What Does Reading Financial Statements Involve?

Financial statements are structured reports providing a window into a company’s financial health and activities. For anyone interested in a business’s performance, learning to read these documents is a valuable skill. The three core statements are the balance sheet, the income statement, and the statement of cash flows.

The balance sheet is a snapshot of what a company owns and owes at a single point in time. The income statement summarizes financial performance over a period, while the statement of cash flows tracks the movement of cash during that same period. Together, they form a comprehensive picture of a company’s financial standing.

The Balance Sheet A Snapshot of Financial Position

The balance sheet is structured around the fundamental accounting equation: Assets = Liabilities + Shareholders’ Equity. This equation shows that a company’s resources are claimed by either its creditors or its owners.

Assets

Assets are economic resources a company owns that have future value and are categorized based on how quickly they can be converted into cash. Current assets are expected to be converted to cash within one year and include cash, accounts receivable (money owed by customers), and inventory.

Non-current assets, or long-term assets, are not expected to be converted to cash within a year. This category includes property, plant, and equipment (PP&E) and intangible assets like patents, copyrights, and goodwill. Goodwill is created when a company acquires another business for a price that exceeds the fair value of its identifiable assets less the liabilities assumed.

Liabilities

Liabilities are a company’s financial obligations to other parties, classified by their due date. Current liabilities are due within one year and include accounts payable (money owed to suppliers) and short-term debt.

Long-term liabilities are obligations due more than one year out. This category includes long-term debt, such as bank loans or bonds, as well as deferred tax and pension fund liabilities. Analyzing the structure of a company’s liabilities can provide insight into its financial leverage and risk.

Shareholders’ Equity

Shareholders’ equity is the company’s net worth, representing the owners’ residual interest after deducting liabilities. Its main components are common stock, which is capital from investors, and retained earnings.

Retained earnings are the cumulative net income earned over time, less any dividends paid to shareholders. This account links the income statement to the balance sheet, as net income is added to the retained earnings balance each period. A healthy and growing shareholders’ equity balance is often seen as a positive indicator of financial stability.

The Income Statement A Measure of Performance

The income statement, or profit and loss (P&L) statement, reports a company’s financial performance over a period. It subtracts expenses from revenues to determine the net income, also known as the “bottom line.”

Revenue and Cost of Goods Sold

The statement begins with revenue, the total money generated from sales. Next, the cost of goods sold (COGS) represents the direct costs of producing those goods, such as materials and labor. Subtracting COGS from revenue yields the gross profit. A low gross profit might indicate that the costs of production are too high or that the company’s pricing strategy is not effective.

Operating Expenses and Operating Income

Operating expenses are costs from a company’s normal business activities not directly tied to production. These include selling, general, and administrative (SG&A) expenses like salaries and rent, as well as research and development (R&D) costs. Subtracting operating expenses from gross profit results in operating income, which shows the profit generated from core business operations before interest and taxes. A consistent and growing operating income suggests a healthy and efficient core business.

Non-Operating Items and Net Income

Non-operating items include revenues and expenses not related to principal activities, such as interest expense and interest income. After these items are accounted for, the company subtracts tax expense to arrive at net income. Net income is the final profit figure and indicates the company’s overall profitability for the period.

The Statement of Cash Flows Tracking the Movement of Cash

The statement of cash flows summarizes a company’s cash inflows and outflows over a period. It reconciles the net income from the income statement with the actual change in cash. The statement is divided into three activities: operating, investing, and financing.

Cash from Operating Activities

Cash flow from operating activities is the cash generated from a company’s main business functions. This calculation starts with net income and adjusts for non-cash expenses, like depreciation, and changes in working capital. For example, an increase in accounts receivable reduces operating cash flow. Conversely, a decrease in inventory suggests the company sold more than it purchased, resulting in a cash inflow.

Cash from Investing Activities

Cash flow from investing activities includes the purchase and sale of long-term assets and other investments. Common examples are the purchase of property, plant, and equipment (a cash outflow) or the sale of assets (a cash inflow). These transactions are important for understanding a company’s long-term growth strategy.

Cash from Financing Activities

Cash flow from financing activities includes transactions with a company’s owners and creditors. These activities show how a company raises capital and repays investors. Common financing activities include:

• Issuing stock (cash inflow)
• Paying dividends to shareholders (cash outflow)
• Borrowing money from a bank or issuing bonds (cash inflow)
• Repaying debt (cash outflow)

The net cash flow from all three activities is added to the beginning cash balance to determine the ending cash balance for the period. This ending balance must match the cash amount on the balance sheet.

How the Three Core Statements Interconnect

The three financial statements are intricately linked and tell a cohesive story. Net income from the income statement flows to the balance sheet through the retained earnings account and is the starting point for the statement of cash flows. The ending cash balance from the cash flow statement must match the cash reported on the balance sheet. Activities on the cash flow statement, like buying equipment or issuing debt, directly alter asset and liability balances.

The Role of Footnotes and Management Discussion

To gain a complete understanding, it is necessary to review the accompanying footnotes and the Management Discussion and Analysis (MD&A). These sections provide context to supplement the financial data.

The footnotes explain the accounting policies used to prepare the statements. For example, a footnote might describe the specific method used to value inventory, such as first-in, first-out (FIFO) or last-in, first-out (LIFO), which can impact reported profits. This detail is important as accounting rules can differ; LIFO is permitted in the United States but not under many international standards.

The Management Discussion and Analysis section provides management’s perspective on the company’s financial results. In the MD&A, leadership discusses trends, events, and uncertainties affecting the business, offering insight into company strategy and its future outlook.