The Relationship Between Three Financial Statements

Small business owner doing calculations using financial statements in a retail shop.

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A company's financial statements are developed from the bookkeeping process of the business firm. As the firm records its financial transactions over an accounting time period, the financial statements begin to emerge.

They are developed through recording the transactions in the accounting journal and the general ledger. The financial statements come together from those records and paint a picture of the financial health of a small business.

The Small Business Administration (SBA) suggests that understanding your financial statements is essential to success and functions as a roadmap to steer you in the right direction and help you avoid costly breakdowns.

The Accounting Equation

Financial statements are based on the accounting equation, which is stated as:

Assets = Liabilities + Owners' equity

For example, if a business owner begins his company with $100,000 of his own money, then spends $15,000 on office computers and furniture and other supplies, the equation would look like this:

$100,000 = $15,000 + $85,000

The purchase of supplies shifts the purchase price to the liability category while the unspent money remains part of the owner's equity. The total assets remain the same. As more purchases are made and revenue is generated, the numbers change, but the equation always balances.

The Income Statement 

The income statement (statement of profit and loss) shows how profitable the firm is and can be viewed as a report card. A positive net income means the firm is making money. A negative net income means the firm is losing money. The income statement is developed from the accounting entries for revenues and expenses over the accounting period.

The Statement of Retained Earnings

The statement of retained earnings is developed after the Income Statement because it uses data from the Income Statement. The net income from the income statement is either retained by the firm or paid out as dividends or a combination of both.

The Balance Sheet and the Accounting Equation

The business firm's balance sheet shows the firm's net worth, separated into assets and liabilities or equity. Balance sheet items are separated into two sides that have to balance since every asset has to be purchased with a liability, like a bank loan, or owners' equity, such as a portion of the retained earnings.

The balance sheet is an indicator of net worth while the income statement or statement of profit and loss is an indicator of profitability.

The Statement of Cash Flows

Does your business have the cash to stay afloat? This is where you look. The statement of cash flows uses data from both the income statement and balance sheet, making it the last financial statement to be developed. This statement tracks how cash is coming into the firm and how it is being spent in the areas of day-to-day operations, financing, and investments.

The statements we have discussed are essential elements of a business plan. Some software programs, such as Excel, offer templates. Of course, in building and interpreting these financial statements you should consult your accounting professionals.