How to Read and Understand Financial Statements
An ability to understand the financial statements of a company is one of the most critical skills for aspiring entrepreneurs, business managers, investors, and audit firms to develop. Armed with this ability, investors, business managers and entrepreneurs have a better chance of identifying promising business opportunities while avoiding unnecessary risk.
Financial statements provide information regarding an entity’s financial performance and position, which can be difficult to obtain using other means. While finance specialists and accountants are trained to read and understand these types of financial documents, many business professionals are not. The inability to understand financial statements and other similar reports results in obfuscation of highly critical and important information.
If you’re new to the world of financial reports and documents then we can help you with understanding financial documents, reports and terms that are necessary for someone that aspires to start a business, manage a business or invest in stocks.
Components of Financial Statements
A financial statement typically has five components which are listed below:
- Balance sheet
- Income statement
- Statement of cash flows
- Statement of changes in equity
- Footnote disclosures
A balance sheet provides information about an entity’s financial position at a given date. A balance sheet includes three essential financial sections which are as follows:
- Assets including both non-current and current assets
- Liabilities including both non-current and current liabilities
An asset can be defined as a resource owned or controlled by an individual, corporation, or government with the expectation that it will generate future economic benefits. An entity classifies its assets on the face of its balance sheet either as non-current assets or current assets
A company’s non-current assets are all those assets whose useful life is more than 12 months or those assets that cannot be easily and readily converted into cash and cash equivalents. Non-current assets are further divided into tangible and non-tangible assets. Non-current assets are also referred to as long term assets, fixed assets, or hard assets. A few examples of non-current assets are mentioned below:
- Plant and Machinery
Current assets represent all those assets of a company that are expected to be sold, used, consumed, or exhausted during the course of normal business operations within one year. Examples of current assets are as follows:
- Cash and cash equivalents
- Accounts receivables
- Short-term deposits
- Marketable securities
Liabilities can be defined as legal obligations arising due to past transactions or events and the settlement of which will result in the outflow of cash. A company classifies its liabilities either as non-current liabilities and current liabilities.
Non-current liabilities, also referred to as long-term liabilities, are debts or obligations that are due after a 12 month period. Non-current liabilities are an integral part of an entity’s long-term financing. Entities borrow long-term loan to obtain immediate capital to fund the purchase of fixed assets or to invest in new projects. Examples of non-current liabilities are as follows:
- Long-term notes payable
- Bonds payable
- Deferred tax liabilities
- Capital leases
- Mortgage payable
Current liabilities are debts or obligations that need to be settled within 12 months. Current liabilities should be closely monitored by the entity’s management to ensure that the entity possess adequate liquidity in the form of its current assets to guarantee that its obligations can be met. Examples of current liabilities are as follows:
- Interest payable
- Accounts payable
- Income taxes payable
- Bank account overdrafts
- Accrued expenses
- Short-term loans
An entity’s equity represents the stake of the shareholders in that entity. It is also referred to as the entity’s net assets as well. Equity appearing on the face of the balance sheet may include the following:
- Share capital
- Retained Earnings
- Revaluation Reserve
A balance sheet lists an entity’s assets on one side and its equity and liabilities on the other. The two halves of the sheet must be equal for the balance sheet to be balanced. In simple words balance sheet is prepared on the basis of the accounting equation in which assets are equal to the sum of liabilities and equity.
An income statement showcases a company’ profitability over a period of time, usually over the course of the company’s financial year. An Income statement is also referred to as statement of profit or loss, statement of operations or statement of earnings. This document is often shared as part of quarterly and annual reports, and shows financial trends, business activities (revenue and expenses), and comparisons between results of two or more financial periods. An income statement usually contains the following:
- Direct costs
- Gross profit
- Indirect expenses (Administrative and selling expenses)
- Net profit
Revenue represents the amount which an entity earns by selling goods or rendering services. It is also referred to as the “top line” because revenues are reported at the top of the income statement.
An income statement of a business breaks an entity’s revenue down by source – for most businesses, that means the sales of services, goods or both. A detailed income statement showcases revenue by month as well, displaying not just how the entity earns but when the business is most profitable.
Next, the income statement lists an entity’s direct costs (also referred as costs of goods sold), which includes all costs and expenses that are directly attributable towards creating and selling a product. For example, a tech-based company’s direct cost would include cost incurred on manufacturing each component of a laptop / personal computer, mobile phone, or tablet.
Gross Profit / Loss and Gross Profit / Loss Margin
An entity’s gross profit represents that how much that entity has earned from selling goods and/or services after accounting for all of its direct costs. If an entity’s direct costs exceed its revenue for a given period then its income statement for that period will show a gross loss. The gross profit/loss margin isn’t necessarily presented on the face of the income statement. However, it is included in annual reports as part of other financial information and analysis. The formulas for calculating gross profit/loss and gross profit/loss margin are as follows:
Gross Profit / Loss = Revenue – Direct Costs
In comparison, the formula for gross profit margin represents an entity’s gross profit as a percentage point. The formula for gross profit margin is as follows:
Gross profit / Loss Margin = Gross Profit / Revenue
Higher gross profit margin means that an entity is making more on each sale. In order to understand an entity’s profitability, you need to look both at gross profit and gross profit margin. A business may have a gross profit but a low profit margin, which could mean that the entity is not much profitable as it seems.
After gross profit, you’ll see a list of non-production costs or indirect expenses. These costs or expenses may include the following:
- General and administrative expense
- Selling and distribution expenses
- Research and development expenses (R&D)
The income statement then tallies up all the expenses except for the direct costs, which are then subtracted from the entity’s gross profit/loss to calculate the entity’s net profit/loss. An entity incurs a net loss when all its administrative and selling expenses exceed its gross profit.
A company’s income statement should also include its earnings per share (EPS). It refers to the amount each shareholder of the company would make per share of stock it’s holding if the company paid out all its net earnings today.
Statement of Cash Flows
A statement of cash flows (or cash flow statement) showcases how much cash is moving in and out of the entity. It also gives information about the sources the cash is coming into the business as well as where the cash is heading. So while an income statement reports on an entity’s profitability and a balance sheet provides information about an entity’s net assets, a statement of cash flows indicates whether a business is managing its funds wisely and effectively or no.
A statement of cash flows includes three main sections which are as follows:
- Cash flow from operating activities: Cash flow from operating activities is that section of an entity’s cash flow statement that represents the amount of cash a company consumes or generates from carrying out its operating activities over a specific period of time. Operating activities include generating income, paying expenses, and funding the entity’s working capital needs. It is calculated by taking an entity’s net income, adjusting it for non-monetary items, and then accounting for all the working capital changes.
- Cash flow from investing activities: This section of the cash flow statement includes cash generated by the entity from its investment portfolio as well as cash used by the entity in long-term investments, such as cash paid for new fixed assets.
- Cash flow from financing activities: This section of the cash flow statement shows the net flow of cash that is used for funding the company. Transactions that are presented under this section involve equity, debt and dividends.
An entity’s cash flow statement shows positive cash flow when more cash is flowing into the entity than it is going out. In other words, it means that the business is flourishing. An entity’s cash flow statement shows negative cash flow when cash outflow from the business is more than the cash inflow. For example, a company may be paying its suppliers on time but not recovering payments from customers on time.
Statements of Changes in Equity
The statement of changes in equity is a reconciliation of the beginning and ending balances in an entity’s equity during a reporting period. It is a common part of the annual financial statements. The statement begins with the opening equity balance, and then adds or subtracts items such as as profits and dividend payments to arrive at the closing balance. In simple words, the statement of changes in equity demonstrates whether the entity’s equity went up or down over a specific period of time.
The transactions that are most likely to appear on the statement of changes in equity are listed below:
- Net profit or loss
- Proceeds from the sale of stock
- Dividend payments
- Gains and losses recognized directly in equity
- Effects of changes in fair value for certain assets
- Effects of changes due to errors in prior periods
- Treasury stock purchases
Footnote disclosures are part of the financial statements. These are found at the end of an entity’s financials that give context and perspective to the company’s figures presented on the face of the company’s income statement and balance sheet.
Footnotes are also used as a way to convey the company’s approach in managing profit and loss and the accounting policies and practices followed in any given financial year. They also help the users of the financial statements in understanding as to how the entity arrived at the figures presented in the financial statements. The notes may also provide the entity’s stakeholders with additional information regarding employee stock options, pension plan funding, and deferred income tax payments.
It is absolutely essential for the financial statements users’ to read and understand the notes to the financial statements as numbers alone won’t tell you the full story. The context and perspective the footnotes provide can help you in understanding how well the company’s finances have been managed.
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