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Financial statements are everywhere in your daily life: bank, brokerage, mutual funds, credit card disclosures, or insurance policies. All these documents contain information that is important to your financial health, and understanding them is very much needed.With that being said, this guide aims to help average investors and accounting and finance entry-level professionals understand the three most important financial statements with an emphasis on clarity and application.
| Balance Sheet | Income Statement | Cash Flow Statement | |
|---|---|---|---|
| Purpose | A snapshot of a company’s financial position | A measure of the company’s operational performance | Reports on the company’s cash movements |
| Time | A point in time | A period of time | A period of time |
| Measure | Assets, Liabilities, Equity | Revenue, Expense, Profitability | Increases and decreases in cash |
| Key components | Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders’ Equity. | Revenue; Cost of Goods Sold; SG&A (Selling, General & Administrative) Expenses; Operating Income; Pre-Tax Income; Net Income | Cash Flow from Operations; Cash Flow from Investing; Cash Flow from Financing |
2.1. Balance Sheet
Assets: Things that the company owns that have values.
Current Asset: include cash and other highly liquid assets that will be turned into cash within a year from the balance sheet date under normal business operations.
Cash and Cash Equivalents: Money on deposit in the bank, cash on hand (petty cash) and highly liquid securities such as Treasury bills.
Accounts Receivable: Amounts due from customers but not yet collected.
Inventories: inventory represents the cost of items on hand that were purchased and/or manufactured for sale to customers.
Property, Plants, and Equipment: Long-lived assets not intended for sales that are used to manufacture, display, warehouse and transport the company’s products, along with buildings and improvements used in operations.
Prepaid Expenses: Payments made for which the company has not yet received benefits, but for which it will receive benefits within the coming year. These are listed among current assets as prepaid expenses.
Liabilities: Amounts of money that the company owes to others
Current Liabilities: current liabilities are obligations due and payable within 12 months of the date on the balance sheet
Accounts Payable: This is the amount the company owes to the regular business creditors from whom it has bought goods and services on open account.
Notes Payable: Money owed to banks, individuals, corporations or other lenders under promissory notes, and due within one year of the balance-sheet date.
Accrued expenses: Items owed but unpaid at the date of the balance sheet appear as a total under “accrued expenses.”
Long-term debt: all debt due more than one year from the date of the balance sheet (other than that specifically reported elsewhere on the balance sheet).
Shareholders’ Equity: the money that would be left if a company sold all of its assets and paid off all of its liabilities
Common Stocks: A type of security that represents ownership of an equity in a company
Preferred Stocks: Preferred stock is an equity—or ownership—security that does not carry the right to vote. They offer a fixed dividend, and in many ways are safer than common stock because they have preference over common shares with regard to dividends and the distribution of assets in case the company is liquidated.
Additional paid-in capital: The amount paid by shareholders in excess of the par, or stated value, of each share.
Retained Earnings: Accumulated profits that the company earns and reinvests into itself.
2.2. Income Statement
Net sales: includes revenue nets the amount reported after taking into consideration returned goods and allowances for price reductions or discounts.
Cost of goods sold: the costs a company incurs to purchase and convert raw materials into the finished products that it sells.
Gross margin: the excess of sales over costs of goods sold.
Depreciation and amortization: Captures each year’s decline in value. Amortization reports the year’s decline in value of intangibles; Depreciation reports the year’s decline in values of tangible goods.
Selling, General, and Administrative Expenses: Includes expenses such as sales agents’ salaries and commissions, advertising and promotion, travel and entertainment, executives’ salaries, office payroll, and office expenses.
Operating Income (EBIT): Determined by subtracting all operating expenses from the gross margin, operating income is revenue earned from operations.
Earnings Before Interests, Taxes, Depreciations and Amortizations (EBITDA): a type of net income that doesn’t take interest and tax payments, and depreciations and amortizations into account. It’s basically the income of a firm after subtracting Costs of Goods Sold and Operating Expenses.
To understand the difference between EBIT and EBITDA, go to this link
Income Tax Expense: Every company has an “effective tax rate” that is based on the level and nature of its income.
Interest Expense: The interest expense paid on debt. It must be paid periodically whether or not the company is profitable.
Net Income: The sum of all income and costs. If net income for the year is negative, the company records a loss for the year.
2.3. The statement of cash flows
Cash flows from financing activities include:
- Issuance of debt or equity securities
- Repayment of debt
- Distribution of dividends
Cash flows from investing activities include:
- Activities related to asset acquisition
- Activities related to asset disposal
Cash flows from operating activities include:
- Cash collected from customers Interest received and paid
- Dividends received
- Salary
- Insurance
- Tax payments
3. How to Analyze a Financial Statement
It is important to not only to understand a financial statement, but also to gather information about the company from its financial statements. Here is a quick walkthrough of important concepts and ratios that will help you analyze the financial health of a company.
3.1. Balance sheet
Working capital (current assets minus current liabilities) represents the amount of a company’s current assets that would be left if all current liabilities were paid. Companies that have a comfortable amount of working capital are more likely to meet short-term , expand its operations, and take advantage of opportunities, and therefore are more likely to attract conservative investors. Changes in working capital is often analyzed with regard to changes in cash flows to have a correct picture of the company’s financial health. in working capital and cash flow are not necessarily a good thing. On the other hand, decreases in working capital and cash flow can be a positive thing if the firm invests in new assets to expand its operations, which generate earnings in the long run.
More information on working capital can be found here.
Current Ratio (current asset divided by current liabilities) is one metric to gauge the working capital. In general, a current ratio of 2:1 is considered adequate.
Debt to equity ratio (total liabilities over total equity) indicates whether a company is using debt responsibly. Industrial companies normally try to maintain a debt-to-equity ratio of less than 1:1—thereby keeping debt at a level below the owners’ investment level. Utilities, service companies and financial companies often operate with much higher ratios.
Inventory turnover (Cost of goods sold over average inventory for a year): the number of times goods are bought, manufactured, and sold out on an annual basis.
Net Book Value refers to the amount of corporate assets backing a company’s bonds or preferred shares. Net book value per share is the amount of money each shareholder would receive if they company were to liquidate.
3.2. Income Statement
Operating margin is derived by dividing operating income for net sales. Changes in operating margin over time reflect a company’s financial health. Operating margins can also be compared among multiple companies in the same field. If a company’s operating margin is low compared with others, it is an unhealthy sign. Conversely, a comparatively high operating margin is a signal of financial health.
Operating cost ratio (operating cost divided by net sales) complements operating margin to reflect a company’s financial performance in the same way.
Net profit ratio is equal net income over net sales. Investors compare the net profit ratio from year to year and from company to company to evaluate progress, or the lack thereof.
Earnings per share (EPS) is calculated by dividing earnings available for common stocks by outstanding common shares. Investors are often more interested in a stock’s earnings than in its dividends, because earnings usually drive stock market prices.
Diluted earnings per common share is determined by dividing the adjusted earnings available to common shareholders by the average number of common and potential common shares outstanding. Here is one example of adjusted earnings: A reduction in interest expense on the conversion of convertible bonds will increase net income.
Price to earnings ratio: If a stock is selling at $25 per share and earning $2 per share annually, its P/E ratio is 12.5 to 1. Generally, a company with a high P/E multiple compared with other companies in its peer group is likely to produce higher profits in future. Remember, though, that the historical P/E multiple is a guide, not a guarantee. In reality, investors can never be certain that any stock will keep the same P/E ratio from year to year.
3.3. The long view
While it is important for accountants to know how to prepare these statements, for finance analysts, it is more important to draw conclusions from these statements. Investors and analysts can do so by comparing company reports over dates and time periods, across comparable companies and industry averages, or even macroeconomic factors to derive any useful information for them. Nowadays, companies’ financial disclosures often include a multiyear summary of their financial highlights. When looking at a financial statement across the time, you can draw significant conclusions by looking at these trends and consistencies:
- Revenue consistency and trends
- Earnings trends, particularly in relation to sales
- Net earnings trends as a percentage of sales
- ROE trends
- Net earnings per common share
- Dividends and dividend trends
Other key items that can be helpful include:
- Changes in net worth
- Book value per share
- Capital expenditures for plant and machinery
- Long-term debt
- Capital stock changes due to stock dividends and splits
- Number of employees
- Number of shareholders
- Number of outlets
Book value per shareHow are the 3 financial statements linked together?
- Beginning cash on the CF statement is cash from last period’s BS, and ending cash on CF statement is this period’s cash in the BS.
- is added to the last period’s retained earnings to get this period’s retained earnings on the BS.
- Depreciation Expense is calculated based on property, plant, and equipment (PP&E) from the Balance Sheet.
- Amortization Expense is calculated based on Amortizable Intangible Assets from the Balance Sheet
- Cash Flow from Investing is often primarily comprised of purchases and sales of PP&E, or other capital assets, including acquisitions. Capital Expenditures increase the PP&E account on the Balance Sheet.
If you can only choose 1 financial statement to evaluate the financial state of a company, which one should you choose?
Go for the cash flow statement. It shows you the liquidity of a business and how much cash it is using and generating. The balance sheet just shows a snapshot of the company at a moment in time without showing how effective the operation is. The income statement can be misleading because it might give you non-cash expenses that are irrelevant to the overall business.
What is the difference between accounts payable and accrued expense?
Both represent an expense that has not been paid in cash and both are reflected in calculating working capital. However, accounts payable is used for one-time expenses with invoices issued by suppliers, while recurring purchases with amounts estimated by the company.
What is the difference between accounts payable and prepaid expense?
Prepaid expenses are payments that have been made for products or services that will be delivered in the future, while accounts payable is a liability for goods and services been delivered but not yet paid in cash.
How can you tell whether or not an expense should appear on the Income Statement?
For an expense to appear on the income statement, it must correspond to something in the current period and it must be tax-deductible.
Let’s say that you have. (Depreciation or Amortization, for example) on the Income Statement. Why do you add back the entire expense on the Cash Flow Statement?
Non-cash expenses are tax-deductible. Adding back these expenses on the CF statement helps reflect the savings on taxes with the non-cash expenses.
How do you decide when to capitalize rather than expense a purchase?
If the purchase corresponds to an asset with a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Over years, it is Depreciated (tangible assets) or Amortized (intangible assets), and the depreciation/amortization expense is recorded.
Purchases like factories, equipment and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only “last” for the current period and therefore show up on the Income Statement as normal expenses instead.
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