Cash from Investing
• Cash from Financing

Refer to Figure 10.7 to review the statement of cash flows for Stress-Buster company for the one-month period ending April 30, 2025. Stress-Buster would have incurred a Net Income of $40 from Operations during the first month of operation, after deducting the month’s expenses from the month’s revenues. The business also incurred cash from financing the initial $400 loan taken out to start the business and the additional $200 of personal income. As Stress-Buster did not invest in new equipment, machinery or other assets for the business or use prior cash flows and/or retained earnings to earn further investment income, Stress-Buster would not report any cash from investing activities.

Media Attributions

“Figure 10.3: Income Statement, Balance Sheet, and Statement of Cash Flows” is adapted from Chapter 10: Financial Management and Accounting in Business Fundamentals, 1st Edition, © Kerri Sheilds, licensed under CC BY-NC-SA.

“Figure 10.4: Income Statement End of First Month” is adapted from Chapter 10: Financial Management and Accounting in Business Fundamentals, 1st Edition, © Kerri Sheilds, licensed under CC BY-NC-SA.

“Figure 10.5: Balance Sheet First Day of Operations” is adapted from Chapter 10: Financial Management and Accounting in Business Fundamentals, 1st Edition, © Kerri Sheilds, licensed under CC BY-NC-SA.

“Figure 10.6: Balance Sheet End of First Month of Operations” is adapted from Chapter 10: Financial Management and Accounting in Business Fundamentals, 1st Edition, © Kerri Sheilds, licensed under CC BY-NC-SA.

“Figure 10.7: Statement of Cash Flow After First Month” is adapted from Chapter 10: Financial Management and Accounting in Business Fundamentals, 1st Edition, © Kerri Sheilds, licensed under CC BY-NC-SA.

Image descriptions

Figure 10.3

The image features a small illustration of a storefront labelled “Connor’s Confections.” The storefront has a light blue awning and an “OPEN” sign hanging in its window. Above it, there are three boxes, each containing a title and bulleted text:

Left box: Income Statement As of: December 31, 2024

• Sales
• Expenses
• Profit

Centre box: Balance Sheet As of: December 31, 2024

• Assets
• Liabilities
• Owner’s Equity

Right box: Statement of Cash Flows As of: December 31, 2024

• Additions to Cash this year
• Subtractions from Cash this year

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