Financial statements provide a detailed overview of assets, liabilities, income, and cash flow, which are essential for business owners and investors looking to make informed decisions.

However, the process of preparing these statements can seem daunting. 

Knowing which statement to prepare first is an important step that can help set a strong foundation for accurate and efficient financial reporting.

For instance, the income statement shows the company’s profitability over a period, while the balance sheet offers a snapshot of its financial position at a specific point in time. Preparing these statements in a logical sequence ensures the information flows correctly, reducing the chances of errors and discrepancies.

Making the financial reporting process less cumbersome involves good planning and the right tools. Accounting software can automate much of the work, reduce manual errors, and save time. In this blog post, we discuss which financial statement to prepare first, why the order is important, and how you can streamline the process to make managing your finances a lot simpler. 

What are financial statements?

Financial statements are formal records that show a company’s financial activities and condition over a specific period. They include key documents such as the cash flow statement, balance sheet, and income statement.

• The cash flow statement details how cash moves in and out of the business—covering operating, investing, and financing activities
• The balance sheet provides a snapshot of the company’s assets, liabilities, and equity at a given time
• The income statement summarizes revenues, expenses, and profits or losses

Together, these statements help business owners, investors, and stakeholders understand a company’s financial performance and make informed decisions.

Overview of the top three financial statements

Financial statements are the core tools used to understand a company's financial performance. The top three financial statements provide key insights into different aspects of a business's financial health:

• Cash flow statement: Shows how cash moves in and out of the business, highlighting operating, investing, and financing activities. It helps assess a company's liquidity and its ability to generate cash.
• Balance sheet: Provides a snapshot of a company's assets, liabilities, and equity at a particular point in time. It helps assess the financial position and stability of the business.
• Income statement: Summarizes the company’s revenues, costs, and expenses during a specific period. This statement shows whether the company is making a profit or a loss.

Each of these statements plays a unique role in financial analysis. The cash flow statement is crucial for understanding the actual cash available, as profit does not always mean cash in hand. The income statement is essential for evaluating profitability over time. Meanwhile, the balance sheet shows the financial structure and resources available to a business. 

1. Cash flow statement

A quick overview on cash flow statements for ecommerce and small businesses.

What is it?

The cash flow statement tracks the flow of cash in and out of a business over a period. It breaks down cash movements into three categories: operating, investing, and financing activities. 

Operating activities include cash from sales and payments to suppliers. Investing activities cover purchases or sales of assets, like equipment or real estate. Financing activities involve cash from issuing stock, repaying loans, or paying dividends. The cash flow statement helps measure a company’s liquidity and shows how well it manages its cash to meet expenses and obligations.

How to prepare it?

To prepare a cash flow statement, start with the cash balance at the beginning of the period. Then, calculate cash inflows and outflows for each category—operating, investing, and financing. 

For operating activities, adjust net income for non-cash items like depreciation and changes in working capital. For investing activities, list any purchases or sales of long-term assets. For financing activities, include cash from loans, stock issuance, or dividend payments. Add the net cash flows from all three sections to find the ending cash balance.

Imagine a company starting with a cash balance of $10,000. During the month, it earns $15,000 from sales (operating inflow) and pays $5,000 in expenses (operating outflow). It buys new equipment for $3,000 (investing outflow) and secures a loan of $7,000 (financing inflow). In this case, the net cash flow for the period would be $14,000, bringing the ending cash balance to $24,000. 

2. Balance sheet

A quick overview on balance sheets for ecommerce and small businesses.

What is it?

The balance sheet is a financial statement that provides a snapshot of a company’s financial position at a specific point in time. It lists a company’s assets, liabilities, and equity, showing what the business owns and owes. 

Assets include items like cash, inventory, and property, while liabilities cover loans, accounts payable, and other debts. Equity represents the owners' stake in the company, including capital invested and retained earnings.

The balance sheet follows the accounting equation: Assets = Liabilities + Equity. This equation ensures the balance sheet is always balanced and helps stakeholders assess the company’s financial stability.

How to prepare it?

You can prepare a balance sheet by listing all assets, divided into current assets (like cash and receivables) and non-current assets (like property and equipment). 

Next, list all liabilities, split into current liabilities (such as accounts payable) and non-current liabilities (such as long-term loans). 

Finally, calculate the equity section, which includes common stock, retained earnings, and any additional paid-in capital. Add up the total assets and total liabilities plus equity to ensure they are equal, confirming the balance sheet is accurate.

Consider a company with $50,000 in cash, $30,000 in inventory, and $100,000 in equipment. These items add up to total assets of $180,000. If the company owes $40,000 in short-term debts and has a long-term loan of $60,000, total liabilities are $100,000. If the owner's equity is $80,000, the equation balances: $180,000 (Assets) = $100,000 (Liabilities) + $80,000 (Equity).

3. Income statement (aka P&L statement)

A quick overview on the P&L statement for ecommerce and small businesses.

‍What is it?

The income statement, also known as the profit and loss statement, provides a summary of a company’s revenues, expenses, and profits or losses over a specific period. It shows how much money the business made (revenue) and how much it spent (expenses), giving insight into its profitability.

The income statement is broken down into key sections: revenues, cost of goods sold (COGS), gross profit, operating expenses, and net income. This statement is crucial for understanding whether the business is generating profits and where it might need to cut costs or increase revenues.

How to prepare it?

Preparing an income statement begins with listing all sources of revenue, such as sales or service income. 

Next, the cost of goods sold is subtracted from the total revenue to calculate gross profit. After that, operating expenses—like rent, salaries, and utilities—are deducted from the gross profit to determine operating income. 

Any non-operating items, such as interest expenses or other income, are added or subtracted to arrive at the net income. The resulting figure shows the company’s profit or loss for the period.

Suppose a business has sales revenue of $100,000 and the cost of goods sold is $60,000. The gross profit would be $40,000. If operating expenses (rent, salaries, utilities) total $20,000, the operating income is $20,000. After subtracting $2,000 in interest expenses, the net income comes to $18,000.

Which financial statement should be prepared first and why?

The income statement (or profit and loss statement) should be prepared first when compiling a set of financial statements. This order is logical because the income statement provides critical information on a company's profitability over a period, which is necessary for preparing the other financial statements. 

Here’s why the income statement comes first:

• Foundation for other statements: The income statement details the company’s revenues, expenses, and profits or losses. This data is needed to determine the ending balance of retained earnings, which is a key part of the equity section in the balance sheet.
• Determines net income: Net income, reported on the income statement, is crucial for preparing the statement of retained earnings. This statement starts with the beginning retained earnings, adds the net income (or deducts a net loss), and subtracts any dividends paid to determine the ending retained earnings. As such, without the income statement, the statement of retained earnings cannot be accurately prepared.

Pro tip: Use DayZero to simplify the process with automated financial statement templates tailored for your business. Based on your incoming transactions, DayZero automatically prepares the three statements for you, leaving you hands-free with more time to focus on your business.

• Feeds into the balance sheet: The balance sheet captures a company's financial position at a specific point. It lists assets, liabilities, and equity. Equity includes the ending retained earnings, derived from the statement of retained earnings. Hence, preparing the balance sheet requires knowing the final retained earnings figure, which relies on the income statement and the statement of retained earnings being completed first.
• Cash flow statement relies on net income: The cash flow statement starts with net income from the income statement when using the indirect method. This statement adjusts net income for non-cash items and changes in working capital to determine cash flows from operating activities. Thus, the cash flow statement preparation depends on the completion of the income statement.

An example of the order of preparing financial statements

Income Statement:

Revenue: $150,000

Cost of Goods Sold: $90,000

Gross Profit: $60,000

Operating Expenses: $30,000

Net Income: $30,000

Statement of Retained Earnings:

Beginning Retained Earnings: $50,000

Add: Net Income: $30,000

Deduct: Dividends: $10,000

Ending Retained Earnings: $70,000

Balance Sheet:

Assets: $200,000

Liabilities: $80,000

Equity (Including Ending Retained Earnings of $70,000): $120,000

Cash Flow Statement:

Cash flows from operating activities (starting with a net income of $30,000): Adjust for depreciation, changes in inventory, etc.

Why does this sequence matter?

The sequence of preparing financial statements is not random. It follows a logical flow that ensures the accuracy and completeness of each statement:

• The income statement sets the stage by showing the company's performance
• The statement of retained earnings builds on this by showing how profits are used or retained
• The balance sheet captures the overall financial position, factoring in retained earnings
• Finally, the cash flow statement shows cash movement based on data from the income statement and changes in balance sheet items

Get better insights with a structured financial reporting approach

When financial statements are prepared in the correct sequence, they provide a clear roadmap for decision-making. Businesses can identify strengths, address weaknesses, and plan for the future with better insights into their performance. 

For small businesses and startups, mastering this process is crucial for growth and stability. The sequence not only aligns with accounting principles but also aids in meeting compliance requirements and enhancing transparency for stakeholders.

Streamlining the preparation of financial statements is easier with the right tools. With DayZero, you can automate parts of the process and maintain organized and accurate records. The platform offers templates tailored to your business needs, making it easier to keep financial statements consistent and up-to-date.

Frequently Asked Questions (FAQs)

A few questions our customers ask regularly.

1. What are the financial statements to be prepared?

Financial statements are the key reports used to assess a company’s financial health.

The main financial statements that businesses need to prepare include:

• Income statement (Profit and loss statement): Shows the revenue, expenses, and profits over a specific period.
• Balance sheet: Summarizes the company’s assets, liabilities, and equity at a particular point in time.
• Cash flow statement: Details the cash inflows and outflows from operating, investing, and financing activities.

These three statements provide a comprehensive overview of a business’s financial performance and position.

2. Which financial statement is always prepared first?

The income statement is typically prepared first. It calculates the company’s net income or loss, which is essential for determining retained earnings on the balance sheet. The net income figure also flows into the cash flow statement, specifically under operating activities. 

Preparing the income statement first ensures the accuracy of the subsequent financial statements, as they build on its data.

3. What is the purpose of an income statement?

The income statement serves to show a company’s profitability over a specific period, such as a month, quarter, or year. It outlines the revenue generated and expenses incurred, providing a clear picture of financial performance. 

This statement helps stakeholders understand how well the company is managing its operations and generating profits. It is also used by management to make decisions on cost control, pricing, and business strategy.

4. How does the balance sheet differ from the income statement?

The balance sheet and income statement serve different purposes:

• Balance sheet: Provides a snapshot of a company’s financial position at a specific point in time. It lists assets, liabilities, and equity, showing what the company possesses and owes.
• Income statement: Covers a period, such as a quarter or year, and shows the company’s profitability by detailing revenues, expenses, and net income.

While the income statement shows performance over time, the balance sheet reflects a single moment, making them complementary tools for financial analysis.