Which financial statement is prepared first: a step-by-step guide

For small business owners diving into the world of financial management, understanding the order of preparing financial statements is crucial. Each statement builds on the previous one, ensuring a clear and coherent financial picture. Let's break down the four main types of financial statements and their purposes.

What is an income statement?

The income statement, also known as the profit and loss statement, provides an overview of a company's revenues and expenses over a specific period.

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Managing finances can be daunting, especially when trying to figure out profitability. This statement helps determine the net income or loss, which is essential for assessing the company's profitability. For more detailed insights, check out this P&L management guide.

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Key components of the income statement include:

• Revenue: Total income generated from sales or services.

• Expenses: Costs incurred in the process of earning revenue, such as operating expenses, cost of goods sold, and taxes.

• Net Income: The difference between total revenue and total expenses, indicating the company's profit or loss.

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For additional tips on managing small business finances, read our tips for small business finances.

What is a balance sheet?

Getting a clear snapshot of your company's financial position can ease a lot of anxiety. The balance sheet offers a snapshot of a company's financial position at a specific point in time. It lists the company's assets, liabilities, and equity, providing a clear picture of what the company owns and owes. Understanding the general ledger importance can further help in preparing an accurate balance sheet.

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Key components of the balance sheet include:

• Assets: Resources owned by the company, such as cash, inventory, and property.

• Liabilities: Obligations the company owes to others, including loans, accounts payable, and mortgages.

• Equity: The residual interest in the assets of the company after deducting liabilities, representing the owners' stake in the company.

What is a cash flow statement?

Cash flow management is a significant concern for small business owners. The cash flow statement tracks the flow of cash in and out of the company over a specific period. It helps assess the company's liquidity, solvency, and financial flexibility. For e-commerce businesses, understanding e-commerce accounting best practices can be particularly beneficial.

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Key components of the cash flow statement include:

• Operating Activities: Cash generated or used in the core business operations, such as receipts from sales and payments to suppliers.

• Investing Activities: Cash spent on or received from investments in assets like property, equipment, or securities.

• Financing Activities: Cash flows related to borrowing, repaying debt, and equity transactions, such as issuing shares or paying dividends.

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What is a statement of retained earnings?

Deciding how much profit to reinvest in your business versus distributing it as dividends is crucial. The statement of retained earnings shows the changes in retained earnings over a specific period. Retained earnings are the portion of net income not distributed as dividends but reinvested in the business.

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Key components of the statement of retained earnings include:

• Beginning Retained Earnings: The retained earnings balance at the start of the period.

• Net Income: The profit or loss from the income statement.

• Dividends Paid: The portion of earnings distributed to shareholders.

• Ending Retained Earnings: The retained earnings balance at the end of the period, calculated as beginning retained earnings plus net income minus dividends paid.

The order financial statements are prepared in

Why financial statement order matters

Preparing financial statements in the correct order ensures accuracy and consistency. Each statement builds on the previous one, creating a logical flow of financial information. This order helps you understand the financial health of your business step-by-step. Learn more about the importance of business finance to grasp why this order is essential.

Step 1: Prepare the income statement

Start with the income statement. This statement comes first because it calculates net income, which is needed for the other financial statements. The income statement lists all revenues and expenses over a specific period, showing whether the business made a profit or incurred a loss. For a detailed guide, see how to prepare an income statement.

Step 2: Prepare the statement of retained earnings

Next, use the net income from the income statement to prepare the statement of retained earnings. This statement shows changes in retained earnings over the same period. It starts with the beginning retained earnings, adds net income, subtracts any dividends paid, and ends with the final retained earnings. This step helps you see how much profit is reinvested in the business versus distributed to shareholders.

Step 3: Prepare the balance sheet

Then, prepare the balance sheet. This statement uses information from both the income statement and the statement of retained earnings. The balance sheet lists the company's assets, liabilities, and equity at a specific point in time. Assets include cash, inventory, and property. Liabilities cover loans and accounts payable. Equity represents the owners' stake in the company. The balance sheet must balance, meaning total assets should equal total liabilities plus equity.

Step 4: Prepare the cash flow statement

Finally, prepare the cash flow statement. This statement comes last because it uses information from the income statement, statement of retained earnings, and balance sheet. The cash flow statement shows cash inflows and outflows from operating, investing, and financing activities. It helps you understand how cash moves through the business, which is vital for managing liquidity and planning for future cash needs. For more insights, check out the financial statements to monitor regularly.

How financial statements work together

The four financial statements are interconnected and provide a comprehensive view of your business's financial health. Each statement feeds into the next, creating a cohesive financial narrative. Understanding the net present value calculation can further enhance your financial analysis.

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The income statement calculates net income, which is then used in the statement of retained earnings. This statement shows changes in retained earnings, reflecting how much profit is reinvested in the business. The balance sheet uses information from both the income statement and the statement of retained earnings to list assets, liabilities, and equity. Finally, the cash flow statement uses data from the other three statements to show cash inflows and outflows.

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Together, these statements offer a full financial picture. They help you understand profitability, financial position, and cash movement. Use these insights to make informed decisions about budgeting, investing, and managing debt. Each statement provides specific details, but together, they give you a complete understanding of your business's financial status. For additional strategies, explore these financial management strategies.

What is the best way to prepare financial statements?

Maintaining good bookkeeping and records

Keeping accurate and up-to-date records is the foundation of preparing financial statements. Track all financial transactions, including sales, expenses, and receipts. Regularly reconcile your accounts to ensure everything matches up. This practice helps you spot discrepancies early and maintain a clear financial picture. For more tips, consider adopting agile accounting practices.

Using accounting software

Accounting software simplifies the process of preparing financial statements. It automates data entry, categorizes transactions, and generates reports. With features like real-time updates and integration with other financial tools, accounting software ensures accuracy and saves time. It also provides templates for financial statements, making it easier to compile and present your financial data. For startups, understanding startup accounting essentials can be particularly beneficial.

Working with an accounting professional

An accounting professional brings expertise and experience to the table. They can help you navigate complex financial regulations, optimize your financial processes, and ensure compliance. An accountant can also provide valuable insights and advice, helping you make informed financial decisions. Working with a professional ensures your financial statements are accurate and comprehensive, giving you confidence in your financial reporting. To avoid common pitfalls, learn how to avoid accounting errors.

Master financial statements with Ramp

Preparing financial statements doesn’t have to be overwhelming. With Ramp’s automated expense management and accounting tools, you can simplify your entire financial reporting process. From automating transaction tracking to generating accurate reports, Ramp integrates seamlessly with your financial workflow, ensuring each statement—whether it’s your income statement, balance sheet, or cash flow statement—is prepared with precision and efficiency. Spend less time on manual tasks and more time focusing on growing your business. Let Ramp streamline your financial operations and give you a clearer view of your business's financial health. Visit Ramp's Pricing to see how we can save you time and money.