You don’t have to be a CPA to understand financial statements. These documents simply present the financial position of a company.
Financial statements are a business’s report card. Their purpose is to show the movement of a company’s money.
You don’t have to be Einstein or have extensive accounting skills to understand them!
Let us help you with this complete guide to reading financial statements.
The Bare Basics of Financial Statements
Financial statements show you four things:
- The amount of money a company has
- The amount of debt a company owes
- The company’s income per month
- The company’s expenses
The majority of these statements have three parts:
- The balance sheet
- The income statement
- Cash flow statements
If the company has shareholders, the financial statement will also include statements of shareholders’ equity.
The Balance Sheet: A Quick Overview
The balance sheet provides a quick look at company assets, liabilities, and shareholders’ equity for a given period.
The “balance” means that a company’s assets must equal the sum of its liabilities and shareholders’ equity.
A balance sheet gives you condensed, detailed information about:
- A company’s assets
- A company’s liabilities
- A company’s shareholders’ equity
An asset is anything a company owns that has value. An asset can be something that is directly sold or something that is used by the company to sell a service or to manufacture and sell a product that can be sold.
Assets can include:
- Physical property, such as product inventory, buildings, and equipment
- Company investments
Assets on the Balance Sheet
There are two types of assets, usually listed according to how fast they can be converted to cash.
Current assets are assets that a company expects to quickly convert to cash, usually within a year. Examples of current assets are:
- Prepaid expenses
- Investments that are easily liquidated
- Accounts receivable (money owed to the company)
Noncurrent assets are ones that would take a company longer than a year to sell. Examples of noncurrent assets are:
- Long-term investments
- Investments in other companies
- Intangible assets such as brand recognition
Noncurrent assets also include fixed assets. Fixed assets are not sold or used by a company but are used to produce goods and services.
Fixed assets include:
- Equipment and machinery
- Computer equipment and software
- Intangible assets such as copyrights, patents, and trademarks
These are simply amounts of money that the company owes. Liabilities, like assets, come in many forms, including:
- Employee payroll
- Government taxes
- Bank loans for new product launches
- Customer obligations
- Rent for buildings and equipment
- Money owed to material suppliers
Liabilities on the Balance Sheet
Balance sheets list liabilities by their due dates.
Current liabilities are those expected to be paid off within a year. Companies must be sure that they have enough to pay these when they are due.
Examples of current liabilities include:
- Accounts payable
- Sales taxes payable
- Payroll taxes payable
- Short-term loans
- Interest payable
- Customer deposits
Long-term liabilities are those that are not due within one year of the balance sheet’s date. Examples of long-term liabilities are:
- Long-term loans
- Pension liabilities
- Bonds payable
Shareholders’ equity, also called capital or net worth, is the amount of money that would be left if a company were to pay off all liabilities and sell all of its assets.
This money would go to the shareholders of that company.
Shareholders’ Equity on the Balance Sheet
Shareholders’ equity will show the amount a shareholder invested in the company plus or minus any company earnings or losses.
Some companies retain earnings, while others distribute them as dividends.
The Income Statement
The income statement shows how much a company has earned over a specified period and includes the expenses and costs that came with those earnings.
It is on the income statement that you’ll see the company’s total, or net, earnings and losses over that period of time.
Income statements also include information for shareholders. By reporting earnings per share, these statements show how much shareholders would receive if net earnings from that period were distributed.
The Bottom Line
Income statements are where the phrase “bottom line” comes from. They start with net earnings, proceed with deductions from various expenses, and end with the amounts for what was earned or lost by the company.
This amount of earnings or loss is the “bottom line.”
There is a general progression to most income statements.
You will first find net sales, also referred to as net revenue, gross sales, or gross revenue. This is the total revenue before anything is taken out.
Cost of Sales
Second, you will find the cost of sales. This includes the cost to produce goods, cost of services rendered, and cost of inventory. This can also include:
- Cost of raw materials
- Cost of labor
- Commission for employees
After cost of sales expenses have been deducted, you’ll see the company’s gross profit, also called gross income.
Dividing this amount by the net sales amount gives you your gross margin. Simply put, out of every $1 you make, the gross margin shows you how much of that dollar is left for expenses after the cost of sales is deducted.
Gross profit will be used to cover all of the company’s other expenses. The greater the gross margin, the more total earnings a company will have.
Next, operating expenses will be listed. These are also referred to as Selling, General, and Administrative expenses (SG&A) and show general expenses of a company’s operation. This will include expenses such as:
- Administrative salaries
- Marketing expenses
- New product research
- Depreciation expense (wear and tear on assets over time)
After the operating expense, you’ll see operating profit, also known as operating income. This represents earnings from a company’s normal operations before any additional income or expenses are considered.
Interest Income and Expense
Interest income and expense will be listed next.
Income interest is money made by a company from anything that earns interest, such as money market funds or savings accounts.
Income expense is money that a company must pay to cover interest on money they have borrowed.
Income tax is estimated and is the final deduction made on the income statement.
The final number, whether it is a gain or a loss, is the “bottom line.” It indicates company profit or loss.
Cash Flow Statements
Cash flow financial statements show how much money is coming into and going out of a company. In other words, cash flow statements report how much cash a company generated during the statement period.
Cash is important; it buys assets and covers expenses. Good bookkeeping involves properly managing cash flow.
There are three parts to a cash flow statement.
This part breaks down a company’s cash flow from net losses or income.
Adjustments are made to net income for things like non-cash items that were calculated into the income statement and balance sheet. This clarifies how much actual cash was generated.
This part shows cash flow from investments. These investments can include purchases or sales of long-term assets such as property or equipment.
If a purchase is made, especially for expensive facilities or machinery used to produce goods, this is reflected as cash outflow.
If investments are sold by the company, the money made would show as cash inflow.
This part accounts for cash flow from any financing activity that company is involved in.
Cash inflow occurs when capital is raised, like when companies issue bonds to the public or borrow from a bank.
Cash outflow occurs when a company pays interest on loans or to bondholders, when they pay off loans, or when they distribute dividends.
Financial statements give you the information you need to calculate financial ratios.
These ratios are indicators of how well (or how poorly) a company is doing.
Is a company profitable? Is management spending too much and accumulating debt? Financial ratios will tell you.
Some of the most important financial ratios are:
- Price to cash flow ratio
- Price to earnings ratio
- Price to earnings growth ratio
- Asset turnover ratio
- Current ratio
- Debt to earnings ratio
Don’t Be Intimidated by Jargon
Different companies and accounting firms use vastly different terminology to fill in entries in their financial statements.
If you find this confusing, keep a financial dictionary on hand or use an online version. That way, you’ll be able to cut through the jargon and get to the numbers.
Preparing Your Financial Documents
The importance of financial statements can’t be overemphasized.
When carefully prepared, reviewed, and managed, financial statements provide invaluable insight into a company’s profitability and viability. Use this guide to help you better understand these documents and the details they contain!