Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports

by Thomas Ittelson

Simply the clearest and most comprehensive introduction to financial reporting available. No accounting background is required.

“Finally, a handbook that takes the mystery out of accounting principles.” —Margi Gandolfi, VP Marketing/Strategic Planning of New York Blood Center

This edition replaces all previous editions of this bestselling title based on the revised and expanded edition corrected and back to the basics.

Financial Statements is a perfect introduction to financial accounting for non-financial managers, investors, business students, lawyers, lenders, entrepreneurs, and more. Financial Statements deftly shows that all this accounting and financial-reporting stuff is not rocket science and that anyone can understand it!

Ittelson empowers non-financial managers by clearly and simply demonstrating how the balance sheet, income statement, and cash flow statement work together to offer a snapshot of any company’s financial health. Every term is defined in simple, understandable language. Every concept is explained with a basic, straightforward transaction example. And with the book’s uniquely visual approach, you’ll be able to see exactly how each transaction affects the three key financial statements of the enterprise. Each statement paints a different and essential picture—the “three-legged stool” of company

• The income statement shows the manufacturing (or service offerings) and selling actions of the company that result in profit or loss during a period. It gives a very important perspective on the company’s performance, its profitability.

• The cash flow statement details cash into and out of the company for a period. You need money to make money. Running out of cash is bad. Duh.

• The balance sheet records at the end of a period, an instant in time, what the company owns and what it owes, including the owners’ stake, called shareholders’ equity.
 

Genres: Finance, Business

273 pages, Kindle Edition

Published September 12, 2022

Reviews

[Abbie Linxwiler]

I didn’t necessarily read the entire book, as only parts were used for my class. However, this textbook beats any finance textbook I used in undergrad. I actually enjoyed reading this one, and the explanations/charts were much easier to understand.

[Lor · Rating 5 out of 5]

Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports - Thomas Ittelson
Mar - Apr, 2026

Hint: Watch where the money flows; watch where goods and services flow. Documenting these movements of cash and product is all that financial statements do. It is no more complicated than that. Everything else is details.


1. Sales and revenue are synonymous and mean the “top line” of the Income Statement, the money that comes in from customers.
2. Profits, earnings and income are all synonymous and mean the “bottom line,” or what is left over from revenue after all the costs and expenses spent in generating that revenue are subtracted. Note that revenue and income have different meanings. Revenue is the “top line” and income is the “bottom line” of the Income Statement. Got that?
3. Costs are money (mostly for materials and labor) spent making a product. Expenses are money spent to develop it, sell it, account for it and manage this whole making and selling process.
4. Both costs and expenses become expenditures when money is actually sent to vendors to pay for them.
5. Orders are placed by customers and signify a request for the future delivery of products. Orders do not have an impact on any of the financial statements in any way until the products are actually shipped. At this point these shipments become sales. Shipments and sales are synonymous.
6. Solvency means having enough money in the bank to pay your bills. Profitability means that your sales are greater than your costs and expenses. You can be profitable and insolvent at the same time. You are making money but still do not have enough cash to pay your bills.

The Balance Sheet
- The Balance Sheet presents:
- what the enterprise has today: assets
- how much the enterprise owes today: liabilities
- what the enterprise is worth today: equity


- Assets Grouping
- Assets are grouped for presentation on the Balance Sheet according to their characteristics:
§ very liquid assets ..... cash and securities
§ productive assets ..... plant and machinery
§ assets for sale ........... inventory
- Assets are displayed in the asset section of the Balance Sheet in the descending order of liquidity (the ease of convertibility into cash). Cash itself is the most liquid of all assets; fixed assets are normally the least liquid.
- Current Assets
- By definition, current assets are those assets that are expected to be converted into cash in less than 12 months. • Current asset groupings are listed in order of liquidity with the most easy to convert into cash listed first:
1. Cash
2. Accounts receivable
3. Inventory
- Current Assets: Inventory
- A manufacturer's inventory includes three groupings:
1. Raw material inventory is unprocessed materials that will be used in manufacturing products.
2. Work-in-process inventory is partially finished products in the process of being manufactured.
3. Finished goods inventory is completed products ready for shipment to customers when they place orders.
- Current Assets: Prepaid Expenses
- Prepaid expenses are bills the company has already paid...but for services not yet received.
- Prepaid expenses are things like prepaid insurance premiums, prepayment of rent, deposits paid to the telephone company, salary advances, etc.
- Prepaid expenses are current assets not because they can be turned into cash, but because the enterprise will not have to use cash to pay them in the near future. They have been paid already.
- Other Assets
- Other assets is a catchall category that includes intangible assets such as the value of patents, trade names and so forth.
- Intangible assets are valued by management according to various accounting conventions too complex, arbitrary and confusing to be of interest here.
- Fixed Assets At Cost
- Fixed assets are productive assets not intended for sale. They will be used over and over again to manufacture the product, display it, warehouse it, transport it and so forth.
- Fixed assets commonly include land, buildings, machinery, equipment, furniture, automobiles, trucks, etc.
- Fixed assets at cost are reported on the Balance Sheet at original purchased price. Fixed assets are also show as net fixed assets—valued at original cost minus an allowance for depreciation. See the depreciation discussion following.
- Depreciation
- “Depreciating” an asset means spreading the cost to acquire the asset over the asset's whole useful life. Accumulated depreciation (on the Balance Sheet) is the sum of all the depreciation charges taken since the asset was first acquired.
- Depreciation charges taken in a period do lower profits for the period, but do not lower cash. Cash was required to purchase the fixed asset originally.
- Net Fixed Assets
The so-called book value of an asset—its value as reported on the books of the company—is the asset's purchase price minus its accumulated depreciation.
- Note that depreciation does not necessarily relate to an actual decrease in value. In fact, some assets appreciate in value over time. However, such appreciated assets are by convention still reported on the Balance Sheet at their lower book value.
-
- Current Liabilities
- Current liabilities are the reverse of current assets:
§ current assets...provide cash within 12 months.
§ current liabilities. take cash within 12 months.
- The cash generated from current assets is used to pay current liabilities as they become due.
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- Current Debt and Long Term Debt
- If the enterprise owes money to a bank and the terms of the loan say it must be repaid in less than 12 months, then the debt is called a note payable and is a current liability.
- A loan with an overall term of more than 12 months from the date of the Balance Sheet is called long-term debt. A mortgage on a building is a common example.
- The so-called current portion of long-term debt is that amount due for payment within 12 months and is a current liability listed under current portion of debt.
- Working Capital
- The company's working capital is the amount of money left over after you subtract current liabilities from current assets.
- Working capital is the amount of money the enterprise has to “work with” in the short-term. Working capital feeds the operations of the enterprise with dollar bills. Working capital is also called “net current assets” or simply “funds.”
-
- Shareholders' Equity
- If you subtract what the company owes (total liabilities) from what it has (total assets), you are left with the company's value to its owners...its shareholders' equity.
- Shareholders' equity has two components:
1. Capital stock: The original amount of money the owners contributed as their investment in the stock of the company.
2. Retained earnings: All the earnings of the company that have been retained, that is, not paid out as dividends to owners.
- Note: Both “net worth” and “book value” mean the same thing as shareholders' equity.
- Retained Earnings
- All of the company's profits that have not been returned to the shareholders as dividends are called retained earnings.
§ retained earnings = sum of all profits − sum of all dividends
- Retained earnings can be viewed as a “pool” of money from which future dividends could be paid. In fact, dividends cannot be paid to shareholders unless sufficient retained earnings are on the Balance Sheet to cover the total amount of the dividend checks.
- If the company has not made a profit but rather has sustained losses, it has “negative retained earnings” that are called its accumulated deficit.
- Changes in Shareholders' Equity
- Shareholders' equity is just the sum of the investment made in the stock of the company plus any profits (less any losses) minus any dividends that have been paid to shareholders.
- The value of shareholders' equity increases when the company: (1) makes a profit, thereby increasing retained earnings, or (2) sells new stock to investors, thereby increasing capital stock.
- The value of shareholders' equity decreases when the company: (1) has a loss, thereby lowering retained earnings, or (2) pays dividends to shareholders, thereby lowering retained earnings.

The Income Statement
- The Income Statement gives one important perspective on the health of a business—its profitability.
- The Balance Sheet reports on assets, liabilities and equity. The Cash Flow Statement reports on cash movements.
- Sales − Costs & Expenses = Income
- Note: Net sales means the total amount the company will ultimately collect from a sale—that is, list price less any discounts offered to the customer to induce purchase.
-
- Costs
- Costs are expenditures for raw materials, workers' wages, manufacturing overhead and so forth. Costs are what you spend when you buy (or make) products for inventory.
- When this inventory is sold, that is, shipped to customers, its total cost is taken out of inventory and entered in the Income Statement as a special type of expense called cost of goods sold.
- Costs lower cash and increase inventory values on the Balance Sheet. Only when inventory is sold does its value move from the Balance Sheet to the Income Statement as cost of goods sold.
- Gross Margin
- Gross margin is the amount left over from sales after product manufacturing costs (cost of goods sold) are subtracted. Gross margin is sometimes called gross profit or the company's manufacturing margin.
- Cost vs. Expense
- Manufacturing expenditures to build inventories are called costs.
- All other business expenditures are called expenses.
- Also note: An expenditure can be either a cost or an expense. Expenditure simply means the use of cash to pay for an item purchased.
- Note: The words profit and income mean the same thing; that is, what's left over from sales after you have subtracted all the costs and expenses.
- Operating Expenses
- Operating expenses are those expenditures (that is, cash out) that a company makes to generate income.
- Common groupings of operating expense are:
1. Sales & Marketing expense.
2. Research & Development (“R&D”) expenses.
3. General & Administrative (“G&A”) expenses.
- Operating expenses are also called SG&A expenses, meaning “sales, general and administrative expenses.”
- Income or (Loss)
- The terms income and profit and earnings all have the same meaning—what's left over when you subtract expenses and costs from sales.
- Note: The Income Statement is often referred to as the Profit & Loss Statement, the Earnings Statement, or simply the P&L.
- Remember: Income is not cash. In fact, a very profitable company with lots of net income can also be insolvent; that is, with no cash left to pay its bills.
- Income (Profits) vs. Sales (Revenue)
- Profit and income do mean the same thing.
- Sales and revenue do mean the same thing.
- Income (also called profits) is at the BOTTOM of the Income Statement.
- Sales (also called revenue) is at the TOP of the Income Statement.
- Accrual Basis vs. Cash Basis
- If income is measured when cash is received and expenses are measured when cash is spent, the business is said to be operating on a cash basis—just like your checkbook.
- If income and expenses are measured when the transactions occur—regardless of the physical flow of cash—the business is said to be operating on an accrual basis. More later.

The Cash Flow Statement
- Non-cash transactions have no effect on the Cash Flow Statement but they can affect the Income Statement and Balance Sheet.
- Note: Cash comes into the company when the customer pays for the product, not when the company ships it. Cash moves out of the company when it pays for materials, not when the company orders or receives them.
- Sources and Uses of Cash
- Cash comes into the business (sources) in two major ways:
1. Operating activities such as receiving payment from customers.
2. Financing activities such as selling stock or borrowing money.
- Cash goes out of the business (uses) in four major ways:
1. Operating activities such as paying suppliers and employees.
2. Financial activities such as paying interest and principal on debt or paying dividends to shareholders.
3. Making major capital investments in long-lived productive assets like machines.
4. Paying income taxes to the government.
a.
- Selling stock is the closest thing to printing money that a company can do...and it's perfectly legal.
- Think of the company's Cash Flow Statement as a check register reporting all the company's payments (cash outflows) and deposits (cash inflows) for a period of time.
Connections
1. The Income Statement shows the manufacturing and selling actions of the enterprise that results in profit or loss.
2. The Cash Flow Statement details the movements of cash into and out of the coffers of the enterprise.
3. The Balance Sheet records what the company owns and what it owes, including the owner's stake.


- Par value is the dollar amount that is assigned to shares by the company's charter. Par value has little significance other than to keep track of stock splits. There is no connection between the stated par value and any underlying worth of the stock or the enterprise.
- Examples























AppleSeed Enterprise Example








- The difference between the actual and the standard cost is then booked in the accounting records. These differences, if any, are called manufacturing variances.
- Types of Variances.
- For AppleSeed's product and production costs to be “at standard,” that is, for no manufacturing cost variances to have occurred:
- We must produce 20,000 cases in a month—no more, no less. Otherwise we will have a volume variance.
- Our raw material must cost just what we have estimated them to be—no more, no less. Otherwise we will have a purchase variance.
- The amount of raw material used must be just as planned. Otherwise we will have a yield variance.
- We need no more or less direct labor and no overtime to produce our 20,000 cases. Otherwise we will have a labor variance.
- We don't have excess scrap produced in the production process. Otherwise we will have a scrap variance.
- Product Pricing
- What should we charge for our delicious applesauce? How should we price our product?
- Marketing textbooks say that pricing decisions are best made in the marketplace. Price-setting should be based on a competitive understanding and on our competitive goals. Manufacturing costs should have little bearing on pricing decisions.
- After we have set a competitive price, we should then look at our costs to see that an adequate profit can be made. If we can't make our desired profit selling our applesauce at a competitive price, then we have just two options: lower costs or exit the business.

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-

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- Profit is the difference between two large numbers: (1) sales less (2) costs & expenses. Small changes in either can result in large swings in profit (loss). Volume, cost and price are all connected to ultimate profits, as is shown in a break-even chart.


- The company has done well in its first year of operation and the board of directors decides to vote a dividend for common shareholders. The question is, how big a dividend?
- Dividends are paid out of retained earnings, of which we have more than $250,000 as of the end of the year. We also have a very strong cash position, so we can afford to pay the dividend.
- After much discussion, a $0.375 per share dividend is voted. With 200,000 shares outstanding, this dividend will cost the company $75,000; $56,250 to the investor group and $18,750 to you, the entrepreneur.
- Cash Flow
- The format introduced here focuses on cash movements divided into three major categories of interest to anyone reviewing the cash performance of a business:
1. Cash Flows from Operations. Cash sources (uses) from activities such as making and selling products.
2. Cash Flows from Investing. Cash uses (sources) from increases (decreases) in the productive assets of the company such as property, plant and equipment.
3. Cash Flows from Financing. Cash sources (uses) from selling stock to investors, borrowing money from a bank and paying dividends.
- What's the Business worth
- Book Value. Book value represents the value at which assets are carried on the “books” of the company. The book value of a company is defined as its total assets less its current liabilities and less any long-term debt.
- P/E
- Price-Earnings Multiple. The company has 200,000 shares outstanding and earned a net income of $251,883 last year. Dividing net income by the number of outstanding shares gives a net income of $1.26 per share. If we assume that companies similar to AppleSeed are currently selling at, let's say, 12 times earnings, then our company is worth $1.26 times this 12 multiple times 200,000 shares outstanding that equals a value of slightly over $3 million.
Keeping Track with Journal and Ledgers
- A journal is a book (or computer memory) in which all of a company's financial events are recorded in chronological order. Everything is there, nothing is missing.
- A ledger is a book of accounts. An account is any grouping of items that we want to keep track of. You can think of a ledger as a book with many pages. Each page of the ledger book represents one account.
- Cash Ledger
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- Accounts Payable Ledger
-
- Inventory Ledger

- Accrued Expenses Ledger

- Account Receivable Ledger


Ratio Analysis
- Both the Income Statement and the Balance Sheet can be converted into “common size” statements for analysis. Common size statements present each item as a percentage of the statement's largest item.
- Common Size Income Statement. Normally, the largest item in the Income Statement is sales.
- Common Size Balance Sheet. To convert the Balance Sheet into a common size statement, all components are expressed as a percentage of total assets.



- Liquidity Ratios
- The so-called liquidity ratios measure the ease with which a company can pay its bills when due. This ability is determined by whether the enterprise has cash in the bank or expects to generate cash (by sale of goods and by the collection of accounts receivable) in sufficient amount to pay its bills as they become due.
- Current Ratio. The current ratio is one of the oldest and best-known measures of short-term financial strength. The ratio determines whether current assets (cash or assets that are expected to be converted into cash wi

[Madhur Bhargava · Rating 5 out of 5]

When art critics get together they talk about Form, Structure, and Meaning. When artists get together they talk about where you can buy cheap turpentine. – Picasso.
The Buffets and the Mungers in all of their talks love discussing turpentine, while the audience like me is clueless regarding form, structure, and meaning itself. This book is just that, it provides an insight into the Form, Structure, and meaning of a business, i.e., the balance sheet, income statement, and cash flow, to the naive/novice audience. Would heavily recommend reading this book before you go ahead and read one of those much-recommended books(eg - one up on Wall Street, the intelligent investor) by the finance gurus. The author understands the audience well and has written in a lucid manner, rich with practical examples that are simple enough for the novice reader.

[António Louro · Rating 5 out of 5]

Top book. It provides an introduction to key financial information using a case study approach.

As we follow the creation of the AppleSeed company and it's story, from a newly born company who requires debt and early investors to bloom, towards the IPO phase and its expansion of operations and acquisition of other businesses - the detailed step-by-step description and overview of its Financial Statements make what could've been a really boring and heavy accounting book, to a must-have for anyone thinking about being introduced to these types of financial concepts.

[Timon Ruban · Rating 2 out of 5]

I had picked up some accounting jargon left and right while reading other books, but was starting to get a little anxiety – "Is there very basic stuff that an economics major would know that I don't?" - and picked up this book.

For my taste, it was a little too slow and too basic (going as far as explaining how exponents work 🙈). The first part about the dance between the three financial statements with real world examples was fun, but the latter part (about strategy and making investment decisions) seemed very superficial and unhelpful ("you shall use a decision tree").

[Nitya · Rating 3 out of 5]

I did not read the entire thing but I read all of the parts which were relevant to what I need to learn, and it ended up being most of the book anyways. It was super digestible and helpful. I feel like people rarely read to learn about a topic nowadays (outside of school papers), I can’t remember the last time I did and I definitely would not have if not for my Dad.

[Adam Manwaring · Rating 4 out of 5]

Solid accounting refresher covering a broad range of topics.

Highlights include the step-by-step transaction walkthroughs, the manufacturing costing section, and product pricing (with add’l analysis). The valuation overview, ratio-based industry comparisons, and capital budgeting content toward the end were also good.

[Christian Nelson · Rating 5 out of 5]

Small business owners Read

Reading and Interpreting financial Statements doesn't excite most small to mid sized business owners or managers but it's a necessity to grow and also help get you through lean times.

[Heather · Rating 5 out of 5]

Riveting. But really though, I bought this to help me understand financial statements better for my job. This book helped me learn about them in a way that brought in real life examples and made it interesting.

[Bratimir · Rating 5 out of 5]

Understanding your business

This book is an excellent starting point for getting your feet wet in understanding financial accounting. Learning through an example.

[Feliciu · Rating 5 out of 5]

Good book for begginers

A very good book for beginners in investing and accounting.
Very detailed book, well explaning and with a very practical example

[Dan Dawson · Rating 1 out of 5]

Just use WSP

[Cesar Ramirez · Rating 5 out of 5]

Easy way to understand financial statements. The capstone case presented in detail in the book is great