How Financial Statements Work Together

Confused by financial statements? You’re not alone. In this video, Steve makes it simple—breaking down how the income statement, balance sheet, and cash flow statement all connect to tell your business’s financial story.

You’ll learn how to read each statement, why they work together, and the #1 metric every business owner should be tracking. No jargon, no fluff—just the clarity you need to make smarter decisions.

Whether you’re running a company or just want to boost your financial IQ, this is a must-watch.

TRANSCRIPT:

The single most important skill you can have in business is financial literacy. But here's the problem. Universities and businesses approach it the wrong way.

They make it super complicated. They hurt people's heads. And therefore, most people don't know how to read financial statements, which is a huge problem, causing them to leave a ton of money on the table.

My name is Steve Coughran. I'm the founder of Coltivar. I've spent the last 15 years of my life working in the world of finance as a CFO, turning around and growing companies.

And in this video, I'm going to show you exactly what you need to know about financial statements and about finance and business. And then at the end, I'm going to reveal to you the number one thing I pay attention to in companies. Let's go ahead and dive in.

Let's keep it really simple by building a three by three matrix. All right. So we have three boxes broken into three sections.

It's me, the whiteboard, my handy dandy tree here and a marker. And let's keep things really simple. So when it comes to understanding financial statements, there are three that you need to know.

Starting with the first one, I'm going to abbreviate. This is the income statement, right? Don't make it overly complicated. It's really simple.

If you follow this type of structure, okay. At the very top of the income statement, we have revenue. Revenue also known as the top line represents the amount of income a company generates by selling its products and services.

Underneath revenue, we have cost of goods sold abbreviated as CODs. These costs represent all the costs associated with fulfilling a product or service in a company. In other words, it's all the costs associated with delivering a product or service into the hands of customers.

These costs may include things such as labor costs, right? Direct labor costs associated with delivering this product or service to the customer, not the labor that is associated with running the business. We'll get into that here in a minute because that's down in general and administrative expenses. So it's direct labor, material costs.

If you use subcontractors and all other costs associated with fulfilling your product or service. The reason why I emphasize this is because a lot of companies that I work with, when I start working with them, they have a lot of costs that should be up in cost of goods sold down below in the next section that I'll get into here in just one minute.

Now, between revenue and cost of goods sold. In other words, if you take revenue and you subtract out cost of goods sold, this is where you get gross margin. Gross margin, gross profit, the same thing. In other words, it's the amount of profit a company generates by pricing its products and services and selling them out there in the market and then incurring all the costs associated with fulfilling that product or service.

All right, so this is profit before overhead, gross margin. That's why it's referred to as gross, right? Then down below, we have op-ex, which is just an abbreviated way of saying operating expense. Within op-ex, you have things such as general and administrative payroll.

So going back to that labor component, all the labor associated with doing the work, fulfilling the product or service needs to go up above in cost of goods sold. Then all the other administrative labor, all the labor for legal, for marketing, for accounting, and for the other functions of the business are going to hit down here in op-ex. Other expenses may include occupancy expense, such as rent, or professional services, or sales and marketing, or insurance and taxes.

All of the costs, in other words, associated with running the business, all right, are going to hit operating expenses. And then from here, if we take gross margin or gross profit and we subtract out op-ex, we arrive at operating income. All right, I'm just simplifying here.

Underneath operating income, typically we have other income and expense. And then we arrive at some variation of net income. All right, but I'm going to just keep things really high level here.

And we're just going to focus on operating income as the end point. In other words, operating income represents the amount of profit a company generates from its normal operations. Let me illustrate this further.

If a company sells a piece of equipment and they're not in the business of selling equipment, that's going to be recorded as other income down below because it's not a part of normal operations. But for today's conversation, we just want to focus on how much income or profit does the business generate from normal operations. And the other income, other expenses, we're just going to ignore for now.

All right, the next financial statement is the balance sheet. No, it's not BS. This is actually a really important financial statement.

And guess what? Most business leaders, they completely ignore it. When I work with companies every single month, I sit down with them and we look at their financial statements because these are the report cards of the company. In other words, it will tell them how the company is performing from a financial perspective.

And if you tie that back to a company strategy, you can focus on solving constraints in the business and ultimately increase firm value. But most businesses, guess what? They ignore the balance sheet. They're like, I don't even know what the heck that is.

Get it out of here. Let's just focus on sales and profit, baby. But that is very myopic if you take that approach.

And if you're not looking at the balance sheet, there could be some hidden things that can come back and haunt you in your business. So let's get into the balance sheet because it's really not that scary. There are three sections.

Once again, we have assets. And within assets, we have current and non-current. Those are the two main categories.

Anytime you see the word current on the balance sheet, so current assets or current liabilities, it just represents within 12 months. So in other words, for assets, if you have current assets, it represents assets that you expect to turn into cash or collect upon within 12 months. When we get into liabilities, the same thing is true.

If you have current liabilities, these are liabilities that are due and payable within 12 months. So anytime you see the word current, just think 12 months. All right, so within current assets, first we have cash.

And then typically there's inventory, accounts receivable, prepaids, and other types of assets that the company owns. All right, right up here, or has claimed to. Under non-current assets, those are long-term assets, typically fixed assets.

So think about this. When a company goes out and buys, let's say a truck, right? Here's a nice truck, such a beautiful truck, right? And let's just say this truck is 50 Gs, 50 K, right? The company can't just take this truck and record it as an expense to the business. You can't do that, all right? Instead, you have to recognize the economic value of the business on the financial statements.

And therefore, since this has a life, let's just say of five years, what you have to do is you have to depreciate it over this five-year period. So you take $50,000 divided by five, and I'm just simplifying here, ignoring salvage value. You say, okay, every year, I'm gonna record $10,000 on the financial statements as depreciation, because the truck is depreciating theoretically.

And therefore, I'm capturing $10,000 of expense every single year for the next five years that you use the truck. And this is recorded as depreciation on the financial statements. But in the meantime, you have to record this as an asset on the balance sheet because you own this asset.

Now, if you finance this truck, you also have to record the liability on the financial statements. Let's just say you finance the entire thing, $0 down, you're gonna record $50,000 as a liability on the balance sheet as well. So that's how the income statement and the balance sheet come together.

I explain this a lot more in other videos, on my podcast, and in the courses that I offer at byfiq.com. But for now, just know that on the balance sheet, you have assets that are current and non-current, and within the non-current section, you have assets such as trucks and equipment and your building and land and other things that are held for the long-term purposes of generating profit in your company, all right? So that's how the balance sheet works from the first section, assets, A for assets. Under assets, we have liabilities. Liabilities include two sections.

We have current, and then we have non-current. Within the current section, remember these are liabilities that are due and payable within 12 months. Typically, it starts with accounts payable.

Accounts payable represents the amount of money that is due and payable to vendors. So let's just say you go buy a bunch of materials on account at one of your vendors, that is recorded here as a liability to the company. You may have other current liabilities such as payroll liabilities.

So when a company processes payroll, they pay their employees and then they withhold a certain amount for taxes, right? And those taxes have to be submitted to the appropriate agencies. So until they're submitted, they are recorded as a liability on the books because the company owes that money. It's a liability, right? So there are other items like accruals and whatnot that are recorded here in current liabilities, but suffice it to say, current liabilities just represents what's due and payable within 12 months.

Under non-current liabilities, this is where companies record their long-term debt. So going back to that truck example, you buy the truck, you have a five-year note, it extends beyond that 12-month period. So you may break out a portion of the debt that's due and payable within 12 months, record that under current, the remaining balance is recorded as non-current.

But just know that non-current liabilities represents long-term debt on pieces of equipment, on a building, et cetera, right? So we have assets and we have liabilities. The last section includes equity. Now, I remember in school, equity for some reason was so confusing for me.

The way that teachers explained it, they're like, here's retained earnings and capital balance. And I was like, what the heck are you talking about? So let me just keep it really simple. Equity is made up of two parts.

You have retained earnings and you have capital, all right? I'm just simplifying things here. Retained earnings represents the amount of income that you earn in the current year and the past years. So the prior year net income, the accumulation of all the previous year's net income, right? So you have net income here at the bottom of your income statement, and that's being carried over to retained earnings as current year net income, plus all the other previous years.

Then you have capital. Capital represents the amount of money an owner or investors put into the business, equity here, right? But also capital includes the amount of money that is taken out of a business through dividends and distributions. So that's how equity works here.

Pretty simple. It's your income or your retained earnings, plus all the capital that is put in and taken out of the business. So that's how a balance sheet works.

I'm gonna just clean this up just a little bit so we don't have all this mess, because I'm kind of type A here, but we have assets, liabilities, and equity. And this leads us into the accounting formula, right? Which is assets equal liabilities plus equity.

Now, at this point, I explained to you how the income statement is broken down into three sections, revenue, costs of goods sold, and operating expenses. And I also showed you where gross profit and operating income sits on the income statement. Then we walk through the balance sheet where I shared with you how assets equal liabilities plus equity and their component parts.

So hopefully you're feeling more comfortable with the financial statements, at least from a high level.

Now, this is where most universities and businesses get it wrong, right? They just stop. They stop here at the income statement, or they may get into the balance sheet a little bit, but they don't necessarily get into the third financial statement as much as they should. I spent years, eight years of my life in undergraduate and graduate studies, learning all about accounting and finance.

And guess what? This last financial statement gets neglected all the time, but it doesn't have to, because I'm gonna explain to you how it works.

This is the statement of cash flows. This is my baby, my favorite financial statement of them all.

And let me just tell you a little bit about our love story here. We have the income statement and the balance sheet. And I don't know if you knew this, but there's a little bit of a romantic connection here between the income statement and balance sheet.

They fell in love, in fact, and they had a baby. And that baby is the statement of cash flows, my baby. Here's the little baby picture right here. See, with a cute, curly little mohawk here and a smile.

All right. The reason why I say the income statement, the balance sheet fell in love, and they had this baby, the statement of cash flows is because if you take the income statement and you take the balance sheet and you combine their component parts, you end up with the statement of cash flows.

In other words, the statement of cash flows is a derivative. It's derived from the income statement and the balance sheet. Let me show you how this works.

In the first section, we have cash from operating activities. And I don't know if you knew this or not, but the statement of cash flows starts with net income. And that income comes from right down here after we account for the other income and other expenses of the business.

So here we have net income, bam, right here. Then what we do is we look at changes in working capital and we combine right here, your current assets and current liabilities on the balance sheet. And we account for them right here under working capital.

That's a terrible W right there. Oh my goodness. All right.

There you go. So we have working capital. Then we have other items that don't necessarily impact cash that we have to add back and account for, such as depreciation, amortization, and gains and losses on pieces of equipment, just to name a few.

All right. So we make all these adjustments and we arrive at cash from operating activities. I'll just abbreviate that there.

That's the first section, cash from operating activities.

Then in the next section, we have cash from investing activities. So when a business invests in equipment or trucks or buildings or other companies or whatever, when it makes investments or when it receives cash from its investments, let's say it sells off some of its investments.

It's recorded here in the second section, cash from investing activities.

And then finally, in the last section, we have cash from financing activities. So think about it like this. When a business acquires debt, right? So they get debt and then they draw down on that debt. Let's say it's a line of credit and they draw on that line of credit and they take that cash off the line of credit and put it into their business. That's cash from a financing activity.

So activities related to debt and equity in a business are gonna be recorded right here in cash from financing activities. The same thing is true. If you pay down debt, that's cash flowing out of financing activities. If you go to investors and you raise capital from investors, that's cash coming in to financing activities. If you take distributions or cash out of your business, that's gonna flow out of financing activities, right?

So debt and equity transactions are recorded right here under financing activities.

There you have it. Not too complicated, right? Cash from operating activities, investing activities and financing activities.

All right. So I'm gonna explain to you here the number one thing I pay attention to in companies, right? And it's really easy to pull together.

But before I get into that, let me just drive home a few more things here with the statement of cash flows. So like I said, the statement of cash flows, we have cash from operating activities. And I showed you how that's derived here.

And then we have non-current liabilities, the long-term debt, right? That's recorded down here in financing activities. And then under equity, we have retained earnings, the net income that's being recorded up here on the top line. And then we have capital, right? Capital flowing in and out of the business.

That's recorded here in the financing section. So therefore the statement of cash flows is a combination of these two other financial statements.

And let me just share this. 70% of companies that go bankrupt are actually profitable when they close their doors, but they go bankrupt because they run out of cash, which is just a precursor to what I'm about to share with you, which is the number one thing I pay attention to in companies.

And that is free cashflow, right? Free cash flow. I'm going to put a heart around this because I love free cashflow in business.

Now, free cashflow just represents the amount of cash that's left over after everything is paid for. And it's the amount of cash that's available to capital providers, such as debt and equity providers, or the amount of cash that's available to reinvest in a business.

And when it comes to driving value in a company, I'm a big strategy guy, right? So strategy and finance is my thing. When I combine them together, I could drive value in a business. And value is ultimately driven by free cashflow.

So if you think about stocks, if you think about real estate, it all comes down to the amount of cash these assets spin off. That's why I love free cashflow so much.

And if you pay attention to free cashflow, and if your cashflow is positive, you'll stay in business, right? If you don't pay attention to free cashflow, and you don't have other sources to replenish your cashflow, if it's declining, you'll go out of business. Even if you show profit right here on your income statement.

This is where most business leaders go astray. It's because they focus so much of their time and attention driving revenue and driving profits. But guess what? If a company doesn't manage its working capital, the difference between its current assets and current liabilities, for example, then a lot of money may be tied up in working capital.

And that's not accounted for on the income statement. And if you're not watching the statement of cash flows, you run out of cash.

The same thing is true with those long-term assets. Remember that ugly truck that I drew? If a company is pouring a ton of its cash into its property plan equipment, into its capital expenditures, well, guess what? That cash is not represented on the income statement. It's nowhere to be seen. And that company may go out of business.

So how do you compute free cashflow? It's actually pretty simple if you have a statement of cash flows, because you just take cash from operating activities, operating cash here, minus capital expenditures, CAPEX for short.

Capital expenditures represents the amount of cash that goes out the door when you're buying property plan equipment, trucks, machinery, buildings, anything with a life greater than one year that helps the business to generate its profit, right?

So there you go. There's your CAPEX, operating cash minus CAPEX. And we arrive at free cashflow, right?

One more thing that I need to point out is that if you take operating cash, investing cash, financing cash, and then you take that change in cash by adding up all these three sections and then add that to the beginning cash from the prior period, you'll arrive at an ending cash balance. And that amount of cash is also shown on the balance sheet and it ticks and ties there.

So that's how these financial statements come together. It may look like a bunch of gobbledygook here on my whiteboard, but I could tell you, if you educate yourself from a financial perspective and you learn how to read financial statements, and more importantly, not just how to look at financial statements and the numbers contained within them. Instead, it's looking at financial statements and understanding the story behind the numbers. So then you could go act in your business and drive greater value, right?

That's what we do at Coltivar. We help to grow and turn around companies by combining strategy and finance, and by teaching them how to look at the value drivers of their company to make better decisions.

If you're a business owner and you need help with this within your own company, you could always connect with us at coltivar.com. If you want to boost your financial IQ and you want to learn more about how to read these financial statements, I've put together excellent courses for you at eyfiq.com, which stands for boostingyourfinancialIQ.com.

Thanks for joining me for this video. Before we sign off, be sure to subscribe so you get notified every time I drop a new episode and let me know down in the comments box, other topics you may be interested in.

All right, take care of yourself. Cheers.