What Are Financial Statements?
A financial statement summarizes a company’s financial performance and business activities. To ensure accuracy and for tax, financing, or investing purposes, financial statements are often audited by government agencies, accountants, and firms. The balance sheet, income statement, cash flow statement, and statement of changes in equity are the primary financial statements of a for-profit organization. Business financial statements are a good reference point for the financial statements of non-business entities. There are differences but not as many as you may think.
Banks use financial statements to determine whether a company is a good credit risk for their loans. Such financial statements are used by institutions and other groups considering a cash infusion or acquisition of the company to determine if the company is a worthwhile investment or acquisition target.
Understanding Financial Statements
Financial statements contain a wealth of information; you just need to know where to look. More than just a yardstick for past performance, your financial statements can provide significant clues for maximizing profitability, improving cash flow, and successfully growing your business.
They’ll help you make decisions, large and small, and maybe even point your company in directions you never dreamed of. Whether your business is brand new or several years old, there’s a lot to be learned from your financial statements, and now is the time to get started.
In addition to creating these statements for yourself, you may have to put them together for someone else to review. For example, the statement of profit and loss will show up on your company’s tax return. When you have a bank loan, the bank may want to monitor your balance sheet.
Then there’s the investor’s perspective. If you’re considering investing your hard-earned money in the stock market, check out the financial statements of any corporation that might make its way into your portfolio. The same information, presented in basically the same way, appears on every set of financial statements, whether they’re revealing the results of your small company’s first year in business or the financial performance of a Fortune 500 corporation.
The Income Statement
The income statement is the all-important financial statement that summarizes the profit-making activities of a business over a period of time.
An external income statement means that the financial statement is released outside the business to those entitled to receive it — primarily its shareowners and lenders. Internal financial statements stay within the business and are used mainly by its management; they aren’t circulated outside the business because they contain competitive and confidential information.
Revenue generated by the sale of a company’s products or services is called operating revenue. The production and sale of automobiles would generate operating revenue for an automobile manufacturer. Operating revenue is generated by a company’s core business activities.
Non-operating revenue is revenue generated by non-core business activities. These revenues are unrelated to the primary function of the business. Examples of non-operating revenues are:
- Interest on bank balances
- Rental income from real estate
- Royalty income from strategic partnerships
- Profits from an advertisement on the company’s premises.
Other income is income earned from other activities. Gains from the sale of long-term assets such as land, vehicles, or a subsidiary are examples of other income.
The cost of goods sold or cost of sales expense and the selling, general, and administrative expenses take the biggest bites out of sales revenue. The other three expenses (interest, income tax, and other expenses) are relatively small as a percent of annual sales revenue but are important enough in their own right to be reported separately.
And though you may not need this reminder, bottom-line profit (net income) is the amount of sales revenue in excess of the business’s total expenses. If either sales revenue or any of the expense amounts are wrong, then profit is wrong.
A service business does not sell products; therefore, it doesn’t have the traditional cost of goods sold expense (as it is not selling any tangible goods). In place of cost of goods sold, a service business often simply refers to the direct costs as costs of sales, which generally capture labor expenses for wages, payroll taxes, benefits, and other expenses that directly vary with sales revenue. Most service businesses are labor intensive; they have relatively large labor costs as a percent of sales revenue.
Service companies differ in how they report their operating expenses. For example, United Airlines breaks out the cost of aircraft fuel and landing fees. The largest expense of the insurance company State Farm is payments on claims. The movie chain AMC reports film exhibition costs separate from its other operating expenses. We offer these examples to remind you that accounting should always be adapted to the way the business operates and makes profit. In other words, accounting should follow the business model.
The Balance Sheet
A balance sheet provides a financial snapshot of your business, frozen at a particular point in time. Also known as the statement of financial position, this report gives you a comprehensive picture of where your business stands. The balance sheet contains current pictures of your assets, liabilities, and equity. Looking at it lets you see what your company has and how much it owes, and it reveals your updated equity share.
Balance sheets are usually prepared in a standard format to make it easier for people to compare different periods for a single company (usually for the business owners) or different companies in the same period (something potential investors or lenders might want to see). For business owners, this comparability between periods offers a glimpse of progress at a glance; for potential investors or lenders, the ability to compare apples to apples offers better information for making decisions.
There are two commonly used options for a standard balance sheet layout:
In the vertical format, the three categories are listed one after the other; assets come first, followed by liabilities, and finally equity. In the side-by-side format, assets appear on the left side of the statement, and liabilities and equity are located on the right. How you decide to lay it out is really a matter of personal preference. But no matter how your balance sheet is laid out, the report will always include the three permanent account categories:
- Owner’s equity
Your balance sheet also follows the rule of the accounting equation: assets must equal liabilities plus owner’s equity (with accounting software, it’s virtually impossible for the accounts to be out of balance).
- Current assets: Current assets include anything that’s expected to be converted into cash within a year of the balance sheet date. On the balance sheet, these assets are listed in order of liquidity. The assets that can be turned into cash the fastest are listed first.
- Long-term investments: Long-term investments are regular investments that your company owns as a way to generate extra income over the long haul. These investments can be stocks, bonds, mutual funds, or even land that the company is holding on to for investment purposes.
- Fixed assets: Common fixed assets owned by the majority of businesses include things like office furniture and equipment, computer systems, vehicles, and shop displays. If your company has fixed assets on the balance sheet, it will also have accumulated depreciation, which is recorded in the fixed-asset contra account that holds all of the depreciation expense that’s been accounted for so far.
- Intangible (or other) assets: Intangible assets include things such as patents and trademarks, which have plenty of value but no real physical form. Their decline in value is measured over time as amortization expense (quite similar to depreciation expense), but there’s usually no separate accumulated amortization contra account. Instead, for accounting purposes, the asset account gets decreased directly as it loses value over time.
Current liabilities include any debts or obligations that will come due within one year of the balance sheet date, mainly the day-to-day stuff, such as accounts payable and sales tax payable (you’ll notice that current liabilities have the word “payable” as part of their names). Current liabilities may also include accrued expenses (like taxes or wages, expenses incurred but not yet paid) for companies that use the accrual accounting method.
Long-term liabilities are debts and obligations that will be outstanding for more than one year; however, the part of a long-term liability that is due in the upcoming 12 months is usually put in the current category. Such long-term liabilities typically include loans, such as business startup loans or mortgages.
The final piece of the balance sheet is the owner’s equity, and its layout depends on the business entity. Sole proprietorships, partnerships, and most LLCs will have owner’s capital accounts. Corporations will have a combination of shareholder’s equity and retained earnings. Whichever form it takes, the owner’s equity reflects the net worth of the company.
Cash Flow Statement
Statements of cash flows are the most complicated of the standard financial reports prepared at the end of every accounting period. But accounting software makes their creation, at least, a snap.
This statement tracks a company’s cash movement, and it’s the most critical report for keeping your new business afloat. If you do decide to give it a go and create this report manually (try it at least once, for the experience), the ending cash balance will tell you immediately whether you’ve done it right or not. Simply, the ending cash balance has to equal the current cash number.
The statement of cash flows covers the same time period as the statement of profit and loss. For example, if the statement of profit and loss covers one month, then the statement of cash flows must also cover this same one-month span.
The statement of cash flows starts with the beginning cash balance for the period (which is the same as the ending cash balance for the last period). Then, there are three categories (formatted on the report into separate sections) that track the way cash flows in and out of your company:
- Operating activities
- Investing activities
- Financing activities
The operating activities section includes all the regular daily transactions that bring in or use up cash. Mainly, these will be revenues and expenses.
The investing activities section includes buying and selling long-term assets that are used by the company. These assets may include things such as stocks and bonds, as well as fixed assets and property improvements (for example, paying to have a building renovated).
The financing activities section includes the things you do to raise cash for your company. These activities might include taking out loans or bringing in more equity contributions; it would also include the payments you make as you pay down debt or pay out dividends.
Cash Flow Statement Format
You can use either of two different formats to prepare your statement of cash flows: direct or indirect. Of the two, the indirect format is simpler to prepare, and is much more popular for that reason. The format difference really appears only in the operating activities section; the other sections look the same either way.
The Direct Method
The direct method focuses on grouping the major sources of cash receipts and causes of cash payments. For example, cash used to pay for inventory is listed separately from cash used to pay employees. The cash coming in and the cash going out are summed to come up with the total cash provided (or used, if it’s negative) by operating activities.
This can get complicated for companies using the accrual accounting method, which may not separate cash and non-cash transactions. For example, all sales would be recorded in the sales account whether they were cash or on-account sales. Because cash transactions appear on this statement, companies who want to use the direct method may have to alter the way they record and track transactions.
The Indirect Method
The indirect method starts with your net income (or net loss) for the period and converts it into cash flow. For example, non-cash expenses such as depreciation are added back to the bottom-line number, and accruals and deferrals (used in accrual basis accounting) are converted into their cash effect. Here’s how conversion works: A decrease in accounts receivable from the period prior to this one indicates more cash has come in, since accounts receivable decrease based on customer payments. That converts on-account sales information into the cash effect for this period.
The basic conversion strategy is this: Increases in assets, such as accounts receivable, translate to decreases in cash, and vice versa; increases in liabilities, such as accounts payable, translate to increases in cash, and vice versa.
Whichever statement style you choose, the results will be the same. Either style will clearly trace the movement of cash in and out of your business. Most accounting software programs will let you choose the style you prefer, and switch back and forth between them.
Statement of Changes in Shareowners’ Equity
Many business financial reports include a fourth financial statement — or at least it’s called a “statement.” It’s really a summary of the changes in the constituent elements of owners’ equity (stockholders’ equity of a corporation). The corporation is one basic type of legal structure that businesses use.
When a business has a complex owner’s equity structure, a separate summary of changes in the components of owners’ equity during the period is useful for the owners, the board of directors, and the top-level managers.
On the other hand, in some cases, the only changes in owners’ equity during the period were earning profit and distributing part of the cash flow from profit to owners. In this situation, there isn’t much need for a summary of changes in owners’ equity. The financial statement reader can easily find profit in the income statement and cash distributions from profit (if any) in the statement of cash flows.
The formula for the change in equity varies from company to company; generally there are two components:
- Beginning equity: this is equity that has been carried forward from the end of the previous period to the beginning of the current period.
- (+) Net income: the amount of money earned by the company in a given period. The income from operations is automatically recorded as the company’s equity and transferred to retained earnings at the end of the fiscal year.
- (-) Dividend: the amount of money distributed to shareholders from profits. Instead of retaining all of a company’s profits, it may choose to distribute a portion of its profits to investors.
- (+/-) Other comprehensive income: the change in other comprehensive income from one period to the next. This figure may represent an addition or subtraction to equity, depending on the transaction.
How To Read Financial Statements?
Now that you know how to prepare these important financial statements, let’s take a look at what they can tell you.
At face value, your financial statements tell you a lot about your company’s performance. The statement of profit and loss lets you know how much the company sold, and whether those sales resulted in overall profitability. The balance sheet tells you where the company stands right now and gives you a look at the overall financial position.
The statement of cash flows informs you of how cash moves through your business, and whether operations are supplying or draining cash. All of this data is critical to your future plans, but it’s really just a small part of the total knowledge you can gain from these exceptionally enlightening reports.
When you delve deeper into these statements and add a little math to the mix, you will open up a whole new world of information that you can use to make your business a better one. With critical analysis, the relationships among the accounts become clearer, as does the impact they can have on one another. Different ways of measuring the same numbers offer new perspectives and insights and can spark innovative and profitable ideas. Your financial statements can tell you things such as:
- Whether your company has sufficient liquidity
- Whether the company is holding too much inventory
- Whether you need to revisit customer payment terms
- Whether you’re charging enough for your products and services
- How to put your assets to better use
- When it’s safe to take on some debt
- Whether serious financial problems are on the horizon
- How well your company stacks up to competitors
- How well the company fares according to industry standards
- Whether your company is ready to grow
The more you know about your business, the better its chances of success. Noticing potential problem areas before they blossom into full-grown crises can save a business from ultimate failure. Planning and allowing for growth before it kicks in helps your company expand in the most profitable ways. Your financial statements contain all of this information; all you have to do is analyze it.
Check The Working Capital That Measures Financial Health
You can tell a lot about a company’s current financial well-being by looking at its working capital. This simple balance sheet calculation lets you see how efficiently a company is using its resources. To calculate working capital, you subtract current liabilities from current assets:
current assets – current liabilities = working capital
Why is this so important? Because if a company’s current liabilities exceed its current assets, the company may not be able to pay its bills, at least in the short term. In the most extreme cases, negative working capital can end in bankruptcy or the dissolution of the business. In addition, working capital gives an indication of how efficiently the company is operating. If the working capital figure is very high, it could indicate that the company has too much inventory (or slow-moving inventory) on hand, or that its accounts receivable customers aren’t paying their bills promptly. Assets tied up as inventory or accounts receivable are still current assets, but they can’t be used to pay the bills.
To see at a glance where the working capital of your company (or a company you’re thinking about investing in) falls on the scale, calculate the working capital ratio, which is simply total current assets divided by total current liabilities. A healthy working capital ratio generally falls between 1.2 and 3.0, depending on the size of the business and the industry it’s in. If the working capital ratio is below 1.0, it means the company has negative working capital, and may not be able to pay its current bills on time. The working capital ratio may also be called the current ratio.
Look At The Ratios That Reveal A Company’s Performance
In addition to knowing the working capital and the working capital (or current) ratio, there are a couple more ratios that can let you know how a company is faring.
The Quick Ratio
The quick ratio is similar to the current ratio, but leaves inventory out of the calculation. Computing the quick ratio can give you a more honest assessment of a company’s ability to pay its current bills. Here’s how you calculate the quick ratio:
(current assets – inventory) ÷ current liabilities
The reason some business gurus recommend focusing on this ratio is that inventory can’t always be counted on to bring in as much cash as was laid out to buy it. For example, if your shop needs to clear out bathing suits to make room for winter coats, you might sell those lingering bathing suits at deep discounts—even below your cost—just to get rid of them. Plus, inventory doesn’t always sell as quickly as you’d like it to.
The Debt to Equity Ratio
Another good measure of a company’s solvency—this time over the long haul— is its debt-to-equity ratio. Here’s how you figure out the debt to equity ratio for a business:
total liabilities ÷ total equity
This calculation lets you know exactly how dependent a company is on debt to survive. If debt outweighs equity (which means ownership), that could indicate financial trouble on the horizon. For that reason, a lower number is more favorable than a higher number.
Pay Attention to the Footnotes
There’s a saying among financial professionals: Accountants hide the problems in the footnotes. Problems are hidden there because financial statement footnotes are a lot like fine print; most of us don’t have the stomach to read all the way through it. Some companies use that to their advantage.
That sounds fishy, but it isn’t. In fact, it’s perfectly legal and extremely common for that kind of information to be disclosed in the corporation’s financial statement footnotes. And even when a company has nothing to hide, the footnotes can offer deeper insights into the company’s current operations and future plans—and that’s information investors need to know. The footnotes explain all numbers found in the financial statements, spelling out how they were calculated and detailing explanations of the results.
In the first section of the footnotes (the explanatory information for the financial statements) you’ll find the specifics of the corporation’s accounting practices,including which valuation methods they’ve used and when they recognize revenue, a critical part of the company’s earnings. To assess whether or not their choices make sense, you can look into what the industry standard is to see whether this company is following it. If it’s not, and the corporation you’re thinking of buying into is using a more aggressive accounting method, then it could be a red flag that the company is trying to hide negative performance or use an accounting trick to make the results seem better than they were.
The next section of the footnotes typically includes detailed disclosures, mainly information the company must provide that doesn’t quite fit neatly into the financial statements. Some information you might find here would be details about:
- Error corrections
- Accounting adjustments
- Changes in accounting procedures
- Long-term debt
- ESOPs (employee stock ownership plans)
- Outstanding stock options
- Ongoing or upcoming legal battles
Keep in mind that the language in financial statement footnotes is often full of legal jargon, making it very challenging to slog through. Though it’s not always the case, lengthy paragraphs and complex language can be used to conceal things the corporation doesn’t want investors to read about. In a now classic example, Enron actually disclosed most of their misdeeds in the footnotes to their financial statements, but practically no one read them.
Before you invest even $1 in a corporation’s stock, take a good look at its most recent financial statements (preferably for the last few years). The same information you would use to assess your own company’s health and potential can tell you a lot about a prospective investment.
While you can find this information in the company’s slickly packaged annual report, to cut through the propaganda and hyperbole go straight to the audited financial statements they’re required to file with the SEC (Securities and Exchange Commission).
On its website (www.sec.gov), the SEC has an online comprehensive database called EDGAR (Electronic Data Gathering, Analysis, and Retrieval) that holds every corporate filing submitted to the agency—more than 20 million documents. There, the annual audited financial statements are included in a filing called the 10-K. EDGAR gives individual investors access to the same information at the same time as massive institutional investors.