# Creating Financial Statements from Transactions - Explained

How to Analyze a Financial Statement

# How to Analyze a Financial Statement

Analyzing a financial statement begins with recording all relevant transactions in that statement. The first step will be to record all of our transactions in a Chart of Analysis. The second step will be to translate that information to the Financial Statements.

We take you through these steps below.

# Creating the Chart of Analysis

Alpha company, our sample company, is going through the following transactions. Below we explain how each of these transactions is recorded in the chart of analysis.

## Transaction 1

This one we are dealing with alpha company. So, we're going to be using a chart that kind of looks like this. Here are the accounts that are going to be affected. How much and do they go up or down?

Alpha company received 8,000 cash investment from a friend in exchange for common stock. The first question that I ask myself is, is cash involved? Typically, cash is involved - not always - but more times than none, cash is going to be involved.

It says that we received eight thousand dollars cash. Cash going up, so I'm going to put in under cash 8,000 positive.

Now we have to have something on the other side - because, remember, it does have to make the accounting equation equal.

The accounting equation is assets equals liability plus equity. So, if we have 8,000 under assets that means 8,000 has to be on the liabilities or owners equity side.

The other side of this would be common stock. Our common stock is also going up by 8,000. The investment in our company is going up, so we're going to also add 8,000 under common stock.

We know we are going to have to do a statement of cash flow. So, I'm going to go ahead and give myself a little note that says where this would fall up under the statement of cash flow.

The three activities that are on the statement of cash flow are operating activity, investing activity, and financing activity. So, we are  going to go ahead and mark this as a financing activity by putting a notes saying "FA" to the side.

## Transaction 2

Transaction two says that alpha company purchased supplies for a thousand dollars cash. Cash is involved. What is my cash doing?

It is going down this time because we paid a thousand dollars cash. I'm going to put negative a thousand under cash. Again, we use parentheses to notate negative.

Remember, we have to have another part here to make the accounting equation equal. In this situation, the other side would be supplies - which is another asset actually. So, I just exchanged assets. I want to put a thousand dollars under supplies. This will balance the accounting equation.

Note: You might want to add a little note again here that this is going to be an operating activity (because this is just day-to-day stuff).

## Transaction Three

Alpha company paid two thousand dollars cash to acquire equipment. Cash is involved and is going down. So, we're going to put negative 2,000 under cash. The other side it's going to be equipment, and it is going up by 2000. Add positive 2,000 to the equipment. And the accounting equation is now balanced.

Note: You may want to make a note that equipment is long-term productive asset. So, this would be recorded on the statement of cash flow as investing activity.

## Transaction Four

Tt says alpha company purchased an additional \$1,400 of supplies on account. No cash is involved, as the supplies are purchased on account. We're expected to pay 1400 at a later date. For that reason, it's a liability. This is going to be our accounts payable. So, under accounts payable, we are going to put \$1,400 - because our balance goes up. So we're going to put that as a positive value. We are also getting supplies, so our supplies goes up by another \$1,400.

Now this one's not going to be operating activity, financing, or investing activity. In fact, it's not going to have an activity at all. There's no cash involved, so there's not going to be any statement of cash flow recognition on this transaction by itself.

## Transaction Five

Alpha company obtains \$1,240 cash by consulting with clients. We've done some work our clients have paid us \$1,240 cash. So, we put a positive \$1,240 under cash. This is money that I've earned, so this is going to make our retained earnings go up. So, I put a positive \$1,240 under retained earnings.

Note: I'll put a note that this is day-to-day operations and goes under operating activity. I'm also going to put a note that this is revenue.

## Transaction Six

Alpha company paid \$400 of rent to a landlord for the building where its facilities are located. We can assume that the company paid in cash - unless it says otherwise. I'll put a negative \$400 on cash. We need to put something on the other side to make the accounting equation balance. So, I put a negative \$400 under my retained earnings - which go down.

Note: This is day to day operations, so we put a note that this is operating activity. Because this something we are going to use, we can also indicate that it will be an expense for later recording on the income statement.

## Transaction 7

Alpha company paid \$600 cash towards the salary of its only employee. What is my cash doing? It's going down, because I paid it. So, we're going to put negative \$600 under cash. Because I am paying out cash, it is making my retained earnings go down.

Note: I write a note that this is operating activity - as I am paying a salary. This is again going to be an expense, because I'm paying for services already performed.

## Transaction 8

Alpha Company provided consulting services of \$1200 on account and rented its facility to a customer for \$200 cash. So, there are a couple things happening here. Cash is involved. What is our cash doing? I

n one situation, it's going up uh how much is our cash going up by \$200. They put \$1200 on account, so we're expected to receive it. So our accounts receivable go up by \$1200 because we're expected to receive it.

Now in total under assets that's \$1400. So, we need to have something that's going to offset that or make the accounting equation balance.

We've done two things. We've provided a service, and we've provided a facility. We're going to put \$1400 under retained earnings because it has made our retained earnings go up.

Note: This is day-to-day operations, so I'm going to put a note that this is operating activities. Also, this is a revenue because I've provided them a service.

## Transaction 9

The people who owed us money in transaction 8. They owed us \$1200 that was recorded in our accounts receivables. They paid their bill off, so we need to recognize that now. Cash is involved because that's how they pay off their bill. Our cash is going up by \$1200.

Note: We're not going to put this under retained earnings as a revenue because we've already recorded it as a revenue under retained earnings in transaction 8. We don't want to record it as revenue twice.

They're getting rid of what they owe us. So, we need to take it off of accounts receivable. So, we will say negative \$1200 under accounts receivable. That gets rid of their bill.

Note: This is our day-to-day operations, so this is an operating activity. But, the oa was only in reference to the two hundred dollars - not the \$1200.

## Transaction 10

Alpha company paid \$1000 as a partial settlement for its purchase of the supplies on account ,which was from transaction four.

As a reminder, in transaction four, we bought \$1400 of supplies on account. In this transaction, we're going to pay off a thousand dollars of that account.

Cash is going down because we're paying off our liability. So, we'll say negative \$1,000 under cash. The other side of the equation is going to be reducing our accounts payable by \$1,000.

Note: This will be an operating activity

## Transaction 11

Alpha company cleared and paid \$200 cash dividends to its owner. Cash is going down because we're paying it. So, we'll put negative \$200 under cash. The other part of that would be dividends which again affects retained earnings

So, it makes my retained earnings go down by \$200. This makes the accounting equation equal.

Note: Because this is dealing with the paying off of or paying to investors and creditors, this is going to be a financing activity. This is specifically dealing with dividends, so I'll make a note indicating dividends.

## Totaling Out the Chart of Accounts

The last thing we need to do before we start doing the financial statements is going to be the totaling out. We total each column by adding and subtracting.

In our scenario, cash's sum will be 5440.

Accounts receivables will be zero, because remember the person paid that off.

Supplies would be 2,400.

Equipment will be 2,000.

Accounts payables would be 400.

Common stock would be 8,000,

Retained earnings would be \$1,440.

Looking at the accounting equation, assets equals liability plus equity. The sum of all my assets is going to be 9840.

If I were to add up all my liabilities in equity that again will give me \$9,840.

## Creating the Financial Statements

We are ready to take the information from the Chart of Analysis and enter it into the Financial Statements.

Our financial statements are the income statement, the statement of retained earnings, the balance sheet, and the statement of cash.

## Creating the Income Statement

I'm going to start by adding the name of my company to the top. This is alpha company. This is the income statement, and this is for the year ending December 31, 2020. This is saying this is what we've done over the course of the year that ends in December 31st.

The income statement its comprised of two parts: revenues and expenses. So, let's go into the revenues first.

## Recording Revenues

We have two types of revenues for Alpha Company:

• Consulting revenue - which is our main type of revenue; and
• Rent revenue - Renting a facility.

We have consulting revenue of \$1240 from Transaction 5. We also have consulting revenue in transaction 8 for \$1200, for a a total consulting revenue of \$2440. We have \$200 in rent revenue. This gives us a total revenue of \$2640.

## Recording Expenses

Now let's go into our expenses. We had a couple types of expenses. In transaction six, we had rent expense of \$400. We also had in transaction 7 in which we paid our employees \$600 in salaries. We record this as a salary expense.

Notice, both of these numbers are positive on my income statement. Whereas, we had a negative on the chart. That's because we're looking at it specifically from expenses not from retained earnings. The expenses went up, but the retained earnings went down. That's why they were negative on the chart,

If we add these two expenses up, that's going to give us a total expense of \$1000. We push it out to the side for the total expenses.

We also know that from the income equation revenues minus expenses gives us net income. So, \$2640 minus \$1,000 gives us \$1640. And, it's going to be double line because that is the last figure on this financial statement.

We're done with calculations. This is our bottom line figure. That is the income statement.

## Creating the Statement of Retained earnings

In the statement retained earnings, it's still for the year ending December 31st. This is showing what we've done over the course of the year.

We are going to start these statement retainers with our beginning retained earnings or what our retained earnings balance was as of January 1st.

We're a brand new business we, so we don't have anything. All of our balances start at zero - no matter what you've invested in it. To that we're going to add the net income we just found, which is the \$1640. From that we're going to subtract out dividends from Transaction 11. We had \$200 paid dividends. tThat will give us an ending retained earnings of \$ 1444. So, that's my last number double lined.

## Creating the Balance Sheet?

Now we're going to go to the balance sheet again. Our name is at the top. This time it doesn't say for the year ending. That's because a balance sheet again tells us exactly what the balance is as of that date - not what we've done or how it's changed over the course of the year.

The balance sheet is split up into assets, liabilities, and equity. So, we're going to start with assets first. We do have a few of them. So, the first one we're going to deal with is cash.

Our cash balance as of that date is going to be \$5440. We get that from the bottom of the column. We have accounts receivables. We had accounts receivables but they were paid off. So, you could add accounts receivables here and have a balance of zero.

We have a supplies balance of \$2400. Then, we have equipment balance of \$2000. So, if we add up all the assets, that's going to give us a total asset balance of \$ 9840. And we're going to double line this one because we're done with the calculations. We're not going to add anything to that number we're not going

Now we go to liabilities. We have accounts payable. So, I'm gonna put accounts payables there - our balance is \$400. So, I can say that's the sum of my total liabilities is also 400,

Then we have equity. Equity has the two parts: the common stock and retained earnings. So, the common stock balance is \$8,000. My retained earnings balance is \$1440.

Now you can get that in two places: our prepared chart or from the statement of earnings that we just completed. Add that up, and it's going to give is a total equity of \$9440.

If I add my liability and my equity up, that's going to give me a total liability in equity of \$9840, which again matches the assets. So, we know that our accounting equation is equal or balanced.

## Creating the Statement of Cash Flow

Now the last one we're going to have to do is the statement of cash flow. The statement of cash flow is a little bit trickier. It says for the year ending December 31st.

This one's broken down in our three areas: operating activity, investing activity, and financing activity. First, we're going to look at only the operating activities. Specifically, let's start with the operating activities that are positive.

The first place you always want to start is with the cash. That comes from your customers because that's your normal business. I had in transaction five \$1240 that came from customers. Transaction eight \$200 came from customers. In transaction nine, \$1200 came from customers. So, if I add all those up, that means all the cash that I got from my customers was \$2640.

Now I look at the negative numbers - the cash payments going out. I have is cash payments for supplies. In transaction two I paid \$1,000. In transaction four, I bought \$1400, but I didn't pay for that in cash. In transaction 10, I actually paid some of that off in cash. So, my cash payments for supplies is actually only \$2000 - not 2400, because I haven't paid cash yet for supplies. I still owe that 400, so my cash. It is negative, so, I am putting parentheses here around the \$2,000.

The next one is cash payments for rent. Transaction six was negative \$400. It was paid for with cash.

The last operating activity that has cash flowing out is cash payments for salaries. That was for \$600.

If I total this up, this is going to give me a net cash flow from operating activities of negative \$360. Now what does that mean?

Net cash flow from operating activities tells me my cash went down because it's a negative number.

So, now let's go into investing activities. We had one investing activity that  was not cash coming in. So, we can't start with a positive number here because we don't have any. We only have one that's cash going out. So, we're going to call that cash payment for equipment of \$2,000. That's going to be our net cash flow from investing activity.

Thus far, we've lost \$2,360 worth of cash just this year alone.

Let's go to financing activities. In financing activities, we actually have two transactions that have financing activities. We want to start with the one that has the positive number.

In Transaction 1, we got cash from investors in exchange for common stock. So, I'm going to put cash received from common stock for \$8,000. Now, let's go to where we paid it out in Transaction 1, which is the dividends. So, cash payments for dividends was negative \$200.

We add that up that's going to give me a net cash flow from financing activities of \$7800. So, there's a positive number.

Now the next line item is the net increase in cash. So, if I add up the net cash flow from operating activities, from investing activities, and from financing activities together - that's going to give me a net increase in cash of \$5,440.

So my cash, based on all of the activities, went up by \$5440 just this year alone.

Now if I add to that my beginning cash balance from the beginning of this the year, which again we're brand new business, it's going to be zero. That's going to give me my ending cash balance which is \$5,440. That's a double line figure because we're done.

If you take a look back at your balance sheet, the ending cash balance here on the statement of cash flow should equal the cash balance on your balance sheet. And it does.