Financial Statements

Introduction to Financial Statements

The Four Major Financial Statements

Of the four primary financial statements—the balance sheet, the cash flow statement, the statement of shareholders’ equity, and the income statement—the income statement is one of the most frequently used, giving information about revenue and expenses.

The four primary financial statements are the balance sheet, the cash flow statement, the statement of shareholders’ equity, and the income statement. The balance sheet is a financial statement that provides a snapshot of the assets, liabilities, and equity of a business at a point in time. The cash flow statement is a financial statement that represents an organization's cash receipts and payments by operating, investing, and financing activity. The statement of shareholders' equity, also referred to as the statement of stockholders' equity or retained earnings statement, represents a summary of changes in a business's equity account over a period of time. The income statement summarizes a business's revenues and expenses over a period of time.

Generally, an income statement may be thought of as an evaluation of a company's commercial performance over a specified time frame. The income statement employs an accrual basis, an accounting method that measures economic events regardless of when cash transactions occur, to account for revenue and expenses. Revenue is net sales or total receipts to be received from a customer resulting from providing services or delivering goods. An expense is the cost of buying materials, paying employees, or any other type of purchase used to generate revenue; total expenses equates to the cost of doing business.

Revenue and expenses are split into two categories on an income statement: operating items and nonoperating items. An operating item is any revenue earned or expense incurred from normal business operations. An example of an operating item is the purchase of the raw materials used to manufacture a product that will be sold. Nonoperating items are revenues and/or expenses that cannot be directly attributed to normal operations. An example of a nonoperating item is the revenue collected from the salvage of old computer equipment.

The Income Statement

The income statement is primarily composed of line items relating to income or expense.

The top portion of the income statement contains a company's gross revenues, which is also sometimes simply referred to as revenue. This is the total income received from business operations. It is important to understand the distinction between gross revenues and net sales. Net sales are gross revenue, minus the cost of sales returns, allowances, and discounts. Gross revenue is the total amount of sales recognized for a reporting period, prior to any expenses. This figure indicates the ability of a business to sell goods and services, but not necessarily its ability to generate a profit. Net sales is the total revenue, or gross revenue, minus the costs associated with returned or undelivered goods and commissions. Gross revenue, on the other hand, is simply all positive revenues. Thus, net sales is all revenue minus costs while gross revenue is just the end positive revenue that is realized which creates a difference between the two concepts. Some companies may have generated revenue from a source other than sales such as interest, revenue, royalties, and rent revenue. When this occurs, it will be listed individually on the income statement.

The next line item on the income statement is the cost of goods sold (COGS). Cost of goods sold is the cost associated with the goods sold to customers and includes the expenses directly associated with the acquisition of raw materials and labor to manufacture a product. Sales minus cost of goods sold yields gross profit. Net sales is the total income from sales and other revenue sources minus the cost of goods sold. Selling, general, and administrative expense (SG&A) are expenses incurred that are related to generating revenue and are deducted from overall gross profit.

Next, the company subtracts depreciation expense. An asset is an economic resource of value that a business owns and that is expected to provide future benefits. Depreciation is the process of allocating the cost of a fixed asset to an expense account over the life of the asset. The reduction of depreciation and selling, general, administrative, or other operating expenses yields the operating income, or earnings before interest and taxes (EBIT). This is the income earned from normal business operations, before interest and taxes are subtracted. The remaining amount after all the expenses have been subtracted is net income, which represents receipts left after all expenses have been deducted. A business's objective is to determine whether its net profit will be reinvested into the company or dispersed to its shareholders by issuing a dividend—the distribution of a corporation's earnings in the form of cash, stock, or property. The remainder will be retained earnings.
A simple income statement shows the company's net income by subtracting the total expenses from gross revenue.