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Beginners' Guide to
Financial Statements
The Basics
If you can read a nutrition label or a baseball box score, you can learn to
read basic financial statements. If you can follow a recipe or apply for a
loan, you can learn basic accounting. The basics arent difficult and they
arent rocket science.
This brochure is designed to help you gain a basic understanding of how to
read financial statements. Just as a CPR class teaches you how to perform
the basics of cardiac pulmonary resuscitation, this brochure will explain
how to read the basic parts of a financial statement. It will not train you to
be an accountant (just as a CPR course will not make you a cardiac doctor),
but it should give you the confidence to be able to look at a set of financial
statements and make sense of them.
Lets begin by looking at what financial statements do.
Show me the money!
We all remember Cuba Gooding Jr.s immortal line from the movie Jerry
Maguire, Show me the money! Well, thats what financial statements do.
They show you the money. They show you where a companys money came
from, where it went, and where it is now.
There are four main financial statements. They are: (1) balance sheets;
(2) income statements; (3) cash flow statements; and (4) statements of
shareholders equity. Balance sheets show what a company owns and what
it owes at a fixed point in time. Income statements show how much money
a company made and spent over a period of time. Cash flow statements
show the exchange of money between a company and the outside world
also over a period of time. The fourth financial statement, called a
statement of shareholders equity, shows changes in the interests of the
companys shareholders over time.
Lets look at each of the first three financial statements in more detail.
Balance Sheets
A balance sheet provides detailed information about a companys assets,
liabilities and shareholders equity.
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Assets are things that a company owns that have value. This typically
means they can either be sold or used by the company to make products or
provide services that can be sold. Assets include physical property, such as
plants, trucks, equipment and inventory. It also includes things that cant
be touched but nevertheless exist and have value, such as trademarks and
patents. And cash itself is an asset. So are investments a company makes.
Liabilities are amounts of money that a company owes to others. This can
include all kinds of obligations, like money borrowed from a bank to launch
a new product, rent for use of a building, money owed to suppliers for
materials, payroll a company owes to its employees, environmental cleanup
costs, or taxes owed to the government. Liabilities also include obligations
to provide goods or services to customers in the future.
Shareholders equity is sometimes called capital or net worth. Its the
money that would be left if a company sold all of its assets and paid off all
of its liabilities. This leftover money belongs to the shareholders, or the
owners, of the company.
The following formula summarizes what a balance sheet shows:
ASSETS = LIABILITIES + SHAREHOLDERS'
EQUITY
A company's assets have to equal, or "balance," the sum of its
liabilities and shareholders' equity.

A companys balance sheet is set up like the basic accounting equation
shown above. On the left side of the balance sheet, companies list their
assets. On the right side, they list their liabilities and shareholders equity.
Sometimes balance sheets show assets at the top, followed by liabilities,
with shareholders equity at the bottom.
Assets are generally listed based on how quickly they will be converted into
cash. Current assets are things a company expects to convert to cash
within one year. A good example is inventory. Most companies expect to
sell their inventory for cash within one year. Noncurrent assets are things
a company does not expect to convert to cash within one year or that
would take longer than one year to sell. Noncurrent assets include fixed
assets. Fixed assets are those assets used to operate the business but that
are not available for sale, such as trucks, office furniture and other
property.
Liabilities are generally listed based on their due dates. Liabilities are said
to be either current or long-term. Current liabilities are obligations a
company expects to pay off within the year. Long-term liabilities are
obligations due more than one year away.
Shareholders equity is the amount owners invested in the companys stock
plus or minus the companys earnings or losses since inception. Sometimes
companies distribute earnings, instead of retaining them. These
distributions are called dividends.
A balance sheet shows a snapshot of a companys assets, liabilities and
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shareholders equity at the end of the reporting period. It does not show
the flows into and out of the accounts during the period.
Income Statements
An income statement is a report that shows how much revenue a company
earned over a specific time period (usually for a year or some portion of a
year). An income statement also shows the costs and expenses associated
with earning that revenue. The literal bottom line of the statement
usually shows the companys net earnings or losses. This tells you how
much the company earned or lost over the period.
Income statements also report earnings per share (or EPS). This
calculation tells you how much money shareholders would receive if the
company decided to distribute all of the net earnings for the period.
(Companies almost never distribute all of their earnings. Usually they
reinvest them in the business.)
To understand how income statements are set up, think of them as a set of
stairs. You start at the top with the total amount of sales made during the
accounting period. Then you go down, one step at a time. At each step, you
make a deduction for certain costs or other operating expenses associated
with earning the revenue. At the bottom of the stairs, after deducting all of
the expenses, you learn how much the company actually earned or lost
during the accounting period. People often call this the bottom line.
At the top of the income statement is the total amount of money brought in
from sales of products or services. This top line is often referred to as gross
revenues or sales. Its called gross because expenses have not been
deducted from it yet. So the number is gross or unrefined.
The next line is money the company doesnt expect to collect on certain
sales. This could be due, for example, to sales discounts or merchandise
returns.
When you subtract the returns and allowances from the gross revenues,
you arrive at the companys net revenues. Its called net because, if you
can imagine a net, these revenues are left in the net after the deductions
for returns and allowances have come out.
Moving down the stairs from the net revenue line, there are several lines
that represent various kinds of operating expenses. Although these lines
can be reported in various orders, the next line after net revenues typically
shows the costs of the sales. This number tells you the amount of money
the company spent to produce the goods or services it sold during the
accounting period.
The next line subtracts the costs of sales from the net revenues to arrive at
a subtotal called gross profit or sometimes gross margin. Its considered
gross because there are certain expenses that havent been deducted
from it yet.
The next section deals with operating expenses. These are expenses that
go toward supporting a companys operations for a given period for
example, salaries of administrative personnel and costs of researching new
products. Marketing expenses are another example. Operating expenses
are different from costs of sales, which were deducted above, because
operating expenses cannot be linked directly to the production of the
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products or services being sold.
Depreciation is also deducted from gross profit. Depreciation takes into
account the wear and tear on some assets, such as machinery, tools and
furniture, which are used over the long term. Companies spread the cost of
these assets over the periods they are used. This process of spreading
these costs is called depreciation or amortization. The charge for using
these assets during the period is a fraction of the original cost of the
assets.
After all operating expenses are deducted from gross profit, you arrive at
operating profit before interest and income tax expenses. This is often
called income from operations.
Next companies must account for interest income and interest expense.
Interest income is the money companies make from keeping their cash in
interest-bearing savings accounts, money market funds and the like. On
the other hand, interest expense is the money companies paid in interest
for money they borrow. Some income statements show interest income and
interest expense separately. Some income statements combine the two
numbers. The interest income and expense are then added or subtracted
from the operating profits to arrive at operating profit before income tax.
Finally, income tax is deducted and you arrive at the bottom line: net profit
or net losses. (Net profit is also called net income or net earnings.) This
tells you how much the company actually earned or lost during the
accounting period. Did the company make a profit or did it lose money?
Earnings Per Share or EPS
Most income statements include a calculation of earnings per share or EPS.
This calculation tells you how much money shareholders would receive for
each share of stock they own if the company distributed all of its net
income for the period.
To calculate EPS, you take the total net income and divide it by the number
of outstanding shares of the company.
Cash Flow Statements
Cash flow statements report a companys inflows and outflows of cash. This
is important because a company needs to have enough cash on hand to pay
its expenses and purchase assets. While an income statement can tell you
whether a company made a profit, a cash flow statement can tell you
whether the company generated cash.
A cash flow statement shows changes over time rather than absolute dollar
amounts at a point in time. It uses and reorders the information from a
companys balance sheet and income statement.
The bottom line of the cash flow statement shows the net increase or
decrease in cash for the period. Generally, cash flow statements are divided
into three main parts. Each part reviews the cash flow from one of three
types of activities: (1) operating activities; (2) investing activities; and
(3) financing activities.
Operating Activities
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The first part of a cash flow statement analyzes a companys cash flow from
net income or losses. For most companies, this section of the cash flow
statement reconciles the net income (as shown on the income statement)
to the actual cash the company received from or used in its operating
activities. To do this, it adjusts net income for any non-cash items (such as
adding back depreciation expenses) and adjusts for any cash that was used
or provided by other operating assets and liabilities.
Investing Activities
The second part of a cash flow statement shows the cash flow from all
investing activities, which generally include purchases or sales of long-term
assets, such as property, plant and equipment, as well as investment
securities. If a company buys a piece of machinery, the cash flow statement
would reflect this activity as a cash outflow from investing activities
because it used cash. If the company decided to sell off some investments
from an investment portfolio, the proceeds from the sales would show up as
a cash inflow from investing activities because it provided cash.
Financing Activities
The third part of a cash flow statement shows the cash flow from all
financing activities. Typical sources of cash flow include cash raised by
selling stocks and bonds or borrowing from banks. Likewise, paying back a
bank loan would show up as a use of cash flow.
Read the Footnotes
A horse called Read The Footnotes ran in the 2004 Kentucky Derby. He
finished seventh, but if he had won, it would have been a victory for
financial literacy proponents everywhere. Its so important to read the
footnotes. The footnotes to financial statements are packed with
information. Here are some of the highlights:
Significant accounting policies and practices Companies are
required to disclose the accounting policies that are most important
to the portrayal of the companys financial condition and results.
These often require managements most difficult, subjective or
complex judgments.
Income taxes The footnotes provide detailed information about the
companys current and deferred income taxes. The information is
broken down by level federal, state, local and/or foreign, and the
main items that affect the companys effective tax rate are described.
Pension plans and other retirement programs The footnotes discuss
the companys pension plans and other retirement or
post-employment benefit programs. The notes contain specific
information about the assets and costs of these programs, and
indicate whether and by how much the plans are over- or under-
funded.
Stock options The notes also contain information about stock
options granted to officers and employees, including the method of
accounting for stock-based compensation and the effect of the
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method on reported results.
Read the MD&A
You can find a narrative explanation of a companys financial performance
in a section of the quarterly or annual report entitled, Managements
Discussion and Analysis of Financial Condition and Results of Operations.
MD&A is managements opportunity to provide investors with its view of
the financial performance and condition of the company. Its managements
opportunity to tell investors what the financial statements show and do not
show, as well as important trends and risks that have shaped the past or
are reasonably likely to shape the companys future.
The SECs rules governing MD&A require disclosure about trends, events or
uncertainties known to management that would have a material impact on
reported financial information. The purpose of MD&A is to provide investors
with information that the companys management believes to be necessary
to an understanding of its financial condition, changes in financial condition
and results of operations. It is intended to help investors to see the
company through the eyes of management. It is also intended to provide
context for the financial statements and information about the companys
earnings and cash flows.
Financial Statement Ratios and
Calculations
Youve probably heard people banter around phrases like P/E ratio,
current ratio and operating margin. But what do these terms mean and
why dont they show up on financial statements? Listed below are just
some of the many ratios that investors calculate from information on
financial statements and then use to evaluate a company. As a general
rule, desirable ratios vary by industry.
Debt-to-equity ratio compares a companys total debt to shareholders
equity. Both of these numbers can be found on a companys balance
sheet. To calculate debt-to-equity ratio, you divide a companys total
liabilities by its shareholder equity, or
Debt-to-Equity Ratio = Total Liabilities / Shareholders
Equity
If a company has a debt-to-equity ratio of 2 to 1, it means that the
company has two dollars of debt to every one dollar shareholders
invest in the company. In other words, the company is taking on debt
at twice the rate that its owners are investing in the company.
Inventory turnover ratio compares a companys cost of sales on its
income statement with its average inventory balance for the period.
To calculate the average inventory balance for the period, look at the
inventory numbers listed on the balance sheet. Take the balance
listed for the period of the report and add it to the balance listed for
the previous comparable period, and then divide by two. (Remember
that balance sheets are snapshots in time. So the inventory balance
for the previous period is the beginning balance for the current
period, and the inventory balance for the current period is the ending
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balance.) To calculate the inventory turnover ratio, you divide a
companys cost of sales (just below the net revenues on the income
statement) by the average inventory for the period, or
Inventory Turnover Ratio = Cost of Sales / Average
Inventory for the Period
If a company has an inventory turnover ratio of 2 to 1, it means that
the companys inventory turned over twice in the reporting period.
Operating margin compares a companys operating income to net
revenues. Both of these numbers can be found on a companys
income statement. To calculate operating margin, you divide a
companys income from operations (before interest and income tax
expenses) by its net revenues, or
Operating Margin = Income from Operations / Net
Revenues
Operating margin is usually expressed as a percentage. It shows, for
each dollar of sales, what percentage was profit.
P/E ratio compares a companys common stock price with its earnings
per share. To calculate a companys P/E ratio, you divide a companys
stock price by its earnings per share, or
P/E Ratio = Price per share / Earnings per share
If a companys stock is selling at $20 per share and the company is
earning $2 per share, then the companys P/E Ratio is 10 to 1. The
companys stock is selling at 10 times its earnings.
Working capital is the money leftover if a company paid its current
liabilities (that is, its debts due within one-year of the date of the
balance sheet) from its current assets.
Working Capital = Current Assets Current Liabilities
Bringing It All Together
Although this brochure discusses each financial statement separately, keep
in mind that they are all related. The changes in assets and liabilities that
you see on the balance sheet are also reflected in the revenues and
expenses that you see on the income statement, which result in the
companys gains or losses. Cash flows provide more information about cash
assets listed on a balance sheet and are related, but not equivalent, to net
income shown on the income statement. And so on. No one financial
statement tells the complete story. But combined, they provide very
powerful information for investors. And information is the investors best
tool when it comes to investing wisely.
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Modified: 02/05/2007
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