The KEY to Understanding Financial Statements

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 Thanks to all my channel members  for supporting Accounting Stuff your contributions are very much appreciated if you haven't signed up yet then you're more 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!