From an accounting perspective, a business – regardless of whether it is sole proprietorship, private, or even public companies – is regarded as a separate entity.
Thus, there are three parties in a business:
- The company (which owns the business);
- The external creditors (external parties that the company owes money to); and
- The shareholders (the parties that injected capital into the company).
With this distinction, there exists the fundamental accounting equation, which is:
|Figure 1: Accounting Equation|
|(the assets the company owns)||(external parties that the company owes money to)||(the amount the company owes the shareholders)|
For people to remember easily, you can use the term “ALOE” (i.e Assets = Liabilities + Owners’ Equity).
A simple explanation to the above equation is that a company cannot exist out of thin air. And it is not able to have funds on its own. Whatever the company has (the assets), it has to be funded either via loans from third parties (liabilities) or from the owners of the company (shareholders’ equity).
Financial statements comprise of three main components, namely:
|1. Income Statement:||Measures the performance of the company, in terms of sales, expenses and profitability.|
|2. Balance Sheet:||This is the statement that captures the accounting equation: Assets, Liabilities & Shareholders’ equity, i.e., records what the company owns and what the company owes.|
|3. Cash Flow:||Shows the movement of cash (inflow and outflow) of the company.|
The relationship between these three financial statements is shown in Figure 2.
Figure 2: The Relationship between the Financial Statements
Whatever assets the company has is used to conduct its business and generate sales and profits. In the conduct of the daily operations of the business, there will be movements in cash. For example, in the Balance Sheet, transactions such as payment of debts and receipt of payment from debtors result in cash outflow and cash inflow respectively. In the income statement, transactions such as payment of salaries and cash sales received (cash inflow) give rise to cash outflow and cash inflow.
In the next three chapters, we will discuss about each of the financial statements.