Financial Statements Made Simple (For Investors)

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financial statements made simple

What Are Financial Statements?

Financial statements are written records that convey a company’s business activities and financial performance. Government agencies, accountants, and firms, among others, frequently audit financial statements to ensure accuracy and for tax, financing, or investing purposes. The balance sheet, income statement, cash flow statement, and statement of changes in equity are the primary financial statements for for-profit businesses. Nonprofit organisations have a similar but distinct set of financial statements.

Key Takeaways

• Financial statements are written records that outline an organization’s operations and financial performance.
• The balance sheet gives a quick picture of the company’s assets, liabilities, and shareholders’ equity.
• The income statement is primarily concerned with a company’s revenues and expenses during a specific time period. After subtracting expenses from revenues, the statement yields a company’s profit figure known as nett income.
• The cash flow statement (CFS) measures a company’s ability to generate cash to pay debt obligations, fund operating expenses, and fund investments.
• The statement of changes in equity documents how profits are retained within a business for future growth or distributed to third parties.

Understanding Financial Statements

Financial information is used by investors and financial analysts to assess a company’s performance and forecast where the stock price will go in the future. The annual report, which includes the company’s financial statements, is one of the most significant sources of trustworthy and audited financial information.

Investors, market analysts, and creditors assess a company’s financial status and profits potential using its financial statements. The balance sheet, income statement, and statement of cash flows are the three main financial statement reports.

Important: Financial statements are not all made equal. The guidelines employed by American businesses are known as Generally Accepted Accounting Principles, while International Financial Reporting Standards are frequently adopted by businesses around the world (IFRS). Additionally, distinct financial reporting guidelines are used by U.S. federal departments.

Balance Sheet

A company’s assets, liabilities, and shareholders’ equity are outlined in the balance sheet as a snapshot in time. You may find out when the snapshot was taken by looking at the date at the top of the balance sheet, which is often the conclusion of the reporting period. A list of the components of a balance sheet is shown below.

Assets

• Liquid assets include cash and cash equivalents, such as Treasury bills and certificates of deposit.
• The sum of money owing to the business by its clients for the sale of its goods and services is known as accounts receivable.
• Inventory is the stock of items that a corporation has on hand and plans to sell regularly. Finished commodities, unfinished work in progress, and unprocessed raw materials may all be included in an inventory.
• Costs that have been paid in advance of their due dates are referred to as prepaid costs. These costs are recorded as an asset since their worth has not yet been appreciated; should this happen, the business would theoretically be entitled to a return.
• A firm owns property, plant, and equipment as capital assets for long-term gain. This includes structures that are utilised for production and large equipment that is used to process raw materials.
• Assets retained for potential future growth are called investments. These are merely held for capital appreciation and are not employed in operations.
• Although they cannot be physically touched, goodwill, patents, trademarks, and other intangible assets have potential economic (and frequently long-term) benefits for the business.

Liabilities

• The bills that are due as part of a business’s regular operations are known as accounts payable. Utility bills, rent statements, and commitments to purchase raw materials all fall under this category.
• Wages payable are sums owed to employees for hours worked.
• Notes payable are recorded debt instruments that document official debt agreements such as payment schedules and amounts.
• Dividends declared to be paid to shareholders but not yet received are referred to as dividends payable.
• Mortgages, sinking bond funds, and other loans with longer-than-one-year full payment due dates can all be considered long-term debt. Keep in mind that this debt’s short-term part is listed as a current liability.

Shareholders Equity

• A company’s entire assets less its total liabilities equals its shareholders’ equity. Shareholders’ equity, also called stockholders’ equity, is the sum of money that would be given back to shareholders if all of the company’s assets were sold and all of its debts were settled.
• The portion of nett earnings that was not distributed to shareholders as dividends is known as retained earnings and is included in shareholders’ equity.

Income Statement

The income statement, unlike the balance sheet, covers a period of time, which is a year for annual financial statements and a quarter for quarterly financial statements. The income statement summarises revenue, expenses, nett income, and earnings per share.

Revenue

The revenue generated by selling a company’s products or services is known as 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 company. Examples of non-operating revenue include:

• Interest earned on cash in the bank

• Rental income from a property

• Income from strategic partnerships like royalty payment receipts

• Income from an advertisement display located on the company’s property

Other income is the revenue earned from other activities. Other income could include gains from the sale of long-term assets such as land, vehicles, or a subsidiary.

Expenses

When a business engages in its main activity, it incurs major expenses in order to generate revenue from that activity. Cost of goods sold (COGS), selling, general and administrative (SG&A), depreciation or amortisation, and research and development are examples of expenses (R&D).

Employee salaries, sales commissions, utilities like electricity, and travel costs are examples of typical costs.

Interest on loans or debt is a cost associated with secondary activity. Expenses are also documented for losses on asset sales.

The income statement’s primary function is to communicate information about profitability and the financial outcomes of business operations, but it can also be a highly useful tool for demonstrating whether sales or revenue are rising when compared across several time periods.

In order to assess if a company’s attempts to lower its cost of sales will ultimately increase profits, investors can also look at how well a company’s management is controlling spending.

Cash Flow Statement

The cash flow statement (CFS) gauges how effectively a business earns cash to cover debt payments, operating costs, and investments. The balance sheet and income statement are enhanced by the cash flow statement.

Investors may learn how a firm operates, where its funding comes from, and how it spends money thanks to the CFS. The CFS offers information about a company’s financial stability as well.

A cash flow statement cannot be calculated using a specific formula. Instead, it has three sections that detail the cash flow for the many purposes that a business uses its funds. The following is a list of the three CFS components.

Operating Activities

Any sources and expenditures of money resulting from managing the company and making sales of its goods or services are included in the operating activities on the CFS. Any adjustments to cash accounts receivable, depreciation, inventory, and accounts payable are included in cash from operations. Wages, tax payments on income, interest payments, rent payments, and cash earnings from the sale of goods or services are also included in this list of transactions.

Investing Activities

Any sources and uses of money from a company’s investments in the long run of the company are considered investing activities. This group includes any payments connected to a merger or acquisition as well as the acquisition or sale of an asset, loans given to or received from suppliers, and customer loans.

Additionally, this part includes purchases of permanent assets like property, plant, and equipment (PPE). In other words, changes to investments, equipment, or assets are related to cash from investments.

Financing Activities

Funds used for financing comprises payments made to shareholders as well as cash obtained from banks or investors. Loans, dividend payments, stock repurchases, equity issuances, debt repayments, and loans are all examples of financing activities.

In three key company activities, the cash flow statement reconciles the balance sheet and the income statement.

Statement of changes in shareholder equity

The statement of changes in equity charts the evolution of total equity. The ending amount on the change in equity statement is equal to the total equity stated on the balance sheet, which shows how this information relates to a balance sheet for the same time period.

The formula for shareholder equity changes will differ from firm to company, but generally speaking there are two elements:

• Beginning equity: this is the equity at the end of the last period that simply rolls to the start of the next period.

• (+) Net income: this is the amount of income the company earned in a given period. The proceeds from operations are automatically recognized as equity in the company, and this income is rolled into retained earnings at year-end.

• (-) Dividends: this is the amount of money that is paid out to shareholders from profits. Instead of keeping all of a company’s profits, the company may choose to give some profits away to investors.

• (+/-) Other comprehensive income: this is the period-over-period change in other comprehensive income. Depending on transactions, this figure may be an addition or subtraction from equity.

Statement of Comprehensive Income

A statement of comprehensive income, a frequently underutilised financial statement, presents standard nett income while also taking changes in other comprehensive revenue into account (OCI). All unrealised profits and losses that are not shown on the income statement are included in other comprehensive income. This financial statement includes gains and losses that have not yet been recorded in accordance with accounting regulations. It also displays a company’s total change income.

The following are some instances of transactions that appear on the statement of comprehensive income:

• Net income (from the statement of income).

• Unrealized gains or losses from debt securities

• Unrealized gains or losses from derivative instruments

• Unrealized translation adjustments due to foreign currency

• Unrealized gains or losses from retirement programs

Limitations Of Financial Statements

Financial statements have limitations even if they offer a plethora of information about a company. Due to the statements’ ambiguity, investors frequently come to quite diverse conclusions about a company’s financial success.

For instance, some investors could prefer to see their money put in long-term assets, while other investors might favour stock repurchases. For one investor, a company’s level of debt may be acceptable, while for another, it might raise concerns.

It’s crucial to compare financial statements from different time periods to look for trends and to assess how the company’s performance compares to that of its competitors in the same sector.

Last but not least, the accuracy of financial statements depends on the data used to generate them. It has been proven far too frequently that erroneous financial activity or insufficient control supervision have resulted in financial statements that are meant to deceive users. There is a level of trust that users must invest in the authenticity of the report and the data being provided, even when studying audited financial records.

What Are the Main Types of Financial Statements?

The balance sheet, income statement, and cash flow statement are the three main types of financial statements. These three statements show a company’s assets and liabilities, revenues and costs, and cash flows from operating, investing, and financing activities.

What Are the Main Items Shown in Financial Statements?

Revenues, costs of goods sold, taxes, cash, marketable securities, inventory, short-term debt, long-term debt, accounts receivable, accounts payable, and cash flows from investing, operating, and financing activities are the most typical line items in a financial statement. The line items in a financial statement will vary depending on the corporation.

What Are the Benefits of Financial Statements?

Financial statements demonstrate a company’s operations. It gives information about a company’s assets, liabilities, operating expenses, cash flow management effectiveness, and how much and how a company earns revenue. A company’s management style is entirely revealed through its financial accounts.

How Do You Read Financial Statements?

There are various ways to read financial statements. To better comprehend changes throughout time, financial statements can first be compared to those from earlier times. Comparative income statements, for instance, show the income for a company both last year and this year. The users of financial statements are informed of the health of a company by noting the year-over-year change. Financial statements can also be interpreted by contrasting their performance with that of rivals or other market players. Analysts can better understand which businesses are outperforming the rest of the industry by comparing their financial statements to those of other businesses.

The Bottom Line

The key to an outside assessment of a company’s financial performance is its financial statements. While the income statement provides information on a firm’s profitability, the balance sheet provides information on the liquidity and solvency of the organisation. By keeping track of the sources and uses of money, a statement of cash flow links these two together. Financial statements taken as a whole show how a business is doing over time and in comparison to its rivals.

Financial Statements Made Simple Conclusion

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