What stories do financial statements tell?

- Every financial statement tells a story about the economic health of an organization. And I'll never forget how I felt the first time I was asked to prepare financial statements to create that story that would be used by others to communicate the financial health of our organization. I was so worried that I would forget something. So my goal is to make financial statements come alive for you so that you see them as a story you can use to better understand your organization and feel more comfortable reading and preparing financial statements. We're going to look at these financial statements in this course, the income statement, the balance sheet, the statement of stockholders' equity and the statement of cash flows. Let's start with the income statement. This is just one of the financial statements used to tell the whole story, but the story told by the income statement is very important, and it is always the same. How well did the organization do this quarter or year at producing income? You might hear the income statement called the PNL or the profit and loss statement. And the income statement is usually prepared for a period of time, usually a quarter or a year. It reports revenues and expenses for this period. So the income statement is like the annual photo album you create for your family, which shows all the family's activities that happened that year. Let's look at an example. Imagine with me that you own a merchandising company. You buy product from a vendor, and you sell it to a customer. Let's say that we purchased three shirts from the vendor for $10 each. Your goal is to sell them each for $13. And let's imagine that we do sell one shirt for $13. The income statement will show the sale for $13 and the cost of $10. In fact, the story shown on the income statement is that we just made $3 of gross profit. Assuming this was the only activity for the period, we'll then report the $3 of gross profit on the statement of stockholders' equity. This financial statement tells the story of our owners and how much stock they've purchased, and how much of our business's earnings will be retained and kept in the business. The board of directors will make the determination if any of those earnings should be distributed as a dividend. Let's assume that they do not declare a dividend, and the $3 will increase the earnings we retain. The statement of stockholders' equity will show, then, the $3 of retained earnings, which we will also report on the balance sheet. If the income statement is similar to a photo album of the year's major activities, then the balance sheet is similar to a selfie. The balance sheet tells a story at one moment in time, usually the last day of the fiscal year. Organizations must show for that one day its assets, liabilities and equity. Let's take a look. It is here that we will show that end-of-period cash. In this case, I'm showing that we paid $30 to the vendor for the three T-shirts and collected $13 for the one T-shirt that we sold. We would never have a negative cash balance, but for this illustration, a negative $17 is the net impact on cash for the period. And we still have two T-shirts in inventory which cost us $20. Combine that with the cash asset, and our total assets are $3. Think of assets as the resources an entity has or has a right to. In our story, the assets involved cash and inventory. So we just finished our asset section, and the next part is liabilities. Our story does not have any liabilities. It would if we had chosen to buy the inventory from the vendor with a promise to pay later, and we would show that on the balance sheet as an accounts payable. Our final section of the balance sheet is equity. And this shows stock ownership and retained earnings. And we do have a change in retained earnings for the $3 of gross profit. The statement of cash flows recognizes the importance of cash flow to an organization's success and presents those cash inflows and outflows from operations, investing and financing. In our example, the cash that exchanged hands was the $30 we paid the vendor for the three shirts and the $13 we received from the customer. And as we noted on the balance sheet, cash decreased by $17 this period. Because this example was so simple, we don't have any investing or financing activities to report. There's so much more to learn about each of these financial statements. And we're going to focus on these four financial statements in this course. Let's have some fun. But before we begin, we need to take care of some accounting basics that will help us better understand why these financial statements are a bit more complex to prepare than simply keeping a bank account.