Basic Financial Accounting: The 3 Financial Statements

Introduction:

Income Statement: details the taxes, revenues, and expenses a company incurs in a period of time
Cash Flow Statement: determines how a company manages its cash position and tracks changes over a period of time, divided into CFO (cash flows from operations), CFI (cash flows from investing), and CFF (cash flows from financing)
Balance Sheet: shows a company's assets and how it acquired them using equity and liabilities at a specific point in time

Income Statement:

But this doesn't give us much information!
We need to expand this. Let's take a brief look at the below example income statement - all income statements will look something like this.

In simpler terms, Net Income = Revenue - COGS - Operating expenses - Taxes +/- other income/expenses.
Now let's break it line by line.
Watch this video to learn more about Net Income

Balance Sheet:

Asset: item that will result in additional cash in the future
Liability: item that will result in negative cash in the future. Related to external parties to fund a business, such as borrowed money
Equity: item that will result in less cash in the future - uses companies' internal operations rather than external parties

Let's take a look below at Nike's balance sheet as of FY 2020 end
As shown, a balance sheet will always show the assets, liabilities, and equities of a company. We need to know the major items that appear in each of the three sections.

Assets:

Liabilities:

Equity:

Shareholder's equity section represents what the company is worth after all liabilities have been paid off. At the beginning of a business, the shareholder's equity is equal to the amount invested into a company - known as shares capital. Investors get shares/stock in exchange for partial ownership of the business. Over time, the balance can go up/down depending on whether the company earns or records losses. If a company produces profit, that net income flows into shareholders' equity as retained earnings. Those earnings can remain on the balance sheet or pay out in dividends, which reduces retained earnings.
Think of retained earnings as the money kept in a piggy bank. The presence of retained earnings on the balance sheet tells us that the company has earned more money than it has given out in dividends or spent on other things. It's like a sign that the company has done well and has some money saved up for future needs, like investing in new projects or handling unexpected expenses.

Cash Flow Statement:

The CFS is divided into CFO (cash flows from operations), CFI (cash flows from investing), and CFF (cash flows from financing)
You may have non-cash revenue or expenses recorded on the IS. This needs to be adjusted on the CFS as we need to account for transactions that impact the company's financials but do not involve the actual inflow or outflow of cash. By adjusting for non-cash revenue or expenses on the cash flow statement, we ensure that we focus on the actual movement of cash in and out of the company
There may be additional cash inflows/outflows not accounted for on the IS as they are not related to a company's core business operations, e.g. Capital Expenditure or Dividends. These need to be factored into the CFS
Let's take a look below at Nike's CFS as of FY 2020 end

CFO

CFO measures the amount of cash generated by a company's normal business operations
Net income is computed on an accrual basis - we want to make adjustments to convert it to a cash basis. This is why we need to account for non-cash transactions like D&A.

Depreciation is added back to the CFO. While it was subtracted from Net Income from the IS, it doesn't involve an actual outflow of cash. It's a non-cash expense that reflects the cost allocation of using those assets over their useful life. Even though it reduces Net Income, it doesn't actually affect the actual cash flow of the business
The Changes in Net Working Capital bit can be a little confusing. Let's break it down:

Changes in balance sheet accounts appear as working capital changes in the CFS
Working capital = current operating assets - current operating liabilities, excluding cash, debt, and investments

The reason why we exclude cash, debt, and investments is because cash is already accounted for in the bottom of the CFS and the ending cash balance, if we did it in working capital, we'd be double-couting it. Investments and debt are non-operational activities

Change in working capital = old working capital - new working capital
If working capital increases, we have a cash OUTFLOW. If working capital decreases, we have a cash INFLOW
Remember: subtract increase in NWC in CFO

Think of it this way using the above diagram. An increase in assets is a use of cash, and an increase in liabilities is a source of cash - if we're being lent more from liabilities, we make money from liabilities. If the net working capital increases, it means we have more current assets than current liabilities - we have more money, or customers owe us more. If it decreases, it means we have less money or we owe more to others
Watch this video to learn more about working capital

CFI

Capex is different from regular operating expenses, such as wages, utilities, or inventory, which are incurred in the day-to-day operations of a business. Capex relates to investments in durable assets that have a longer-term impact on the company's operations and future profitability

CFF

Remember that dividend payments draw from a company's retained earnings on the balance sheet

Summary:

The income statement starts with revenue and ends with net income. It includes D&A, tax, and interest expense
The cash flow statement uses net income from the income statement as the top line. It is split into 3 sections: CFO, CFI, and CFF, and provides visibility into changes in working capital
On the balance sheet, the net income from the income statement flows to the cash balance into shareholder's equity. Changes in the balance sheet appear as working capital changes in the cash flow statement. Assets = Liabilities + Equity

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