Beginners' Guide to Financial
Statements
The Basics
If you can read a nutrition label or a baseball box score, you
can learn to read basic financial statements. If you can follow
a recipe or apply for a loan, you can learn basic accounting.
The basics aren’t difficult and they aren’t rocket science.
This brochure is designed to help you gain a basic understanding
of how to read financial statements. Just as a CPR class teaches
you how to perform the basics of cardiac pulmonary
resuscitation, this brochure will explain how to read the basic
parts of a financial statement. It will not train you to be an
accountant (just as a CPR course will not make you a cardiac
doctor), but it should give you the confidence to be able to
look at a set of financial statements and make sense of them.
Let’s begin by looking at what financial statements do.
“Show me
the money!”
We all remember Cuba Gooding Jr.’s immortal line from the movie
Jerry Maguire, “Show me the money!” Well, that’s what
financial statements do. They show you the money. They show you
where a company’s money came from, where it went, and where it
is now.
There are four main financial statements. They are: (1) balance
sheets; (2) income statements; (3) cash flow statements; and
(4) statements of shareholders’ equity. Balance sheets show what
a company owns and what it owes at a fixed point in time. Income
statements show how much money a company made and spent over a
period of time. Cash flow statements show the exchange of money
between a company and the outside world also over a period of
time. The fourth financial statement, called a “statement of
shareholders’ equity,” shows changes in the interests of the
company’s shareholders over time.
Let’s look at each of the first three financial statements in
more detail.
Balance
Sheets
A balance sheet provides detailed information about a company’s
assets, liabilities and shareholders’ equity.
Assets are things that a company owns that have
value. This typically means they can either be sold or used by
the company to make products or provide services that can be
sold. Assets include physical property, such as plants, trucks,
equipment and inventory. It also includes things that can’t be
touched but nevertheless exist and have value, such as
trademarks and patents. And cash itself is an asset. So are
investments a company makes.
Liabilities are amounts of money that a company owes to
others. This can include all kinds of obligations, like money
borrowed from a bank to launch a new product, rent for use of a
building, money owed to suppliers for materials, payroll a
company owes to its employees, environmental cleanup costs, or
taxes owed to the government. Liabilities also include
obligations to provide goods or services to customers in the
future.
Shareholders’ equity is sometimes called capital or net
worth. It’s the money that would be left if a company sold all
of its assets and paid off all of its liabilities. This leftover
money belongs to the shareholders, or the owners, of the
company.
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The following formula summarizes what a balance sheet
shows:
ASSETS = LIABILITIES + SHAREHOLDERS' EQUITY
A company's assets have to equal, or "balance," the sum of its
liabilities and shareholders' equity.
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A company’s balance sheet is set up like the basic accounting
equation shown above. On the left side of the balance sheet,
companies list their assets. On the right side, they list their
liabilities and shareholders’ equity. Sometimes balance sheets
show assets at the top, followed by liabilities, with
shareholders’ equity at the bottom.
Assets are generally listed based on how quickly they will be
converted into cash. Current assets are things a company
expects to convert to cash within one year. A good example is
inventory. Most companies expect to sell their inventory for
cash within one year. Noncurrent assets are things a
company does not expect to convert to cash within one year or
that would take longer than one year to sell. Noncurrent assets
include fixed assets. Fixed assets are those
assets used to operate the business but that are not available
for sale, such as trucks, office furniture and other property.
Liabilities are generally listed based on their due dates.
Liabilities are said to be either current or long-term.
Current liabilities are obligations a company expects to
pay off within the year. Long-term liabilities are
obligations due more than one year away.
Shareholders’ equity is the amount owners invested in the
company’s stock plus or minus the company’s earnings or losses
since inception. Sometimes companies distribute earnings,
instead of retaining them. These distributions are called
dividends.
A balance sheet shows a snapshot of a company’s assets,
liabilities and shareholders’ equity at the end of the reporting
period. It does not show the flows into and out of the accounts
during the period.
Income
Statements
An income statement is a report that shows how much revenue a
company earned over a specific time period (usually for a year
or some portion of a year). An income statement also shows the
costs and expenses associated with earning that revenue. The
literal “bottom line” of the statement usually shows the
company’s net earnings or losses. This tells you how much the
company earned or lost over the period.
Income statements also report earnings per share (or “EPS”). This
calculation tells you how much money shareholders would receive
if the company decided to distribute all of the net earnings for
the period. (Companies almost never distribute all of their
earnings. Usually they reinvest them in the business.)
To understand how income statements are set up, think of them as
a set of stairs. You start at the top with the total amount of
sales made during the accounting period. Then you go down, one
step at a time. At each step, you make a deduction for certain
costs or other operating expenses associated with earning the
revenue. At the bottom of the stairs, after deducting all of the
expenses, you learn how much the company actually earned or lost
during the accounting period. People often call this “the bottom
line.”
At the top of the income statement is the total amount of money
brought in from sales of products or services. This top line is
often referred to as gross revenues or sales. It’s called
“gross” because expenses have not been deducted from it yet. So
the number is “gross” or unrefined.
The next line is money the company doesn’t expect to collect on
certain sales. This could be due, for example, to sales
discounts or merchandise returns.
When you subtract the returns and allowances from the gross
revenues, you arrive at the company’s net revenues. It’s called
“net” because, if you can imagine a net, these revenues are left
in the net after the deductions for returns and allowances have
come out.
Moving down the stairs from the net revenue line, there are
several lines that represent various kinds of operating
expenses. Although these lines can be reported in various
orders, the next line after net revenues typically shows the
costs of the sales. This number tells you the amount of money
the company spent to produce the goods or services it sold
during the accounting period.
The next line subtracts the costs of sales from the net revenues
to arrive at a subtotal called “gross profit” or sometimes
“gross margin.” It’s considered “gross” because there are
certain expenses that haven’t been deducted from it yet.
The next section deals with operating expenses. These are
expenses that go toward supporting a company’s operations for a
given period – for example, salaries of administrative personnel
and costs of researching new products. Marketing expenses are
another example. Operating expenses are different from “costs of
sales,” which were deducted above, because operating expenses
cannot be linked directly to the production of the products or
services being sold.
Depreciation is also deducted from gross profit. Depreciation
takes into account the wear and tear on some assets, such as
machinery, tools and furniture, which are used over the long
term. Companies spread the cost of these assets over the periods
they are used. This process of spreading these costs is called
depreciation or amortization. The “charge” for using these
assets during the period is a fraction of the original cost of
the assets.
After all operating expenses are deducted from gross profit, you
arrive at operating profit before interest and income tax
expenses. This is often called “income from operations.”
Next companies must account for interest income and interest
expense. Interest income is the money companies make from
keeping their cash in interest-bearing savings accounts, money
market funds and the like. On the other hand, interest expense
is the money companies paid in interest for money they borrow.
Some income statements show interest income and interest expense
separately. Some income statements combine the two numbers. The
interest income and expense are then added or subtracted from
the operating profits to arrive at operating profit before
income tax.
Finally, income tax is deducted and you arrive at the bottom
line: net profit or net losses. (Net profit is also called net
income or net earnings.) This tells you how much the company
actually earned or lost during the accounting period. Did the
company make a profit or did it lose money?
Earnings Per Share or EPS
Most income statements include a calculation of earnings per
share or EPS. This calculation tells you how much money
shareholders would receive for each share of stock they own if
the company distributed all of its net income for the period.
To calculate EPS, you take the total net income and divide it by
the number of outstanding shares of the company.
Cash Flow
Statements
Cash flow statements report a company’s inflows and outflows of
cash. This is important because a company needs to have enough
cash on hand to pay its expenses and purchase assets. While an
income statement can tell you whether a company made a
profit, a cash flow statement can tell you whether the company
generated cash.
A cash flow statement shows changes over time rather than
absolute dollar amounts at a point in time. It uses and reorders
the information from a company’s balance sheet and income
statement.
The bottom line of the cash flow statement shows the net increase
or decrease in cash for the period. Generally, cash flow
statements are divided into three main parts. Each part reviews
the cash flow from one of three types of activities:
(1) operating activities; (2) investing activities; and
(3) financing activities.
Operating
Activities
The first part of a cash flow statement analyzes a company’s cash
flow from net income or losses. For most companies, this section
of the cash flow statement reconciles the net income (as shown
on the income statement) to the actual cash the company received
from or used in its operating activities. To do this, it deducts
from net income any non-cash items (such as depreciation
expenses) and any cash that was used or provided by other
operating assets and liabilities.
Investing
Activities
The second part of a cash flow statement shows the cash flow from
all investing activities, which generally include purchases or
sales of long-term assets, such as property, plant and
equipment, as well as investment securities. If a company buys a
piece of machinery, the cash flow statement would reflect this
activity as a cash outflow from investing activities because it
used cash. If the company decided to sell off some investments
from an investment portfolio, the proceeds from the sales would
show up as a cash inflow from investing activities because it
provided cash.
Financing
Activities
The third part of a cash flow statement shows the cash flow from
all financing activities. Typical sources of cash flow include
cash raised by selling stocks and bonds or borrowing from banks.
Likewise, paying back a bank loan would show up as a use of cash
flow.
Read the
Footnotes
A horse called “Read The Footnotes” ran in the 2004 Kentucky
Derby. He finished seventh, but if he had won, it would have
been a victory for financial literacy proponents everywhere.
It’s so important to read the footnotes. The footnotes to
financial statements are packed with information. Here are some
of the highlights:
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Significant accounting policies and practices – Companies are required to disclose the accounting policies that
are most important to the portrayal of the company’s financial
condition and results. These often require management’s most
difficult, subjective or complex judgments.
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Income
taxes
– The footnotes provide detailed information about the
company’s current and deferred income taxes. The information
is broken down by level – federal, state, local and/or
foreign, and the main items that affect the company’s
effective tax rate are described.
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Pension
plans and other retirement programs – The footnotes discuss the company’s pension plans and other
retirement or post-employment benefit programs. The notes
contain specific information about the assets and costs of
these programs, and indicate whether and by how much the plans
are over- or under-funded.
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Stock
options
– The notes also contain information about stock options
granted to officers and employees, including the method of
accounting for stock-based compensation and the effect of the
method on reported results.
Read the
MD&A
You can find a narrative explanation of a company’s financial
performance in a section of the quarterly or annual report
entitled, “Management’s Discussion and Analysis of Financial
Condition and Results of Operations.” MD&A is management’s
opportunity to provide investors with its view of the financial
performance and condition of the company. It’s management’s
opportunity to tell investors what the financial statements show
and do not show, as well as important trends and risks that have
shaped the past or are reasonably likely to shape the company’s
future.
The rules governing MD&A require disclosure about trends, events
or uncertainties known to management that would have a material
impact on reported financial information. The purpose of MD&A is
to provide investors with information that the company’s
management believes to be necessary to an understanding of its
financial condition, changes in financial condition and results
of operations. It is intended to help investors to see the
company through the eyes of management. It is also intended to
provide context for the financial statements and information
about the company’s earnings and cash flows.
Financial
Statement Ratios and Calculations
You’ve probably heard people banter around phrases like “P/E
ratio,” “current ratio” and “operating margin.” But what do
these terms mean and why don’t they show up on financial
statements? Listed below are just some of the many ratios that
investors calculate from information on financial statements and
then use to evaluate a company. As a general rule, desirable
ratios vary by industry.
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Debt-to-equity ratio
compares a company’s total debt to shareholders’ equity. Both
of these numbers can be found on a company’s balance sheet. To
calculate debt-to-equity ratio, you divide a company’s total
liabilities by its shareholder equity, or
Debt-to-Equity Ratio = Total Liabilities / Shareholders’
Equity
If a company has a debt-to-equity ratio of 2
to 1, it means that the company has two dollars of debt to every
one dollar shareholders invest in the company. In other words,
the company is taking on debt at twice the rate that its owners
are investing in the company.
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Inventory turnover ratio
compares a company’s cost of sales on its income statement
with its average inventory balance for the period. To
calculate the average inventory balance for the period, look
at the inventory numbers listed on the balance sheet. Take the
balance listed for the period of the report and add it to the
balance listed for the previous comparable period, and then
divide by two. (Remember that balance sheets are snapshots in
time. So the inventory balance for the previous period is the
beginning balance for the current period, and the inventory
balance for the current period is the ending balance.) To
calculate the inventory turnover ratio, you divide a company’s
cost of sales (just below the net revenues on the income
statement) by the average inventory for the period, or
Inventory Turnover Ratio = Cost of Sales / Average
Inventory for the Period
If a company has an inventory turnover ratio
of 2 to 1, it means that the company’s inventory turned over
twice in the reporting period.
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Operating margin
compares a company’s operating income to net revenues. Both of
these numbers can be found on a company’s income statement. To
calculate operating margin, you divide a company’s income from
operations (before interest and income tax expenses) by its
net revenues, or
Operating Margin = Income from Operations / Net Revenues
Operating margin is usually expressed as a
percentage. It shows, for each dollar of sales, what percentage
was profit.
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P/E
ratio
compares a company’s common stock price with its earnings per
share. To calculate a company’s P/E ratio, you divide a
company’s stock price by its earnings per share, or
P/E Ratio = Price per share / Earnings per share
If a company’s stock is selling at P20 per
share and the company is earning P2 per share, then the
company’s P/E Ratio is 10 to 1. The company’s stock is selling
at 10 times its earnings.
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Working
capital
is the money leftover if a company paid its current
liabilities (that is, its debts due within one-year of the
date of the balance sheet) from its current assets.
Working Capital = Current Assets – Current Liabilities
Bringing It
All Together
Although this brochure discusses each financial statement
separately, keep in mind that they are all related. The changes
in assets and liabilities that you see on the balance sheet are
also reflected in the revenues and expenses that you see on the
income statement, which result in the company’s gains or losses.
Cash flows provide more information about cash assets listed on
a balance sheet and are related, but not equivalent, to net
income shown on the income statement. And so on. No one
financial statement tells the complete story. But combined, they
provide very powerful information for investors. And information
is the investor’s best tool when it comes to investing wisely.
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