Lesson 9 of 9
The same numbers, rearranged
One closed ledger becomes an income statement, a balance sheet and a cash flow statement. Nothing is added. Profit was $61,600 and cash rose $88,200.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The three statements are three arrangements of one ledger. Nothing new is measured when they are drawn up.
- Profit was $61,600 and cash rose $88,200 in the same year, and both figures are correct.
- Operating cash flow of $36,200 differs from profit by $25,400, and every dollar of that gap is a balance sheet movement you can point at.
The ledger is complete, the adjustments are made and the temporary accounts are closed. Every figure that will appear in the statements is already sitting in an account.
What follows is presentation. The income statement takes the accounts that were closed, the balance sheet takes the ones that were not, and the cash flow statement explains the movement in one of them.
Three statements, one ledger
- Profit for the year$61,600
- Cash generated by operations$36,200
- Increase in cash over the year$88,200
The income statement
The balance sheet
The cash flow statement
Reading the gap
Profit was $61,600 and operations produced $36,200 of cash. The difference is $25,400 and it is not a mystery. Every line between the two in the statement above is a balance sheet account that moved.
Depreciation added $6,000 back because it was a cost that took no money. Receivables, materials and prepaid rent consumed $47,000 together, because the business spent or committed money it has not yet charged against profit. Payables, the customer deposit and the unpaid interest gave back $15,600, because those costs were charged against profit without being paid.
Add them: $6,000 less $47,000 plus $15,600 is a reduction of $25,400, which is exactly the difference between the two figures.
What this course built
A reader who has followed the nine lessons can now say where any figure in a set of accounts came from. Revenue is a credit balance in a closed account. Retained earnings is the accumulation of those closings. Operating cash flow is profit adjusted for the balance sheet accounts that moved.
One ratio, to show the next courses have something to work with. Profit of $61,600 against closing equity of $121,600 is a return on equity of 50.7 percent. Against the average of opening and closing equity, $90,800, it is 67.8 percent. Both are defensible, they differ by seventeen points, and no ratio is comparable with another unless both were built the same way.
Check yourself
What is added when the three statements are drawn up from a closed ledger?
- The adjusting entries
- The cash balance
- Nothing. All three are arrangements of accounts that already exist
Show the answer
Answer: C.
The measurement happened in the journal and the adjustments. The statements are a presentation, which is why they cannot disagree with each other.Profit was $61,600 and operating cash flow was $36,200. What explains the difference?
- An error in one of the statements
- Movements in receivables, materials, prepaid rent, payables, deferred revenue and interest payable, plus depreciation added back
- The purchase of the machine
Show the answer
Answer: B.
The machine is an investing item, not an operating one. The $25,400 gap is entirely the balance sheet accounts that moved during the year.Return on equity here is 50.7 percent on closing equity and 67.8 percent on average equity. What follows?
- One of them is wrong
- Both are defensible, so a published ratio means nothing until you know which basis was used
- Average equity is always the correct basis
Show the answer
Answer: B.
A period figure divided by a position figure needs a stated convention. Two sources using different conventions produce different ratios from identical accounts.Sources
- Fridson and Alvarez, Financial Statement Analysis, for the standard bridge from a set of books to the analytical questions the later courses ask of them.
What this leaves out
- Fen Street Bindery and every figure are invented, chosen so all three statements can be rebuilt by hand from the ledger.
- A real published set includes a statement of changes in equity, comparative figures for prior years, and notes that are longer than the statements themselves.
- The cash flow statement here uses the indirect method, which is the usual US presentation. The direct method reaches the same $36,200 by listing cash receipts and payments instead.
- Nothing here is advice about any security.