Financial statements are four connected reports. The balance sheet shows what an organisation owns and owes on one day. The income statement shows what it earned and spent over the year. The statement of retained earnings or equity shows what was kept. The cash flow statement shows how cash actually moved. The notes explain how the figures were measured.
How they connect
The statements on these pages belong to one invented company and tie together exactly. That is the quickest way to understand them.
| Link | From | To |
|---|---|---|
| Net income $87,000 | Income statement | Increases retained earnings on the balance sheet (less $8,000 dividends) |
| Amortization $42,000 | Income statement (an expense) | Reduces equipment on the balance sheet; added back on the cash flow statement |
| Change in receivables ($41,000) | Balance sheet, year over year | Cash flow statement, operating activities |
| Cash $64,000 | End of the cash flow statement | First line of the balance sheet |
The order to read them in
- The accountant’s report. Compilation, review or audit? It tells you how much the figures were checked.
- The balance sheet. Can it pay what is due within a year? How much does it owe in total?
- The income statement. Is it profitable, and are margins holding?
- The cash flow statement. Does profit turn into cash, or into receivables and inventory?
- The notes. Debt terms, commitments, related parties, anything uncertain.
The balance sheet
Assets, liabilities and equity on one day, and the two ratios to calculate first.
Read the guideThe income statement
Revenue, margins and what “operating income” leaves out.
Read the guideThe cash flow statement
Why profit and cash are different numbers, and which one pays the bills.
Read the guideThe notes
Where the debt covenants, commitments and related parties are disclosed.
Read the guideQuestions people ask
What are the four financial statements?
The balance sheet (statement of financial position), the income statement (statement of operations or of comprehensive income), the statement of changes in equity or retained earnings, and the statement of cash flows, together with the notes that explain them.
Which financial statement is most important?
It depends on the question. For whether an organisation can pay its bills, start with the balance sheet and the cash flow statement. For whether it makes money, the income statement. For the risks, the notes. A careful reader uses all of them together.
How do the financial statements connect?
Net income on the income statement flows into retained earnings on the balance sheet. The cash flow statement explains why cash on the balance sheet changed from one year to the next. The notes give detail behind lines on all of them.