How Do You Read Financial Statements | Investment Series

What Are Financial Statements?

Financial statements are written documents that represent the business operations and the financial performance of a corporation. Financial statements are routinely audited by government agencies, accountants, corporations, etc. to guarantee correctness and for tax, financing, or investment reasons. 

For-profit main financial statements comprise the balance sheet, income statement, statement of cash flow, and statement of changes in equity. Nonprofit organisations employ a comparable but separate set of financial statements.

KEY TAKEAWAYS

Financial statements are written documents that communicate the business operations and the financial performance of an organization.

The balance sheet gives a summary of assets, liabilities, and shareholders' equity as a snapshot in time.

The income statement mainly focuses on a company’s revenues and costs within a certain period. Once costs are removed from sales, the statement provides a company's profit number called net income.

The cash flow statement (CFS) indicates how successfully a firm earns cash to fulfil its debt commitments, support its operational expenditures, and fund investments.

The statement of changes in equity tracks how earnings are maintained inside a corporation for future development or given to external parties.

Financial Statements

Understanding Financial Statements

Investors and financial analysts depend on financial data to examine the success of a business and make forecasts regarding the future direction of the firm's stock price. One of the most essential pieces of trustworthy and certified financial data is the annual report, which comprises the firm's financial statements.

The financial statements are used by investors, market analysts, and creditors to assess a company's financial health and profits potential.

The three primary financial statement reports are the balance sheet, income statement, and statement of cash flows.

Not all financial statements are created equally. The standards used by U.S. firms is termed Generally Accepted Accounting Principles, but the regulations commonly utilized by overseas companies is International Financial Reporting Standards (IFRS) (IFRS). In addition, U.S. government entities employ a distinct set of financial reporting regulations.

Balance Sheet

The balance sheet offers a picture of a company's assets, liabilities, and shareholders' equity as a snapshot in time. The date at the top of the balance sheet shows you when the snapshot was taken, which is normally the conclusion of the reporting period. Below is a breakdown of the things in a balance sheet.

Assets

Cash and cash equivalents are liquid assets, which may include Treasury bills and certificates of deposit.

Accounts receivables are the amount of money due to the firm by its customers for the sale of its product and service.

Inventory is the items a firm on hand it plans to sell as a course of business. Inventory may comprise completed items, work in progress that are not yet done, or raw materials on hand that have yet to be processed.

Prepaid expenditures are costs that have been paid in advance of when they are due. These costs are recorded as an asset since the value of them has not yet been recognised; should the benefit not be realised, the firm would potentially be awarded a refund.

Property, plant, and equipment are capital assets held by a firm for its long-term benefit. This comprises structures used for manufacture for large machines used for processing raw materials.

Investments are assets kept for speculative future growth. These aren't employed in operations; they are just kept for capital appreciation.

Trademarks, patents, goodwill, and other intangible assets can't be physically be touched but have future economic (and often long-term advantages) for the firm.

Liabilities

Accounts payable are the invoices due as part of the usual course of operations of a firm. This comprises the utility payments, rent charges, and responsibilities to acquire raw materials.

Wages payable are payments owing to personnel for time worked.

Notes payable are documented debt instruments that reflect formal debt arrangements including the payment schedule and amount.

Dividends payable are dividends that have been declared to be distributed to shareholders but have not yet been paid.

Long-term debt might involve a number of commitments include sinking bond funds, mortgages, or other debts that are due in their whole in more than one year. Note that the short-term element of this loan is recognised as a current liability.

Shareholders' Equity

Shareholders' equity is a company's total assets less its total liabilities. Shareholders' equity (also known as stockholders' equity) reflects the amount of money that would be returned to shareholders if all of the assets were liquidated and all of the company's debt was paid off.

Retained earnings are part of shareholders' equity and represent the amount of net profits that were not given to shareholders as dividends.

Income Statement

Unlike the balance sheet, the income statement covers a span of time, which is a year for yearly financial statements and a quarter for quarterly financial statements. The income statement offers a summary of sales, costs, net income, and profits per share.

Revenue

Operating revenue is the money gained by selling a company's goods or services. The operational revenue for an auto manufacturing would be generated via the production and sale of vehicles. Operating revenue is earned from the fundamental business operations of a corporation.

Non-operating revenue is the money produced from non-core company activity. These revenues lie beyond the principal purpose of the firm. Some non-operating income examples include:

Interest generated on monies in the bank

Rental revenue from a property

Income from strategic alliances like royalty payment receipts

Income from an advertising display installed on the company's premises

Other income is the money obtained from other activities. Other revenue might include earnings from the sale of long-term assets such as property, automobiles, or a subsidiary.

Expenses

Principal costs are incurred during the process of obtaining money from the primary activity of the firm. Expenditures include the cost of goods sold (COGS), selling, general and administrative expenses (SG&A), depreciation or amortisation, and research and development (R&D) (R&D).

Typical expenditures include personnel salary, sales commissions, and utilities such as energy and transportation.

Expenses that are connected to secondary activity include interest paid on loans or debt. Losses from the selling of an asset are also recognised as costs.

The major objective of the income statement is to express information of profitability and the financial consequences of company operations; nevertheless, it may be quite useful in illustrating if sales or revenue is rising when compared across numerous periods.

Investors may also assess how effectively a company's management is managing expenditures to see if a company's efforts in decreasing the cost of sales could enhance profits over time.

Cash Flow Statement

The cash flow statement (CFS) indicates how successfully a firm earns cash to fulfil its debt commitments, support its operational expenditures, and fund investments. The cash flow statement supports the balance sheet and income statement.

The CFS lets investors to understand how a company's operations are working, where its money is coming from, and how money is being spent. The CFS also gives information as to whether a firm is on a strong financial foundation.

There is no method, per se, for computing a cash flow statement. Instead, it has three parts that show cash flow for the different activities for which a firm utilises its cash. Those three components of the CFS are given below.

Operating Activities

The operational activities on the CFS include any sources and uses of cash from running the firm and selling its goods or services. Cash from operations comprises any changes made in cash accounts receivable, depreciation, inventory, and accounts payable. These transactions also include wages, income tax payments, interest payments, rent, and cash revenues from the sale of a product or service.

Investing Activities

Investing operations encompass all sources and uses of funds from a corporation's investments in the long-term future of the company. A purchase or sale of an asset, loans paid to suppliers or received from consumers, or any payments linked to a merger or acquisition is covered in this category.

Also, acquisitions of permanent assets such as property, plant, and equipment (PPE) are mentioned in this section. In brief, changes in equipment, assets, or investments correspond to cash from investing.

Financing Activities

Cash from financing operations comprises the sources of cash from investors or banks, as well as the uses of cash delivered to shareholders. Financing operations include debt issuance, equity issuance, stock repurchases, loans, dividends paid, and repayments of debt.

The cash flow statement reconciles the income statement with the balance sheet in three primary company operations.

Statement of Changes in Shareholder Equity

The statement of changes in equity records total equity over time. This information connects back to a balance sheet for a similar time; the ending balance on the change of equity statement is equal to the total equity shown on the balance sheet.

The formula for changes to shareholder equity will differ from firm to company; in general, there are a few of components:

Beginning equity: this is the equity at the conclusion of the previous period that simply rolls to the start of the following period.

(+) Net income: this is the amount of money the firm generated in a certain time. The proceeds from operations are immediately recorded as equity in the firm, and this income is rolled into retained profits at year-end.

(-) Dividends: this is the amount of money that is paid out to shareholders from earnings. Instead of maintaining all of a firm's earnings, the corporation may opt to give some profits away to investors.

(+/-) Other comprehensive income: this is the period-over-period variation in other comprehensive income. Depending on transactions, this amount may be an increase or decrease from equity.

Statement of Comprehensive Income

An generally less used financial statement, a statement of comprehensive income presents normal net income while also integrating changes in other comprehensive income (OCI) (OCI). Other comprehensive income covers all unrealized profits and losses that are not recorded on the income statement. This financial statement illustrates a company's overall change income, despite gains and losses that have yet to be reported in conformity to accounting regulations.

Examples of transactions that are reported in the statement of comprehensive income include:

Net income (from the statement of income) (from the statement of income).

Unrealized profits or losses from debt securities

Unrealized profits or losses from derivative instruments

Unrealized translation changes owing to foreign currency

Unrealized earnings or losses from retirement schemes

Nonprofit Financial Statements

Nonprofit organisations document financial transactions across a comparable set of financial statements. However, because to the variations between a for-profit corporation and a completely altruistic organisation, there are discrepancies in the financial statements utilised. The basic set of financial statements used by a charitable corporation include:

Statement of Financial Position: this is the equivalent of a for-profit entity's balance sheet. The main distinction is nonprofit organisations do not have equity holdings; any leftover balances after all assets have been liquidated and obligations have been met is termed 'net assets'.

Statement of Activities: this is the equivalent of a for-profit entity's statement of revenue. This report chronicles the changes in operation over time including the reporting of contributions, grants, event income, and costs to make things happen.

Statement of Functional Expenses: this is particular to non-profit organisations. The statement of functional expenditures summarises spending by entity function (typically separated into administrative, programme, or fundraising expenses) (often broken into administrative, program, or fundraising expenses). This information is presented to the public to illustrate what percentage of company-wide costs are tied directly to the objective.

Statement of Cash Flow: this is the equivalent of a for-profit entity's statement of cash flow. Though the accounts presented may change owing to the diverse nature of a nonprofit organisation, the statement is still separated into operating, investing, and financing operations.

The function of an external auditor is to review whether an entity's financial statement have been produced in compliance with current accounting standards and if there are any substantial misstatements influencing the validity of results.

Limitations of Financial Statements

Although financial statements give a plethora of information about a firm, they do have limits. The statements are susceptible to interpretation, and as a consequence, investors frequently draw dramatically divergent conclusions about a company's financial performance.

For example, some investors would demand stock repurchases while other investors might like to see that money put in long-term assets. A corporation's debt level can be good for one investor while another might have worries about the degree of debt for the company.

When evaluating financial accounts, it's vital to compare different periods to identify whether there are any patterns as well as comparing the company's performance to its counterparts in the same industry.

Last, financial statements are only as trustworthy as the information being supplied into the reports. Too frequently, has been established that dishonest financial activities or insufficient control supervision have led to misstated financial statements meant to deceive users. Even when studying audited financial accounts, there is a degree of faith that consumers must invest into the veracity of the report and the statistics being provided.

What Are the Main Types of Financial Statements?

The three basic kinds financial statements are the balance sheet, the income statement, and the cash flow statement. These three statements collectively reveal the assets and liabilities of a firm, its revenues and expenses, as well as its cash flows from operating, investing, and financing operations.

What Are the Main Items Shown in Financial Statements?

Depending on the corporation, the line items in a financial statement will differ; however, the most common line items are 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.

What Are the Benefits of Financial Statements?

Financial statements demonstrate how a firm functions. It offers insight into how much and how a firm produces revenues, what the cost of doing business is, how effectively it manages its cash, and what its assets and liabilities are. Financial statements contain all the facts on how successfully or badly a firm operates itself.

How Do You Read Financial Statements?

Financial statements are interpreted in various different ways. First, financial statements may be compared to earlier periods to better comprehend changes over time. For example, comparative income statements indicate what a company's income was last year and what a company's income is this year. Noting the year-over-year change informs consumers of the financial statements of a company's health.

Financial statements can also read by comparing the performance to rivals or other industry players. By comparing financial statements to other firms, analysts may get a clearer idea on which companies are doing the best and which are underperforming the rest of the industry.

What Is GAAP?

Generally Accepted Accounting Principles (GAAP) is the collection of regulations under which United States corporations must compile their financial accounts. It is the standards that define how to record transactions, when to recognise income, and when costs must be acknowledged. International corporations may follow a similar but separate set of guidelines called International Financial Reporting Standards (IFRS) (IFRS).

In Conclusion

Financial statements are the passport to external examination of a company's financial performance.

The balance sheet reflects a company's financial health via its liquidity and solvency, whereas the income statement indicates a company's profitability.

A statement of cash flow links these two together by recording sources and uses of cash.

Together, financial statements explain how a firm is performing over time and against its rivals.

Happy Investing! 😉