4.2 Essentials of Financial Statements

The following is a brief introduction to financial statements. The examples used in this Chapter will illustrate some of the essential elements of each.

The Core Statements

There are various elements to a full set of financial statements. From a modelling perspective, the core statements are:

  • Income Statement. This contains “flow” items as recognised in the accounting period. It will in principle show sales, operating costs, operating profits, interest expenses, tax, and net income.
  • Cash Flow Statement. This contains the “flow” items as incurred in the period. It may be structured into operating, investing and financing sections, in order to highlight the different natures of the various cash flows.
  • Balance Sheet. This shows the store or “stock” items. It includes the effect of timing differences i.e. between the recognition of transactions for accounting purposes and their cash impact (for example, a sale to a customer may be considered as a sale, even if the cash payment has not yet been received from the customer).

(Other statements such as The Statement of Funds Flows, or The Statement of Retained Earnings are less relevant from a modelling perspective, at least at this point in the materials).

More on the Balance Sheet and the Accounting Equation

The Balance Sheet has two sides (Assets, and Liabilities). The total of the value of items on each side is the same (that is, the Balance Sheet “balances”). The two sides can be thought of as:

  • Assets describe “What the business owns” or “how capital is employed”. This is typically split into items such as cash, equipment, raw materials, finished goods, accounts receivable, and so on.
  • Liabilities describe “Who owns the business”, including equity owners, debt owners, and other external claims, such as tax liabilities, and so on. This typically include accounts payable, suppliers payable, taxes due, debt, initial equity (share) capital and cumulative retained profits (i.e. those which have not been distributed as dividends), and so on.
The “Accounting Equation” splits the value of the business in two ways: From an asset perspective, and from an ownership perspective.

The Accounting Equation states:
  • ASSETS = LIABILITIES

… which is sometimes written as:

  • ASSETS = LIABILITIES + EQUITY

(in which the Liabilities are the non-equity claims i.e. all claims on the business aside from those of the owners, who are generally required to be in a position resolve all claims before being able to make their own claim on the business).

These concepts are illustrated within the examples later in the Chapter.

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