Accounting is the language of finance. Though you do not need an advanced CPA skill set, you must be familiar with GAAP and IFRS accounting. Certain real estate investment case studies may require you to tease out crucial information from financial statements. If you do not understand the information below, you are not prepared to underwrite real estate equity investments. After reading this, you will understand: (i) what are the three most important financial statements, (ii) examples of major line items in each of the three statements, and (iii) how the three financial statements tie together.
Walk me through the three most important financial statements.
The three most important financial statements are the income statement, the cash flow statement, and the balance sheet.
The income statement shows the net income for a given period of time according to GAAP, IFRS, or the local accounting standards. Note, net income includes many non-cash items such as depreciation and amortization.
The cash flow statement shows the actual cash generated in a given period. Most cash flow statements work from net income, then adjust for non-cash items and other cash-generating or cash-using items not shown in the income statement to arrive at the total change in cash for the period. This most common method that starts with net income is called the indirect method.
The balance sheet shows the total balance of all accounts at the end of the period, split between assets on one side and liabilities and shareholder equity on the other side. On the asset side, typical accounts include cash, property plant and equipment, accounts receivable, and prepaid expenses. The other side of the balance sheet of course shows shareholder equity, as well as liabilities such as debt, accounts payable, and unearned revenues. The two sides of the balance sheet must always tie, hence the name.
Give examples of major line items on each of the three financial statements.
On the balance sheet, the most relevant asset line items would be cash, accounts receivable, fixed assets, and total assets. Major liabilities include accounts payable, current maturities of long term debt, long term debt, and total debt.
On the income statement, the major line items are rents, other revenues, property taxes, insurance, depreciation and amortization, interest expense, and net income.
On the statement of cash flows, major lines include: changes in accounts receivable and accounts payable, changes in short term and long term debt, and depreciation and amortization expense.
How do the three financial statements flow together?
The income statement is an accumulation of business activity for a specific period (month, quarter, or year) that reflects profit and loss. The income statement ends with net income. GAAP rules require both cash and non-cash items to be included on the income statement, which you typically back out in the cash flow statement.
Next, the statement of cash flows begins with net income. You typically see non-cash items reversed out of net income, such as depreciation. Additionally, you must factor any many cash activities that do not touch the income statement, such as issuance of debt or capital investment. The statement of cash flows reconciles all of this activity and explains the change in cash period-over-period. The statement of cash flows is the bridge between the balance sheet and the income statement.
Finally, the balance sheet will be impacted by the activity captured on the income statement and the statement of cash flows. On the asset side, depreciation will decrease asset value, and changes in cash will impact your cash balance. On the liabilities and shareholder equity side, net income will impact retained earnings. Any debt issued will increase your total debt balance, and so on. Contrasting with the income statement and statement of cash flows, the balance sheet represents the accumulated balances of assets versus liabilities and shareholder equity at a singular point in time.
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