Which financial statement is prepared first? A step-by-step guide

For small business owners just diving into the world of financial management, it's crucial to know the order of preparing your financial statements. Each statement builds on the previous one, from the income statement to the cash flow statement, ensuring a clear and coherent financial picture.

However, it can be a confusing process, and tackling your statements in the wrong order risks financial complications. We'll clarify which financial statement is prepared first and break down the four main types of financial statements and their purposes. We'll also explain why this sequence matters.

Which financial statement is prepared first?

Your income statement is the first financial statement you should prepare, followed by your statement of retained earnings, then your balance sheet, and, finally, your cash flow statement.

Financial statements work together like building blocks, with each one providing essential information for the next. Here's the sequence to follow and why:

1. Income statement: This statement comes first because it calculates net income, which you need for the other financial statements. It lists all revenues and expenses over a specific period, showing whether your business made a profit or incurred a loss.
2. Statement of retained earnings: This statement shows changes in retained earnings over the same period. It starts with the retained earnings at the beginning of the period, adds net income, subtracts any dividends paid, and ends with the final retained earnings.
3. Balance sheet: This statement uses information from both the income statement and the statement of retained earnings. The balance sheet lists your company's assets, liabilities, and equity at a specific point in time.
4. Cash flow statement: This statement comes last because it uses information from the income statement, statement of retained earnings, and balance sheet. It shows cash inflows and outflows from operating, investing, and financing activities, helping you understand how cash moves through your business.

Following this order creates accuracy across all your financial statements and creates a complete picture of your company's financial health and performance over time. Now let's look at each statement in more detail.

What is an income statement?

The income statement, also known as the profit and loss (P&L) statement, provides an overview of your revenues and expenses over a specific period. This statement helps determine net income or loss, which is essential for assessing your company's profitability.

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 (COGS), and taxes
• Net income: The difference between total revenue and total expenses, indicating your company's profit or loss

The income statement is prepared first because you need net income for the next statement and step in the process. Ramp can help simplify this step by automatically categorizing expense data, reducing manual entry and helping you calculate profitability faster.

How to prepare an income statement

Preparing an income statement is straightforward if you follow a clear process. These steps help you organize your financial data and calculate your company's profitability accurately:

1. Gather all revenue sources: Collect sales data, service income, and any other money earned during the reporting period
2. Compile operating expenses: List costs such as salaries, rent, utilities, supplies, and other day-to-day business expenses
3. Add non-operating items: Include interest income, interest expenses, and any one-time gains or losses
4. Calculate gross profit: Subtract COGS from total revenue to see your basic profitability
5. Determine net income: Subtract all expenses from total revenue to arrive at your final profit or loss figure

Following these steps in order gives you a clear view of your business performance. Your completed income statement now serves as the starting point for preparing your other financial documents.

What is a statement of retained earnings?

The retained earnings statement tracks how much profit your company keeps and reinvests in the business vs. what gets distributed to shareholders as dividends. It takes the net income figure directly from your income statement, adds it to your beginning retained earnings balance, and subtracts any dividends paid out during the period.

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 total retained earnings after the period, calculated by adding net income to the starting balance and subtracting dividends.

How to prepare a statement of retained earnings

The statement of retained earnings connects your income statement to your balance sheet by tracking profit retention. This straightforward document shows how your company's earnings flow into long-term growth.

1. Start with beginning retained earnings: Use the retained earnings balance from your previous period's balance sheet as your starting point
2. Add net income from your income statement: Take the final profit figure directly from your completed income statement and add it to the beginning balance
3. Subtract dividends paid: Deduct any cash dividends or stock dividends distributed to shareholders during the reporting period
4. Calculate ending retained earnings: Add net income and subtract dividends from your beginning balance to get your final retained earnings figure

Your completed statement of retained earnings now provides the ending balance needed for your balance sheet. This figure represents the cumulative profits reinvested in your business.

What is a balance sheet?

The balance sheet provides a snapshot of your company's financial position at a specific point in time, showing what you own (assets), what you owe (liabilities), and what belongs to owners or shareholders (equity).

It takes the ending retained earnings figure directly from your statement of retained earnings and includes it in the equity section, ensuring all your financial statements connect properly. This document must balance, meaning your total assets should always equal your total liabilities plus equity.

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' stakes in the company

Your balance sheet completes the financial picture by showing how assets, liabilities, and equity work together. This statement sets the foundation for preparing your final cash flow statement.

How to prepare a balance sheet

Creating an accurate balance sheet requires precise data from your other financial statements. The ending retained earnings figure serves as a key component that links everything together.

1. List all current and non-current assets: Include cash, accounts receivable (AR), inventory, equipment, and property at their appropriate values
2. Record all liabilities by category: Document current liabilities, such as accounts payable (AP) and long-term debts
3. Enter equity components: Include common stock, additional paid-in capital, and the ending retained earnings from your completed statement
4. Verify the accounting equation: Confirm that total assets equal total liabilities plus total equity to make sure your balance sheet balances

Your balance sheet now reflects your company's complete financial position. The accurate retained earnings figure means your equity section correctly represents the profits reinvested in your business over time.

What is a cash flow statement?

The cash flow statement tracks the actual movement of cash in and out of your business across three main categories: operating, investing, and financing activities. It provides insight into your company's liquidity and cash management.

This statement shows how cash flows differ from profits by revealing when money actually changes hands. It pulls information from your income statement, balance sheet changes, and additional records to create a complete picture of cash activity during the reporting period.

Key components of the cash flow statement include:

• Operating activities: Cash generated or used in your core business operations, such as receipts from sales and payments to suppliers
• Investing activities: Cash spent on or received from investments in assets such as property, equipment, or securities
• Financing activities: Cash flows related to borrowing, repaying debt, and equity transactions, such as issuing shares or paying dividends

Your cash flow statement completes the full set of financial statements, giving you a comprehensive view of how cash moves through your business and supports your overall financial health.

How to prepare a cash flow statement

Your cash flow statement completes the financial reporting cycle by showing actual cash movements. This final statement draws from all previous documents to reveal your company's cash performance.

1. Start with net income: Begin with the net income figure from your income statement as the foundation for your operating activities section
2. Adjust for non-cash items: Add back depreciation, amortization, and other expenses that don't involve actual cash outflows during the period
3. Account for working capital changes: Calculate changes in AR, inventory, and AP using your current and previous balance sheets
4. Record investing activities: Document cash spent on or received from asset purchases, sales, and investments using balance sheet comparisons and transaction records
5. Document financing activities: Include cash from loans, stock issuances, dividend payments, and debt repayments based on equity and liability changes

Your completed cash flow statement now shows whether your business generated positive cash flow. This final piece gives you a complete view of your company's financial health and performance.

What is the best way to prepare financial statements?

Preparing financial statements requires attention to detail, consistent procedures, and the right tools to present your financial position to stakeholders and meet regulatory requirements. Here are a few ways to prepare accurate statements:

Maintain 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 confirm that everything matches up.

By maintaining and automating your records, finance teams can save up to 20 hours each month, which creates more time for strategic work. This practice helps you spot discrepancies early and maintain a clear financial picture.

Use accounting software

Accounting software simplifies the process of preparing financial statements. It automates data entry, transaction categorization, and report generation. With features like real-time updates and integrations with other financial tools, accounting software improves accuracy and saves time.

It also provides templates for financial statements, making it easier to compile and present your financial data.

Work with an accounting professional

An accounting professional brings expertise to the table. They can help you navigate complex financial regulations, optimize your financial processes, and make sure you stay compliant with financial rules.

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.

Financial statement preparation in action

Here's a simple scenario showing how ACME Corp. prepares their financial statements in the correct order:

Step 1: Income statement

ACME's accounting team begins by compiling all revenue and expenses for the fiscal year. They calculate total revenues of $500,000 from product sales, subtract operating expenses of $350,000 (including salaries, rent, and utilities), and account for interest expenses of $10,000.

This results in a net income of $140,000 for the year. The income statement must be completed first because the net income figure is essential for the next statement.

Step 2: Statement of retained earnings

Using the $140,000 net income from the income statement, ACME's accounting team now prepares the retained earnings statement. They start with the beginning retained earnings balance of $75,000, add the current year's net income of $140,000, then subtract dividends paid to shareholders of $30,000.

This gives them an ending retained earnings balance of $185,000. This ending balance is necessary for completing the balance sheet.

Step 3: Balance sheet

With the retained earnings figure now determined, ACME Corp. can complete their balance sheet.

They list assets totaling $470,000 (including cash, inventory, and equipment) and liabilities of $235,000 (accounts payable and long-term debt). In the equity section, they include common stock of $50,000 plus the retained earnings of $185,000 from the previous statement, bringing total equity to $235,000.

The accounting equation balances:

$470,000 assets = $235,000 liabilities + $235,000 equity

Step 4: Cash flow statement

Finally, ACME Corp. prepares the cash flow statement, which requires information from both the income statement and balance sheet. They start with the net income of $140,000 from the income statement, then make adjustments for non-cash items and changes in working capital accounts shown on the balance sheet.

After calculating net cash for operating (+$150,000), investing (-$30,000), and financing activities (-$55,000), they determine that cash increased by $65,000 during the year, which reconciles with the change in the cash balance shown on their comparative balance sheets.

This sequential preparation allows each statement to build on information from the previous ones, maintaining accuracy and consistency across all four financial statements.

Why the order of financial statements matters

The sequence in which you prepare your financial statements directly affects their accuracy and reliability. Each statement builds upon information from the previous one, creating a logical flow that ensures all your numbers align properly.

When you prepare statements out of sequence, you risk creating inconsistencies that can lead to significant problems. Inaccurate reporting undermines the credibility of your financial information, making it difficult for investors, lenders, and company leaders to make sound decisions.

These errors can also trigger compliance issues with regulatory bodies, potentially resulting in penalties or audit complications.

Following the proper order of financial statements makes sure they tell a coherent story about your business performance and financial position. This systematic approach saves time on corrections and builds confidence in your financial reporting process.

Master financial statements with Ramp

Preparing financial statements doesn’t have to be a time-consuming task. With Ramp’s expense management and accounting automation software, 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 is prepared with precision and efficiency. Spend less time on manual tasks and more time focusing on growing your business.

Try an interactive demo and see how Ramp streamlines your financial operations and gives you a clearer view of your business's financial health.