What Financial Statement Is Prepared First?

Financial statements serve as a universal language for businesses, communicating their financial health and performance. These reports are crucial tools for decision-making, providing insights for owners, investors, and creditors alike. While several primary financial statements exist, they are not prepared in isolation. Instead, they are developed in a specific, interconnected sequence, with information from one statement often forming the basis for the next.

Understanding the Income Statement

The Income Statement, also known as the Profit and Loss (P&L) Statement, is typically the first financial document prepared by a business. Its primary purpose is to report a company’s financial performance over a defined period, such as a fiscal quarter or a full year. This statement summarizes all revenues earned and expenses incurred, along with any gains or losses, to arrive at a net income or net loss figure. This “bottom line” result is an indicator of profitability and represents the earnings available to the business owners or shareholders. The net income or loss directly impacts subsequent financial statements, making its accurate determination essential for future financial calculations.

Tracking Changes in Equity

Following the Income Statement, the Statement of Owner’s Equity, or for corporations, the Statement of Retained Earnings, is prepared. This statement tracks the changes in the total equity of the business over the same accounting period as the Income Statement. For sole proprietorships and partnerships, it details owner contributions, withdrawals, and the impact of net income or loss. Corporations, conversely, focus on retained earnings, which represent the accumulated profits not distributed as dividends.

The net income or loss calculated on the Income Statement directly flows into this statement, either increasing or decreasing the equity balance. For instance, a net income increases retained earnings or owner’s equity, while a net loss reduces it. Other factors, such as new capital contributions from owners or the payment of dividends to shareholders, are also accounted for here. This statement provides a clear link between a company’s profitability and its overall ownership stake.

Snapshot of Financial Position

The Balance Sheet is typically prepared after the Income Statement and the Statement of Owner’s Equity or Retained Earnings. Unlike the previous statements that cover a period, the Balance Sheet presents a company’s financial position at a specific point in time. It adheres to the fundamental accounting equation: Assets equal Liabilities plus Equity, providing a comprehensive view of what a company owns, what it owes, and the owner’s stake.

Assets include items like cash, accounts receivable, and property, while liabilities encompass obligations such as accounts payable and loans. The ending balance of owner’s equity or retained earnings, calculated in the preceding statement, is carried over directly to the equity section of the Balance Sheet. This direct transfer ensures that the accounting equation remains balanced and that all financial components are accurately represented.

Analyzing Cash Movements

Finally, the Statement of Cash Flows is generally the last of the primary financial statements to be prepared. This statement provides a detailed account of how a company generated and used cash during the accounting period, offering insights distinct from net income. It categorizes cash movements into three main activities: operating, investing, and financing.

Operating activities relate to the core business operations, investing activities involve the purchase or sale of long-term assets, and financing activities deal with debt, equity, and dividends. Information from both the Income Statement, such as net income, and the Balance Sheet, including changes in various asset and liability accounts, is essential for constructing the Statement of Cash Flows. This statement reconciles the beginning and ending cash balances reported on the Balance Sheet, explaining the changes in cash throughout the period. It helps stakeholders understand the liquidity of the business and its ability to generate cash.