In finance, every organization needs to understand where money comes from, how it’s used, and what remains at the end of each period.
This is where financial statements, taxes, and cash flow analysis come in.
Together, they help answer three critical questions:
- What does the firm own and owe?
- How much did it earn?
- How much cash did it actually generate?
These questions are answered through:
- Balance Sheet (what the firm owns and owes)
- Income Statement (how much it earned)
- Cash Flow Statement (where the cash moved)
Understanding these fundamentals is the foundation of every business and finance course.
The Balance Sheet
The Balance Sheet is a snapshot of a company’s financial position at a specific point in time.
It lists assets, liabilities, and shareholders’ equity, following the core accounting equation:
Assets = Liabilities + Shareholders’ Equity
This means whatever a company owns (assets) has been financed either by borrowing (liabilities) or by owners’ investments (equity).
Assets
Assets are resources a firm owns — things that have value and can generate future benefits.
They are categorized as current assets and fixed assets.
Current Assets
These are assets expected to be converted into cash within one year, such as:
- Cash and cash equivalents
- Accounts receivable
- Inventory
A business with high current assets is considered liquid, meaning it can quickly meet short-term obligations.
Fixed Assets
These are long-term assets used to produce goods or services. Examples include:
- Buildings
- Machinery
- Land
Liabilities and Shareholders’ Equity
On the right side of the balance sheet are the sources of funds — what the company owes.
Liabilities
Liabilities represent obligations to pay others. These are divided into:
- Current Liabilities: Debts due within a year (like accounts payable, short-term loans).
- Long-term Liabilities: Debts that are payable over longer periods (like bonds and long-term loans).
Shareholders’ Equity
This represents the residual interest in the assets after deducting liabilities — essentially what belongs to the owners.
The equation balances because every asset is financed through either debt (liability) or owners’ capital (equity).
Net Working Capital (NWC)
Net Working Capital shows the short-term financial health of a company.
Net Working Capital = Current Assets – Current Liabilities
A positive NWC means the company can cover its short-term debts and still have resources to operate.
A negative NWC signals liquidity problems.
Healthy firms usually maintain a positive working capital, ensuring smooth operations and timely payments.
Important Balance Sheet Concepts
1. Liquidity – It refers to how quickly and easily an asset can be converted to cash without losing value.
Example: Cash is highly liquid, while real estate is illiquid.
Liquidity protects a company during financial stress.2. Debt vs Equity – Debt provides borrowed capital, while equity represents ownership.
Lenders have a legal claim on interest and repayment, while shareholders earn dividends after creditors are paid.
3. Financial Leverage – This refers to using debt to amplify potential returns.
High leverage increases both risk and reward.
Formula:Financial Leverage = Total Debt / Total Assets
- Book Value is what assets are recorded for in the company’s books.
- Market Value is what investors are willing to pay for them today.
- For financial managers, market value is more important, since it reflects current worth.
The Income Statement
The Income Statement summarizes a firm’s performance over a specific period, showing whether it made a profit or a loss.
Revenues – Expenses = Net Income
It records how much money a firm earned (revenue) and how much it spent (expenses).
Key Concepts for Understanding the Income Statement
1. GAAP (Generally Accepted Accounting Principles)
- Revenues are recognized when earned (revenue recognition principle).
- Expenses are recorded when incurred (matching principle).
- This means income statements may not always match actual cash flow timing — some cash inflows or outflows may appear in other periods.
2. Cash vs Noncash Items
- Noncash items like depreciation are accounting charges that reduce reported income but do not directly affect cash.
- It’s crucial to separate cash flows (actual money movement) from noncash flows (accounting adjustments).
- Costs are divided into product costs (raw materials, labor, overhead) and period costs (administrative and selling expenses).
- Product costs are tied to goods sold, while period costs depend on time.
Taxes
Taxes can be one of the largest expenses for a firm. Understanding how taxes work is essential for financial planning.
- The size of a company’s tax bill is determined by the tax code.
- After the Tax Cuts and Jobs Act (2017), the U.S. corporate tax rate became a flat 21%.
Types of Tax Rates
Average Tax Rate:Total Taxes Paid ÷ Total Taxable Income
This shows what percentage of income is paid in taxes overall.
Cash Flow
Cash flow refers to the difference between cash inflows (money received) and outflows (money spent) during a specific period.
It measures a company’s ability to generate enough cash to sustain operations, pay debts, and return value to shareholders.
Statements of cash flow show where money came from and how it was used — across three main categories:
- Operating Activities
- Investing Activities
- Financing Activities
Cash Flow Identity
The total cash flow from a firm’s assets equals the cash flow paid to suppliers of capital:
Cash Flow from Assets = Cash Flow to Creditors + Cash Flow to Stockholders
This is known as the cash flow identity, balancing the inflows and outflows between business activities and financing sources.
Components of Cash Flow
1. Operating Cash Flow (OCF):
Cash generated from normal business operations.
OCF = Revenues – Costs
Excludes depreciation and interest, but includes taxes.
- Positive OCF indicates healthy operations.
- Negative OCF signals financial trouble.
Money spent on fixed assets like machinery or buildings, minus proceeds from selling assets.
Capital Spending = Fixed Assets Purchased – Fixed Assets Sold
Measures how much money is tied up in short-term operations.
Change in NWC = Ending NWC – Beginning NWC
If current assets grow faster than liabilities, more cash is used.
Interest paid to lenders minus any new borrowing.
Sometimes called “cash flow to bondholders.”
Dividends paid minus new equity raised.
It represents the cash returned to owners after financing activities.
Why Cash Flow Matters
Even profitable firms can fail if they don’t manage cash properly.
For example, a company may show strong sales but face a shortage of cash due to late customer payments.
That’s why analysts focus on cash flow, not just accounting profit.
Healthy cash flow ensures a business can invest, pay debts, and reward investors.
Summary of Key Formulas
| Concept | Formula | Meaning |
|---|---|---|
| Balance Sheet Equation | Assets = Liabilities + Shareholders’ Equity | Basic accounting equation |
| Net Working Capital | Current Assets – Current Liabilities | Measures liquidity |
| Revenues – Expenses | Income | Profitability |
| Operating Cash Flow | Revenues – Costs (including taxes) | Cash from operations |
| Capital Spending | Fixed Assets Bought – Fixed Assets Sold | Investment in long-term assets |
| Cash Flow Identity | Cash Flow from Assets = Cash Flow to Creditors + Cash Flow to Stockholders | Flow balance equation |
Real-World Example
Imagine a small electronics company:
- It buys new equipment worth ₹10,00,000 (capital spending).
- It earns ₹30,00,000 in revenue and spends ₹25,00,000 in costs.
- It pays ₹1,00,000 in taxes.
Then:
- OCF = 30,00,000 – 25,00,000 – 1,00,000 = ₹4,00,000
- Cash Flow to Creditors = ₹50,000 (interest paid – new loans)
- Cash Flow to Stockholders = ₹1,00,000 (dividends paid)
- Cash Flow from Assets = ₹4,00,000 – ₹50,000 – ₹1,00,000 = ₹2,50,000
This demonstrates how cash flow reveals true business performance beyond just profits.
FAQs About Financial Statements, Taxes, and Cash Flow
1. What is the purpose of financial statements?
They help summarize a company’s financial performance, position, and cash flow for decision-making.
2. What is the difference between the balance sheet and income statement?
The balance sheet shows what a company owns and owes at a point in time; the income statement shows how much it earned over a period.
3. Why is net working capital important?
It measures a firm’s short-term liquidity and ability to pay current liabilities.
4. What is the formula for operating cash flow?
Operating Cash Flow = Revenues – Costs (including taxes).
5. How does capital spending affect cash flow?
Buying fixed assets reduces cash; selling them increases cash.
6. What are noncash items in an income statement?
Expenses like depreciation that don’t involve actual cash payments.
7. What is the difference between average and marginal tax rates?
Average rate = total tax paid ÷ total income; marginal rate = tax on the next dollar earned.
8. What is cash flow to stockholders?
The cash paid to shareholders through dividends, minus any new equity raised.
