The best way to learn about accounting is to understand (and enjoy) the accounting process. If we memorize accounting, it will not only be difficult to learn but also very boring.

## The 3 financial statements of accounting

There are 3 financial statements most commonly used to understand a business’s incoming and outgoing money.

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The first, the Income Statement, tells us how much money we make and how much money we spend. However, the Income Statement doesn’t always reflect the increase or decrease in cash. As a result, we need a separate financial statement to explain changes in cash flow.

The second financial statement is the Cash Flow Statement, which “corrects” the Income Statement by explaining the change in cash for a given period.

The third financial statement is the Balance Sheet, which explains what a company has in its possession and who owns those possessions, also known as assets.

Let’s discuss the three financial statements in more detail.

## The Income Statement

The top of the Income Statement is called revenue, which accounts for total sales. Sometimes you will hear business people say, “What is your top line?” The top line of the Income Statement is like our salary.

The bottom of the Income Statement is called net income, which is the same thing as net profit or earnings. “Bottom line” is a common phrase to account for how much money we make after we pay for expenses. These expenses can include rent, supplies, taxes, salary, and more.

Let’s discuss the Income Statement of our company, Donkey Kong Banana Company, which sells bananas. Pretend each banana is sold for \$1 and we sold 100 bananas last year. This means that our revenue is \$1 times 100 bananas, meaning \$100 for our top line. But, this doesn’t mean that we can keep \$100 because it cost us money to grow, pick, and sell the bananas.

What does it cost us to sell \$100 worth of bananas? Assume we have three employees. We paid one employee \$20 to pick the bananas. We also paid another \$20 to sell the bananas and another \$20 to advertise the bananas. That’s \$60 so far in expenses. Our revenue of \$100 minus our expenses of \$60 means we have \$40 remaining.

We have to pay taxes on the \$40 of pre-tax income. Assume our tax rate is 50%. This means that we are left with \$20 in net profits. The bottom line of our Donkey Kong Banana Company is \$20 in net profits.

We can use formulas to analyze our Income Statement. Before we do, whenever we use fractions, always think of the denominator as being the number 1. There is a formula called net profit margin. This means net profits/revenue. Thus, for every \$1 in revenue, how much net profit did we make?

We know that our net profit is \$20, and our revenue is \$100. Thus \$20/\$100 = 20%. This means for every \$1 in revenue, we make 20 cents in net profit. Thus, for every one banana sold (on the denominator), we made 20 cents of profit for selling that one banana. The net profit margin for our Donkey Kong Banana Company is 20%.

Separately, let’s assume we bought a ladder to pick the bananas for \$10 and the ladder should work for 10 years. This means that we can expense \$1 each year for the ladder. This is an amazing concept called depreciation.

Why is it amazing? Because every year we can put the depreciation expense on the Income Statement to pay less in taxes. So instead of us paying \$20 in taxes, we pay less. How so? Well since our pre-tax profit was \$40 and we paid 50% (meaning \$20) in taxes, we can deduct the \$1 in depreciation expense every year for 10 years.

This means that we calculate the tax amount that we need to pay based on \$39 times 50%. This \$19.50 is what we pay in taxes and our net income is \$20.50. We saved 50 cents because of depreciation.

## The Cash Flow Statement

That \$1 in depreciation is not really money coming out of our pocket every year though. Thus, we need another financial statement to correctly account for the amount of cash the company has on hand every year. The Cash Flow Statement helps us understand the real flow of cash in our bank accounts each year.

## The Balance Sheet

The third type of financial statement is the Balance Sheet, which documents the assets a company has in its possession. The Balance Sheet also tells us who owns what we have, which is referred to as liabilities and equity. Liabilities include items like debt to pay for your assets. Equity deals with who owns your assets.

For example, assume all that we have in our possession in the Donkey Kong Banana Company is the ladder that costs \$10. We paid \$4 in cash for the ladder and received a \$6 loan from the Bank of Mario. Think of the Balance Sheet like an old balance scale. On the left side of the scale are assets, which is the \$10 ladder we have in our possession. On the right side are liabilities, which is the \$6 loan from the Bank of Mario. Also, on the right side is your ownership in the ladder, meaning your equity of \$4. Liabilities + Equity = Assets.

The left side of the Balance Sheet must equal the right side. People refer to this as the double-entry accounting process, or debits and credits. Assets are the possessions or items that are owed to us, known as Accounts Receivable. Liabilities are the money we owe, known as Accounts Payable. Equity is ownership, also referred to as Owner’s Equity.
To summarize, the Income Statement tells us what we make, the Cash Flow Statement tells us what’s on hand from a cash perspective, and the Balance Sheet tells us what we have and who owns our stuff. Understanding general ledgers is easier if we understand the basics of accounting. With this introduction to the basics of accounting, you are empowered to make important financial decisions for your company.

Page Last Updated: September 2020

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