Hey viewers welcome to Accounting Stuff your guide to the basics
I'm James and in this quick video i'll share with you what i believe is the
key to understanding financial statements specifically the balance sheet
and the income statement so let's do this!
Financial statements are accounting reports that summarize a business's activities
over a period of time Essentially they give
the business's investors, lenders and creditors an idea of its financial health
But how do they work exactly? It all boils down to one basic principle
the stuff that a business owns is equal to the stuff that a business owes
Seriously that's all there is to it a business owns assets and it owes
liabilities to third parties but it also owes equity to the people who own the business
For a company that's listed on a stock exchange that would be the shareholders
so we have assets are equal to liabilities plus equity or shareholders equity which is what we
call the accounting equation Now you might be thinking...
how does this have anything to do with financial statements?
And the answer to that is this equals sign This equal sign tells us that a business's assets
always have to balance with its liabilities and equity
In fact when we pick a business and look at this accounting equation at a single point
in time then we're looking at a balance sheet This balance sheet is for a business called
Cache Me If You Can which makes microchips and computer stuff
and what we're looking at is a snapshot of Cache Me If You Can's
assets, liabilities and equity at a single point in time
Essentially it's a summary of what they own and what they owe on December 31st
Great! But at the start of this video I said that I'd show you the key to
understanding financial statements and we haven't quite got there yet
Here's the Balance Sheet but where's the Income Statement?
Let's go back to the accounting equation assets equal liabilities plus equity
or the stuff that a business owns is equal to the stuff that it owes to third parties and its owners
but let's focus on equity what kind of stuff does a business
owe to its owners? Two things
it shows them their capital contributions and the business's retained earnings
Capital contributions is the money that the owners take out of their own pockets
and invest in the business for example if Cache Me If You Can
issues some shares and you buy one then you've made a capital contribution
now you're a shareholder and you're a part owner of the business
Okay so what's the deal with retained earnings then?
These are the businesses accumulated profits that it's holding on to for the future
and this doesn't mean a huge pile of cash that just keeps on getting bigger and bigger
cash and profit are two very different things Profit is the financial benefit that a
business gains when its revenues are bigger than its expenses
and a business's accumulated profits held for future use is called its retained earnings
this is what's left over after we add up all of the profits that the business has generated and
take away what's been withdrawn by the owners and that looks a little something like this
Retained earnings are made up of opening retained earnings which is last year's retained earnings
carried forward into the start of this year plus current year profits which is the difference
between revenues and expenses minus current year withdrawals the profit distributions to
the owners or shareholders of the business which i'm pretty sure you've heard of...
we often call them dividends I like to think of this as the
expanded accounting equation and in my opinion it's the key to understanding financial statements
let me show you why if we jump back into
Cache Me If You Can's Balance Sheet we can see what the business owns
and what it owes on December 31st they own $1,551,000 in assets
and the same amount in liabilities and equity
because these two sides of the balance sheet are in balance
now if we zoom into the equity section we can see that Cache Me If You Can owes $1,342,000
to the owners of the business it's shareholders of which $100,000
is made up of capital contributions that the owners have put into the business
and $1,242,000 in retained earnings or profits held for future use
Now here's where things get interesting if we expand retained earnings we can see
what they're made of last year's retained
earnings which came to $1,215,500 less the current year dividends which were $10,000
this number is negative because these profits have been withdrawn by the shareholders
and we can also see that this year Cache Me If You Can generated $36,500 in profit
Where did they get this number from? Current year profit
comes straight from the income statement which looks like this...
The income statement summarizes a businesses revenues and expenses over a period of time
It's a financial statement just like the balance sheet
but this one tracks Cache Me If You Can's performance over a one year period
and tells us how profitable they are Pretty cool hey?
So if we go back to the accounting equation and expand it out
we can see that retained earnings is the key that links together two of the
most important financial statements the income statement and the balance sheet
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than welcome to hit the join button below I have a free cheat sheet which
covers the expanded accounting equation if you'd like to grab a copy then head over to
my website the link will be in this box here and in the description
and as always if you have any questions or requests let me know
in the comments or message me on instagram Thank you and I'll see you again very soon!