The KEY to Understanding Financial Statements - YouTube

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 

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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!