The balance sheet, income statement and cash flow statement together explain why a profitable company can run short of cash while expanding. Sales, inventory purchases and borrowing affect the three statements differently.
When you examine a financing candidate, separate resources available today from performance during the year. A balance sheet reports assets, liabilities and owners' interests at a date. The income statement reports revenue, expenses and profit over a period. The cash flow statement explains cash receipts and payments over that period. Financial-statement overview.
Balance sheet line items follow the accounting equation:
Assets = Liabilities + Stockholders' equity.
For balance sheet line items, assets are economic resources; liabilities are obligations; equity is the owners' residual book interest. Thus, $500 of assets less $300 of liabilities leaves $200 of equity. Book equity does not measure the market price of the shares. The accounting examples below use United States (U.S.) generally accepted accounting principles (GAAP).
To assess near-term resources, begin with current assets. These generally become cash, are sold or are consumed within one year or the normal operating cycle, whichever is longer.
Common mistakes
- Counting depreciation twice. If $600,000 COGS already includes $50,000 depreciation, subtracting it again understates operating income by $50,000.
- Treating borrowing as earnings. A $50,000 loan adds $50,000 financing cash flow and debt, with zero revenue.
- Misplacing an inventory numerator. Example 1's FIFO total asset turnover is 0.561 times; its 4.86 inventory turnover uses COGS and a different denominator.
Bottom line
- Balance sheets report amounts at a date; income and cash flow statements report activity over a period.
- Net income affects retained earnings, while the cash flow statement reconciles cash balances.
- Deferred tax assets and liabilities are noncurrent on classified U.S. GAAP balance sheets.
- Rising purchase costs generally give LIFO higher COGS and lower inventory than FIFO.
Exam shortcut
Before calculating, mark every input as a dated balance, period earnings item or cash movement. For indirect-method questions, write increases in operating assets with minus signs and increases in operating liabilities with plus signs. For FIFO or LIFO, assign costs to units sold before calculating ending inventory. Check that the two amounts exhaust available cost.
The full lesson (about 3,968 words, 26 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- A2
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