Financial Statements
The Big 4 and how they connect
Why This Matters
Everything you've learned—debits, credits, adjusting entries, closing entries—has been building to this moment.
Financial statements are the output of the accounting system. They transform thousands of transactions into four concise reports that tell the complete financial story of a business.
An investor wants to know: “Is this company worth buying?”
A bank wants to know: “Can they repay the loan?”
A manager wants to know: “How did we perform this quarter?”
The IRS wants to know: “How much tax do they owe?”
All four questions are answered by financial statements.
They are the purpose of accounting. Everything else is scaffolding to build them.
What Are Financial Statements?
Financial statements are standardized reports that communicate a company's financial position and performance.
There are four primary financial statements. Together, they tell the complete story. Individually, they each answer different questions.
The Big 4: Deep Dive
Income Statement
“How much did we earn/lose during the period?”
What It Shows:
- Revenue (what came in)
- Expenses (what went out)
- Net income (the bottom line profit or loss)
Time Period:
For a specific period (month, quarter, year)
Key Insight: Measures performance (how profitable you were)
Balance Sheet
“What do we own and owe at this moment?”
What It Shows:
- Assets (what we own)
- Liabilities (what we owe)
- Equity (what the owner is worth)
Time Period:
At a specific point in time (last day of the period)
Key Insight: Measures position (what we're worth at a moment)
Statement of Cash Flows
“Where did our cash come from and where did it go?”
What It Shows:
- Operating cash flows (cash from operations)
- Investing cash flows (cash for/from investments)
- Financing cash flows (cash from/to lenders and owners)
Time Period:
For a specific period (month, quarter, year)
Key Insight: Measures liquidity (cash availability, not profit)
Statement of Retained Earnings
“How did the owner's equity change during the period?”
What It Shows:
- Beginning equity
- Plus: Net income from the period
- Minus: Dividends paid
Time Period:
For a specific period (month, quarter, year)
Key Insight: Tracks equity changes (profit retained vs. distributed)
The Connection: How They Fit Together
The four statements are interconnected. Information flows from one to another:
Income Statement
The Year's Performance
Revenue - Expenses = Net Income
Statement of Retained Earnings
Equity Changes
Beginning Equity + Net Income - Dividends = Ending Equity
Balance Sheet
Position at Period-End
Assets = Liabilities + Equity
Statement of Cash Flows
How Cash Moved
Regardless of profit reported
Real-World Example: ABC Coffee Shop
Let's trace ABC Coffee Shop through all four statements for the year 2026:
Income Statement (The Performance)
ABC COFFEE SHOP
Income Statement
For the Year Ended December 31, 2026
Revenue
Expenses
Key finding: The business earned $29,000 profit.
Statement of Retained Earnings (Equity Changes)
ABC COFFEE SHOP
Statement of Retained Earnings
For the Year Ended December 31, 2026
Key finding: Equity increased from $50,000 to $69,000 (profit earned + retained).
Balance Sheet (Position at Year-End)
ABC COFFEE SHOP
Balance Sheet
As of December 31, 2026
ASSETS
Current Assets
Fixed Assets
LIABILITIES
Current Liabilities
Long-Term Liabilities
EQUITY
Key insight: Assets ($87,000) = Liabilities ($18,000) + Equity ($69,000)
Statement of Cash Flows (Cash Movement)
ABC COFFEE SHOP
Statement of Cash Flows
For the Year Ended December 31, 2026
OPERATING ACTIVITIES
INVESTING ACTIVITIES
FINANCING ACTIVITIES
Key insight: Despite $29,000 profit, cash changed by only -$4,000 (money went to equipment and debt repayment).
Critical Insight: Profit ≠ Cash
This is the biggest lesson from seeing all four statements together:
ABC made $29,000 profit but only -$4,000 change in cash
Income Statement (Accrual):
Revenue: $170,000 (earned, not necessarily received)
Expenses: $141,000 (incurred, not necessarily paid)
Profit: $29,000
Cash Flows (Cash Basis):
Cash In: $165,000 (cash received)
Cash Out: $169,000 (cash paid)
Net Cash: -$4,000
This is why companies can be profitable but still go out of business—they run out of cash.
Which Statement Answers Which Question?
| Question | Statement | Why |
|---|---|---|
| Are we profitable? | Income Statement | Shows revenue - expenses |
| What's our cash position? | Balance Sheet | Shows cash on hand |
| Do we have cash to pay bills? | Cash Flows | Shows cash coming in/going out |
| What's our net worth? | Balance Sheet | Shows total equity |
| Did profits increase? | Income Statement | Compare to prior period |
| Did cash increase? | Cash Flows | Shows cash movement |
| Did the owner invest more? | Retained Earnings | Shows capital changes |
| Can we pay long-term debt? | Cash Flows | Shows financing capacity |
The Standard Sequence
Financial statements are always presented in this order:
1
Income Statement
Start with performance
2
Retained Earnings
Show equity changes
3
Balance Sheet
Show position
4
Cash Flows
Explain cash
This sequence makes logical sense: You earned a profit, which increased equity, which appears on the balance sheet, and you can see how cash actually flowed.
Real Users & Their Questions
Each user has different needs. Financial statements must serve them all:
The Investor
“Is this company worth investing in?”
Focuses on: Income Statement (profit growth), Balance Sheet (solvency)
The Banker
“Can they repay the loan?”
Focuses on: Cash Flows (debt service), Balance Sheet (collateral)
The Manager
“How's this business performing?”
Focuses on: Income Statement (revenue/expense), Cash Flows (cash health)
The IRS
“How much tax do they owe?”
Focuses on: Income Statement (taxable income)
Key Takeaway
Financial statements are the output of the accounting system. The four primary statements (Income Statement, Balance Sheet, Statement of Retained Earnings, and Statement of Cash Flows) are interconnected and together tell the complete financial story. Income Statement shows profit, Retained Earnings shows equity changes, Balance Sheet shows position, and Cash Flows shows liquidity. Understanding how they connect is essential to interpreting financial health.
Test Your Understanding
1. Which statement shows profit or loss for a specific period?
2. Which statement shows what a company owns and owes at a specific moment?
3. A company has $100,000 in net income but only $20,000 increase in cash. How is this possible?
4. Where does the Net Income from the Income Statement appear in other statements?
5. True or False: The Statement of Retained Earnings is the least important because it's short.
Ready to Practice?
Prepare real financial statements
You now understand why the four statements exist and how they connect. The Practice Lab is where you'll prepare them yourself. Take adjusted trial balances and produce all four statements, seeing how information flows from one to another.
Try the Practice Lab