The Financial Statements Are a System (Balance Sheet & Statement of Cash Flow)
Financial statements paint a picture of the transactions that flow through a business. Each transaction or exchange–for example, the sale of a product or the use of a rented facility–is a building block that contributes to the whole picture.
Let’s approach the financial statements by following a flow of cash-based transactions. In the illustration below, we have numbered four major steps:
1. Shareholders and lenders supply capital (cash) to the company.
2. The capital suppliers have claims on the company. The balance sheet is an updated record of the capital invested in the business. On the right-hand side of the balance sheet, lenders hold liabilities and shareholders hold equity. The equity claim is “residual”, which means shareholders own whatever assets remain after deducting liabilities.
The capital is used to buy assets, which are itemized on the left-hand side of the balance sheet. The assets are current, such as inventory, or long-term, such as a manufacturing plant.
3. The assets are deployed to create cash flow in the current year (cash inflows are shown in green, outflows shown in red). Selling equity and issuing debt start the process by raising cash. The company then “puts the cash to use” by purchasing assets in order to create (build or buy) inventory. The inventory helps the company make sales (generate revenue), and most of the revenue is used to pay operating costs, which include salaries.
4. After paying costs (and taxes), the company can do three things with its cash profits. One, it can (or probably must) pay interest on its debt. Two, it can pay dividends to shareholders at its discretion. And three, it can retain or re-invest the remaining profits. The retained profits increase the shareholders’ equity account (retained earnings). In theory, these reinvested funds are held for the shareholders’ benefit and reflected in a higher share price.
This basic flow of cash through the business introduces two financial statements: the balance sheet and the statement of cash flows. It is often said the balance sheet is a static financial snapshot taken at the end of the year (please see “Reading the Balance Sheet” for more details), whereas the statement of cash flows captures the “dynamic flows” of cash over the period (see “What is a Cash Flow Statement?”).
Taken From : Advanced Financial Statements Analysis