Meaning of BS, CF, and IS in Accounting (Elaborate Description of the 3 Terms)
Meaning of BS, CF, and IS in Accounting: BS, CF, and IS are all financial statements. The financial statements are a record of the financial activities of a business. But what is the meaning of BS, CF, and IS in Accounting? How are they applied? Read on.
What are Financial Statements
A financial statement is a report containing financial statements and management’s summary of thecurrent status of the firm and its future prospects.
The financial statements are:
- Balance Sheet: A statement of the firm’s accounting value at a specific point in time.
- Income Statement: A statement of the firm’s revenues and expenses over the quarteroryear
- Statement of Retained Earnings: A statement showing how much of the firm’searningswere retained in the business rather than paid out as dividends.
- Statement of Cash Flows: A statement of the firm’s operating, investing andfinancingactivities on cash flows over the quarter or year.
Meaning of BS
BS means Balance Sheet. The balance sheet is the statement of the financial position of a business.
The balance sheet comprises Assets, Liabilities and Equity.
In its simplest form, the balance sheet can be divided into assets and liabilities.
Assets are recorded on left while liabilities are entered on the right hand side.
The assets are listed in order of decreasing liquidity. While liabilities are listed in order of when they must be paid.
Assets
The items your company owns that can provide future economic benefit are known as assets.
Assets can be divided into Current Assets and Non-current Assets.
Current Assets are assets that are expected to be converted into cash in less than one year. Whereas non-current asset (Fixed Assets) is any asset that is expected to be held for more than one year.
Fixed assets are divided into tangible and intangible assets.
Tangible assets have physical substance; e.g., buildings, machines, etc.
Intangible assets are without physical substance but are held to generate revenue. Common intangible assets include trademarks, copyrights, patents, etc.
Liabilities
Liabilities are what you owe other parties.
Liabilities are also divided into two: current liabilities and non-current liabilities.
A current liability is any amount due to be paid to a creditor in less than one year. Non-current liability is any obligation that is not due to be repaid within one year.
Equity
Equity consists largely of common shares. However, companies may also issue preferred shares.
Common shares
Common shares offer an equal share in earnings after obligations to debt holders and preferred shareholders are met. Also, common shares give the right to vote on appointments to the board of directors (and a number of other matters). In addition, common shares hold a residual claim on the business and therefore have the ultimate
control of the company’s affairs.
Preferred shares
Preferred shares offer investors a fixed annual dividend. Most preferred shares are cumulative (if not paid, it accumulates and must be paid in full before common dividends can be paid). Furthermore, preferred shares are not a widely used form of financing. Most businesses view preferred shares as debt with a tax disadvantage (dividends do not reduce taxable income).
Assets vs. Liabilities
Assets add value to your company and increase its equity, whereas liabilities reduce its value and equity. The greater your assets exceed your liabilities, the better your company’s financial health. However, if you have more liabilities than assets, you may be on the verge of going out of business.
Examples of assets are:
- Cash
- Investments
- Inventory
- Office equipment
- Machinery
- Real estate
- Company-owned vehicles
Examples of liabilities are:
- Bank debt
- Mortgage debt
- Money owed to suppliers (accounts payable)
- Wages owed
- Taxes owed
Constructing a Balance Sheet
A balance sheet must always balance. To ensure this is the case, all transactions are recorded in the balance sheet in two places. This is known as the double entry principle.
There are two options for this.
- Record the transaction on both sides of the balance sheet, or
- Record the transaction twice on the same side of the balance sheet as both positive and negative numbers.
Meaning of IS
IS is an acronym for Income Statement. It is the statement of operation/profit and loss.
IS is a statement of the Revenues and Expenses of the business from which you will arrive at a profit or loss.
In principle, it is only necessary for a company to produce a balance sheet. However, in practice, the detailed items that make up the retained earnings for the year are shown in the income statement.
The income statement includes only the revenues and expenses that relate to the accounting year.
Meaning of CF
CF stands for Cash Flow. It is the statement of cash flows.
In theory, it is not necessary to have a cash flows statement as all cash items could be recorded in the balance sheet. However, in practice just the closing cash balance is recorded on the balance sheet and all the details are shown in the cash flow statement.
See the photo below for better understanding.
The cash flow statement (CFS) is a financial statement that summarizes the movement of cash and cash equivalents (CCE) that enter and leave a business. The Cash Flow Statement assesses a company’s ability to manage its cash position, or how well it generates cash to pay debt obligations and fund operating expenses. The Cash Flow Statement, as one of the three main financial statements, supplements the balance sheet and income statement.
Cash Flows are organized based on:
- Cash flows from OPERATING ACTIVITIES (e.g., revenues, operating expenses). This is known as Operating Cash Flow.
- Cash flows relating to INVESTING ACTIVITIES (e.g., sale/purchase of assets). This is known as Cash Before Financing.
- Cash flows relating to FINANCING ACTIVITIES (e.g., issuing shares, raising debt). This produces the net cash movement.
- Disclosure of non-cash activities, which is sometimes included when prepared under generally accepted accounting principles (GAAP).
Cash from Operating Activities
The operating activities on the Cash Flow Statement include any sources and uses of cash from business activities. In other words, it reflects how much cash is generated from a company’s products or services.
Changes made in cash, accounts receivable, depreciation, inventory, and accounts payable are generally reflected in cash from operations.
These operating activities include:
- Receipts from sales of goods and services
- Interest payments
- Income tax payments
- Payments made to suppliers of goods and services used in production
- Salary and wage payments to employees
- Rent payments
- Any other type of operating expenses
- In the case of a trading portfolio or an investment company, receipts from the sale of loans, debt, or equity instruments are also included because it is a business activity.
Cash from Investing Activities
Investing activities encompass all sources and uses of cash generated by a company’s investments.
This category includes asset purchases and sales, loans made to vendors or received from customers, and payments related to mergers and acquisitions (M&A).
In a nutshell, changes in equipment, assets, or investments are related to cash from investments.
Because cash is used to purchase new equipment, buildings, or short-term assets such as marketable securities, changes in cash from investing are usually considered cash-out items. However, when a company sells an asset, the transaction is treated as cash-in when calculating cash from investing.
Cash from Financing Activities
Cash from financing activities includes cash from investors and banks, as well as how cash is distributed to shareholders. This includes any dividends, payments for stock repurchases, and debt principal repayment (loans) made by the company.
When capital is raised, cash is brought in, and cash is taken out when dividends are paid. As a result, if a company issues a bond to the public, it receives cash financing. However, when interest is paid to bondholders, the company’s cash is depleted.
Remember that, while interest is a cash-out expense, it is reported as an operating activity rather than a financing activity.
Key elements in a cash flow statement
Net cash provided by operating activities
The net cash provided by operating activities represents the operating ‘lifeblood’ of business after paying necessary
outgoings for financing and tax.
Changes in working capital
This shows whether a business is absorbing funds for working capital or releasing them. Trends may indicate either financial stress or loose control over working capital.
PPE investment
Companies must invest in PPE to maintain their production capacity. A downward trend may indicate a declining company. PPE investment identifies the necessary sustainable level of expenditure.
Financing requirement/surplus
This shows whether internally generated funds are sufficient to cover investments made in fixed assets and businesses. Continuous deficits indicate that growth depends on regular injections of external finance.
How Cash Flow is Calculated
The direct method and the indirect method are both used to calculate cash flow.
Direct Cash Flow Method
The direct method totals all cash payments and receipts, including cash paid to suppliers, cash received from customers, and salary payments. This CFS method is simpler for very small businesses that use cash basis accounting.
These figures can also be calculated by using the beginning and ending balances of a variety of asset and liability accounts and examining the net decrease or increase in the accounts.
Indirect Cash Flow Method
The indirect method calculates cash flow by adjusting net income by adding or subtracting differences from non-cash transactions. Non-cash items appear on the balance sheet as changes in a company’s assets and liabilities from one period to the next.
As a result, the accountant will identify any changes to asset and liability accounts that must be added back to or subtracted from the net income figure in order to calculate an accurate cash inflow or outflow.
Changes in accounts receivable (AR) on the balance sheet from one accounting period to the next must be reflected in cash flow:
- If AR drops, more cash may have entered the company as a result of customers paying off their credit amount; the amount by which AR falls is then added to net earnings.
- An increase in AR must be deducted from net earnings because, although the amounts represented in AR are in revenue, they are not cash.
What about inventory changes in a business? On the CFS, they are accounted for as follows:
- A rise in inventory indicates that a company has spent more money on raw materials. Using cash means that the increase in the value of the inventory is deducted from net earnings.
- A reduction in inventory would increase net earnings. Credit purchases are reflected on the balance sheet by an increase in accounts payable, and the amount of the increase from one year to the next is added to net earnings.
The same logic applies to taxes, salaries, and prepaid insurance. If something is paid off, the difference in the amount owed from one year to the next must be deducted from net income. If there is an outstanding balance, any differences must be added to net earnings.
The indirect cash flow method allows for a reconciliation between two other financial statements: the income statement and balance sheet.
Limitations of the Cash Flow Statement
Negative cash flow should not automatically raise a red flag without further analysis. Poor cash flow is sometimes the result of a company’s decision to expand its business at a certain point in time, which would be a good thing for the future.
Analyzing changes in cash flow from one period to the next gives the investor a better idea of how the company is performing, and whether a company may be on the brink of bankruptcy or success. The CFS should also be considered in unison with the other two financial statements.
How BS, CF, and IS (the 3 Financial Statements) are Linked
The 3 financial statements are all linked and dependent on each other.
The income statement is not prepared on a cash basis – that means accounting principles such as revenue recognition, matching, and accruals can make the income statement very different from the cash flow statement of the business. If a company prepared its income statement entirely on a cash basis (i.e., no accounts receivable, nothing capitalized, etc.) it would have no balance sheet other than shareholders’ equity and cash.
It’s the creation of the balance sheet through accounting principles that leads to the rise of the cash flow statement.
That is it for the “meaning of BS, CF, and IS in Accounting.” I hope you enjoyed this article? Do well to share it with others. Thank you.
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