The four financial statements¶
Marlow Landscaping just finished its first year mowing lawns and trimming hedges around Atlanta. The owner wants one question answered: did the business make money, and is it in decent shape? No single number answers that. You need four different reports, each built to answer a different question, and all four are built from the same handful of building blocks.
The building blocks: what a company owns, owes, and earns¶
Every transaction a company records eventually lands in one of these buckets.
| Element | What it means | Example at Marlow Landscaping |
|---|---|---|
| Asset | Something the company owns or controls that has future value | Cash, mowers, amounts customers owe |
| Liability | Something the company owes to someone outside the business | A supply bill not yet paid |
| Stockholders' equity (Common Stock) | What stockholders put in (usually cash) for ownership shares | What Dana Marlow invested to start the company |
| Stockholders' equity (Retained Earnings) | Profit the company has kept instead of paying out | Prior years' profit still sitting in the business |
| Revenue | Value earned by delivering goods or services | Cash and billings for completed lawn jobs |
| Expense | The cost of earning that revenue | Gas, advertising, insurance |
| Net income | Revenue minus expenses for the period; a net loss if expenses exceed revenue | This year's profit |
| Dividend | A payment of profit out to stockholders | Cash paid to Dana Marlow |
Notice that net income and dividend describe what happened during the year, not something the company owns or owes at a single moment. Net income is earned value; a dividend is earned value handed back out. When expenses exceed revenue, the same calculation produces a net loss instead, and it subtracts from retained earnings the same way a positive net income adds to it.
Common mistake: a dividend is not an expense
A dividend never lowers net income. It's a distribution of profit that already exists, paid out to stockholders. Rent, insurance, and salaries are expenses because the company has to spend that money to earn revenue in the first place. A dividend doesn't help earn anything, so it skips the income statement entirely and reduces retained earnings directly.
Four statements, four questions¶
A complete set of financial statements always has four parts, released together, because no single report tells the whole story.
| Statement | Question it answers |
|---|---|
| Income statement | How much did the company earn this period? |
| Statement of stockholders' equity | Why did stockholders' equity change this period? |
| Balance sheet | What does the company own, and who has a claim on it, right now? |
| Statement of cash flows | Where did cash come from, and where did it go? |
Here is how those four questions play out for Marlow Landscaping's first year in business.
Income statement: how much did we earn?¶
Quick math: net income
Marlow Landscaping earned $10,650 in Service Revenue and spent $6,550 total on expenses. $10,650 − $6,550 = $4,100. That $4,100 is net income, the number that flows into the next statement.
Every real statement carries a three-line heading: the company's name, the statement's name, and whether it covers a period or one date. Here's Marlow's income statement with that heading in place.
Marlow Landscaping
Income Statement
For the Year Ended December 31, 20X1
| Income statement item | Amount |
|---|---|
| Service Revenue | $10,650 |
| Advertising Expense | $1,050 |
| Insurance Expense | $2,500 |
| Salaries Expense | $800 |
| Rent Expense | $1,100 |
| Supplies Expense | $1,100 |
| Total Expenses | $6,550 |
| Net Income | $4,100 |
Statement of stockholders' equity: why did equity change?¶
Net income is only half the story. The company also paid $500 back to its stockholder as a dividend, so equity did not grow by the full $4,100.
Marlow Landscaping
Statement of Stockholders' Equity
For the Year Ended December 31, 20X1
| Line | Amount |
|---|---|
| Common Stock, beginning of year | $0 |
| Add: Stock issued during the year | $15,000 |
| Common Stock, end of year | $15,000 |
| Retained Earnings, beginning of year | $0 |
| Add: Net Income | $4,100 |
| Less: Dividends | ($500) |
| Retained Earnings, end of year | $3,600 |
| Total Stockholders' Equity | $18,600 |
Retained earnings started at zero because this is Marlow Landscaping's first year, and so did common stock: every dollar of it was issued this year. Notice the dividend shows up here, reducing retained earnings directly, and nowhere on the income statement above.
Balance sheet: what do we own, and who has a claim on it?¶
The balance sheet is a snapshot at one date, not a period like the other statements. It lists everything the company owns on one side and everyone with a claim on those resources, lenders and stockholders alike, on the other.
Marlow Landscaping
Balance Sheet
At December 31, 20X1
| Assets | Amount | Liabilities and equity | Amount |
|---|---|---|---|
| Cash | $6,750 | Accounts Payable | $900 |
| Accounts Receivable | $2,400 | Total Liabilities | $900 |
| Supplies | $850 | Common Stock | $15,000 |
| Equipment | $9,500 | Retained Earnings | $3,600 |
| Total Assets | $19,500 | Total Liabilities and Equity | $19,500 |
The two sides land on the same total. That is not a coincidence: everything the company owns was paid for either by borrowing it (a liability) or by stockholders putting in cash or leaving profit in the business (equity).
Common mistake: the balance sheet is not a price tag
Equipment sitting on the balance sheet at $9,500 does not mean Marlow Landscaping could sell it today for $9,500. That number is based on what the company paid for it, reduced over time as the equipment is used up (you'll see how in Chapter 3), not what it would sell for today. Marlow is in its first year, so no reduction has happened yet. A balance sheet reports resources and claims at the amounts recorded when they happened, not what the business or its assets are worth on the market right now. Two companies with identical mowers bought years apart can show very different amounts for equipment that would sell for similar prices today.
The statement of cash flows: three buckets¶
The fourth statement asks a different question: where did cash come from, and where did it go? You will not build one yet, that comes later in the course, but you should know its shape now. It splits the company's cash inflows and outflows into three sections, the same three you used to sort a business's activities in the last section.
| Section | What it captures | Examples |
|---|---|---|
| Operating activities | Cash from running the core business day to day | Cash collected from customers, cash paid for supplies and salaries |
| Investing activities | Cash spent on or received from long-term resources | Buying equipment, selling old equipment |
| Financing activities | Cash exchanged with stockholders and lenders | Issuing stock, borrowing or repaying a loan, paying dividends |
That last line is worth a second look. A dividend never shows up as an expense on the income statement, but it does show up here, as a cash outflow in the financing section. Paying stockholders is financing activity, not the cost of doing business.
Right now these four statements look like four separate reports sitting side by side. Next, you will see exactly how they lock together, with numbers flowing straight from one into the next.
Pause and work¶
Try rebuilding the three statements yourself, in the order you just saw them built: income statement, then equity, then balance sheet.
Here the income statement and equity numbers are already filled in. Finish the balance sheet using the same logic.
Now try a fresh company with new numbers, start to finish.