What it means
The income statement, sometimes called the profit and loss account, covers a period and shows revenue less the costs of earning it, ending with profit or loss. It answers whether the business made money over the month, quarter or year.
The balance sheet, also called the statement of financial position, is a snapshot on one date showing assets, liabilities and equity. It answers what the business owns and owes at that moment rather than how it traded.
The cash flow statement covers the same period as the income statement but tracks money in and out, split into operating, investing and financing activities. It exists because profit and cash are different things and a business only pays wages with cash.
The three statements are linked, which is what makes them powerful. Profit from the income statement increases equity on the balance sheet, and the cash flow statement explains why the cash figure on the balance sheet changed from the start of the period to the end.
The notes are not decoration. They set out the accounting policies used, break down large balances, and disclose commitments and contingencies that never appear on the face of the statements but can matter enormously.
A common variant is the difference between statutory accounts and management accounts. Statutory accounts follow formal reporting standards and are filed publicly, while management accounts are internal, produced monthly and formatted for decisions rather than compliance.
In practice
Real-world examples.
Example
A commercial landlord asks a prospective tenant for two years of financial statements before granting a five year lease. The balance sheet showing net assets of $640,000 matters more to the decision than the modest reported profit.
Example
A brewery preparing for a bank loan produces monthly management accounts alongside its statutory accounts. The monthly statements show a seasonal cash dip each January that the annual figures alone would completely hide.
Example
A charity's trustees review annual statements and notice that restricted funds are being spent on general overheads. The notes, rather than the headline totals, reveal the problem and lead to a change in the accounting treatment.
Think of it
“Financial statements are like a complete health checkup for a business-different tests measuring different aspects of financial health.
Formula
Calculation
The relationship holding the statements together is the accounting equation:
Assets = Liabilities + Equity
Closing equity = opening equity + profit for the period - dividends
A furniture retailer reports revenue of $900,000 and total expenses of $780,000 for the year, so profit is $900,000 - $780,000 = $120,000.
Opening equity was $500,000 and no dividends were paid, so closing equity = $500,000 + $120,000 - $0 = $620,000.
The balance sheet shows total assets of $980,000 and total liabilities of $360,000, giving equity of $980,000 - $360,000 = $620,000, which matches.
The cash flow statement shows operating cash inflow of $145,000, investing outflow of $60,000 for new shop fittings and financing outflow of $25,000 for loan repayments.
Net change in cash = $145,000 - $60,000 - $25,000 = $60,000.
With opening cash of $70,000, closing cash = $70,000 + $60,000 = $130,000, which is the cash figure inside the $980,000 of total assets. The three statements agree, which is the check that they have been prepared correctly.Case study
Seen in the real world.
The following is an illustrative, fictional example. Calderwood Prints, an invented commercial printer, prepared full financial statements once a year, roughly seven months after the year end, purely to satisfy filing requirements. The owner ran the business day to day from the bank balance.
In the fictional year in question, the statements eventually showed a loss of $85,000 driven by a large increase in the depreciation charge on equipment bought two years earlier and by a write-down of obsolete paper stock. By the time the owner saw the numbers, the loss was already eleven months in the past and a second year of the same trend was well underway.
Calderwood moved to monthly management accounts covering all three statements, produced within ten working days of month end. The change did not alter a single underlying transaction, but it let the owner see the depreciation burden and the stock problem in month two rather than month nineteen, and the business returned to profit the following year.
Watch out
Common mistakes.
- Looking only at the profit figure and ignoring the balance sheet and cash flow statement, which is where funding problems and slow collections show up.
- Treating the notes as optional, when accounting policies, leases and contingent liabilities disclosed there can change the meaning of the headline numbers.
- Assuming annual statutory accounts are enough for running a business, when they arrive months late and are formatted for compliance rather than management decisions.
Questions
People also ask.
How many financial statements are there?
Three primary statements are used in practice, the income statement, balance sheet and cash flow statement, usually accompanied by a statement of changes in equity and the notes.
Do small businesses have to prepare all of them?
Filing requirements vary by jurisdiction and size, and many small companies file abbreviated accounts, but preparing all three internally is strongly advisable regardless.
Why can profit be positive while cash falls?
Because revenue is recorded when earned rather than when collected, and because buying equipment or repaying loans uses cash without appearing as an expense in the income statement.
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