UNDERSTANDING ACCOUNTING TALK 4: Financial Statements should be read together

The Balance Sheet, the Income Statement, and the Cash Flow Statement –what accountants and the business world call “Financial Statements”– are built from / around the basic accounting equation:

Assets = Liabilities + Equity or Assets – Liabilities = Equity.

It is best that they should be read together because each presents a different set of information about a business (corporate or small business) or personal finances. However, if only one of the three Financial Statements can be made available, the Balance Sheet should be it. The Balance Sheet can tell what a corporation, a small business, or a person is truly worth and whether or not there are present or impending financial problems. It is also possible to deduce from the Balance Sheet (although only in general terms) in what condition the accompanying Income Statement and Cash Flow Statement would be.

The Income Statement, on its own, can only tell you the difference between income and expenses during the time period covered by the Statement. Because it only covers a time period, it cannot say whether a business or a person is really financially healthy. It is not always true that, when income is greater than expenses, the business or the person is in a stable or healthy financial condition. This is also the case with the Cash Flow Statement (listing of cash coming in versus cash being paid out).

Of course, it is also not accurate to conclude that, when expenses are greater than income (an Income Statement reflecting a loss) or more cash is being paid out than coming in (a Cash Flow Statement showing a negative net inflow), the business or the person is in financial trouble. This is because these two Statements only give information about the defined period just ended.

An Income Statement and a Cash Flow Statement are presented with the caption “for the period ended x x x “, while a Balance Sheet has “as of x x x.” The Balance Sheet is a snapshot of the financial condition of a business or a person at a point in time. The Income Statement summarizes the activities and the results of these activities during the defined period. The Cash Flow Statement shows the flow of cash –as its descriptive title appropriately declares.