Financial Statement Fundamentals
Updated: Nov 30, 2020
I've gotten a lot of feedback from people saying that they appreciate the content we've been publishing, but that they would like more posts covering some of the very basics. In light of this, I have decided to put together this brief primer on financial statements to quickly review what they are and how they work together.
So, what are financial statements? They are the primary means of communicating financial information to those with a specific economic interest in the business. This includes those with direct economic interest in the business such as managers, employees, suppliers, creditors, or investors. It also includes those with indirect interests in the business such as financial analysts, stock exchanges, or regulators. Users may be external to the firm or internal to the firm. External users will use the reported financial information to determine if they should do business with the firm, or if the firm is in compliance with applicable regulations in the case of regulatory agencies. External users usually require reports to conform to commonly accepted accounting standards known in the US as GAAP - which stands for generally accepted accounting principles. Internal users generally use financial statements to make decisions regarding the operation of the business. This may result in internal financial statements that do not conform with GAAP, which occurs if management finds it more useful for decision making to display information in a different format. An example would be a variable costing income statement. We won't go into detail on that though since it is beyond the scope of this primer.
A full set of financial statements includes the following:
Income Statement (Profit & Loss Statement)
Statement of Comprehensive Income
Balance Sheet (Statement of Financial Position)
Statement of Changes in Equity
Statement of Cash Flows
Since I want to keep this brief, I will focus on the big three for our discussion here: the income statement, the balance sheet, and the statement of cash flows.
Before I dive in though, one thing you need to be aware of when you are reviewing your financial statements is what basis of accounting they are using. The basis of accounting basically describes when you recognize transactions. There are two kinds:
Accrual Basis - this basis is allowed under GAAP for financial reporting. It recognizes the financial effects of transactions when they occur, not when the cash is received or paid out. Revenues are recognized in the period they are earned even if the cash is received in the future, and expenses are recognized when they are incurred even if the cash will be paid in the future.
Cash Basis - this basis is not allowed under GAAP for financial reporting. It recognizes transactions when the actual cash enters or leaves the company. Revenues are recognized when the cash is received and expenses are recognized when they are paid.
We will be discussing these financial statements under the assumption that they are prepared on the accrual basis. Now that we have that cleared up, let's dive in.
Also called the "Profit & Loss Statement", this is the financial statement I find business owners are most familiar with. It reports the business's operations over a period of time, generally over one year or year-to-date, but it is commonly also reported by month or by quarter. It shows the net income generated by the firm during the period in question. It generally breaks this down into the following elements:
Revenues - usually these are inflows resulting from delivering or producing goods, providing services, or whatever the entity's main operations are.
Expenses - usually these are outflows resulting from costs incurred while delivering or producing goods, providing services, or doing whatever the entity's main operations are.
Gains/Losses - the most common instance of this results from selling an asset above or below its recorded value in your accounting system. Technically gains are usually increases in equity or net assets by some means other than the entity's main operations and losses are usually decreases in equity or net assets by some means other than the entity's main operations.
At the end of each fiscal year, the net income is moved to retained earnings (an equity account), minus any dividends distributed during the reporting period the income statement covered. This is why each income statement, and the associated accounts, are zero at the beginning of each new fiscal year.
A common Income Statement is shown below. It is prepared using the multi-step approach, which simply means it calculates net income using multiple steps and groupings. This is the most common approach.
The income statement does have some limitations you should be aware of. First, it does not always show all items of income and expense. Some more obscure changes (translation gains from foreign currency translation for example) show up in the statement of comprehensive income. Going into detail on these is beyond the scope of this primer. Also, if your statements are prepared on the accrual basis (and most are) the cash received will likely not equal the reported revenue and the net change in cash will not equal the net income. This is what the statement of cash flows helps to rectify. Also, some of the items on the income statement will require management judgement for how to best represent and report them. Lastly, understand that no one financial statement will give you a comprehensive view of the company. You need to look at all of them in conjunction to get a reasonably full picture.
Also called the "Statement of Financial Position", this statement shows the amount of Assets (items of value), Liabilities (debt/obligations), and Equity (net worth basically) of the firm. In contrast to the income statement, which looks at the business over a period of time, the balance sheet is a snap shot of the business at a single moment in time - usually the end of a quarter or the fiscal year. This statement is an expression of the old accounting equation you may have heard of: Assets = Liabilities + Equity. It is called the balance sheet because the Assets must always equal (or balance with) the sum of the Liabilities and Equity. The balance sheet also helps show how the entity is financially structured. But what exactly are Assets, Liabilities, and Equity? Let's look at these a little deeper:
Assets - assets are the resources controlled by the business. They represent a likely future benefit to the company. They are usually organized into two sub-categories: current and non-current.
Current assets are any assets that are expected to be converted to cash, consumed, or sold within one year. Current assets generally include cash, accounts receivable (invoices to customers that haven't been paid yet), inventory, and prepaid expenses. Occasionally, they will include other items as well.
Non-current assets are assets that aren't current; they have expected durations longer than one year. Typical non-current assets include Property, Plant, and Equipment (PPE), and intangible assets (like a patent). There are some other assets that can show up here but we won't go into them now.
Liabilities - liabilities represent obligations or claims against the assets of the firm. They generally are expected to result in an outflow of cash for the company. These are also usually organized into two sub-categories: current and non-current. As with assets the delineation is based on timing.
Current liabilities are those liabilities that will be resolved within one year of the balance sheet date. Common current liabilities include accounts payable (vendor invoices you have not paid), other payables (such as accrued wages), unearned revenues, short-term loans (like a line of credit or credit card), and various other short-term items.
Non-current liabilities are those liabilities that aren't current. These can include long-term notes payable (loans) and various other long-term obligations.
Equity - equity is the residual interest in the assets after the liabilities have been satisfied. It is affected not just by the operations of the business, but also by the owners' interactions with the entity. These interactions can include putting money into the business or taking money out of the business through dividends/distributions. Equity commonly has two main components:
Capital contributions by owners, which includes common & preferred stock and additional paid in capital.
Retained earnings, which is the accumulated net income from past years that was not distributed to the owners.
It can also include various other accounts like Treasury stock, but again we won't go that deep into this now.
Each year the firm's net income (minus any dividends paid) is recorded in the retained earnings section of the balance sheet. A positive net income (a profit) increases the equity of the firm and a negative net income (loss) decreases it. Ideally, as the firm grows, the assets will increase and if they increase more rapidly than the liabilities, the difference is an increase in equity (the owner's interest in the business). Below is an example balance sheet:
Unlike the income statement, the accounts on the balance sheet do not zero at the end of a fiscal year. That is why the balance sheet is a "snapshot" in time at the reporting date, since they are constantly changing and can vary significantly even one day before or after the report date.
There are several other limitations to the balance sheet you should be aware of when you look at it. Many accounts are recorded at historical costs, which might not reflect their actual fair value today. Also, like the income statement, the balance sheet requires management judgement and estimates about how to best represent items. The balance sheet does not record all things of value in a company. Many items that add value to a company would be extremely difficult to quantify accurately and objectively but are none the less valuable. One example is the culture of the firm which can clearly be valuable, but is not shown on the balance sheet. There also can be some items that aren't technically debt but still pose some potential exposure to liability, that aren't shown on the balance sheet (a joint venture is an example). Again, we won't dive deeper into this here, but it is something to keep in the back of your mind.
Cash Flow Statement
The statement of cash flows shows the change in the cash balance for the business during the period (usually a quarter or year). It reconciles the beginning cash balance of the firm with the ending cash balance of the firm and does so by referencing accounts reported on the income statement and balance sheet. It pulls the information from these two statements and translates it into what it means for the cash balance of the firm. The cash flow statement is broken down into three sections, each corresponding to a different type of activity that will generate or consume cash:
Cash from Operating Activities - operating activities are all the activities related to the main, revenue-producing activities of the firm (selling goods, providing a service, etc.). This section includes cash receipts from the sale of goods or services, and cash outflows for payments to suppliers, employees, taxes, etc. It excludes investing or financing activities though (except interest paid on debt). If you want to get into the weeds a bit, I'll describe some of the nuance of this section here. Otherwise, skip ahead to the next bullet point. Commonly this statement calculates these cash flows by:
Starting with the net income as reported on the income statement
Adjusting it by any non-cash expenses like depreciation - which represents loss of value on an asset due to use/aging but no actual cash outlay. You would add back this amount
Adjusting it by the change in accounts receivable. An increase in this account here means you didn't receive cash yet for revenue you recognized (or invoiced) shown on the income statement. You'd subtract any increase. A decrease means you received cash for revenue recognized last period but not collected then. You'd add any decrease.
Adjusting it by the change in inventory. An increase in this account means your spent more on the purchase of inventory than the cost of goods sold expense. You'd subtract any increase. A decrease means you spent less on the purchase of inventory than the cost of goods sold expense. You'd add any decrease.
Adjusting it by the change in accounts payable. An increase in this means you didn't pay cash for some expenses shown on the income statement for the period. You'd add any increase. A decrease means you paid for some expenses that weren't reported this period - they were reported last period but not paid then. You'd subtract any decrease.
Adjusting it for any activities that are included in the investing or financing section. This is to avoid double reporting it. A common one would be gain/loss on the sale of equipment. This are simply entered as the reverse of how they are shown on the income statement: gains are subtracted here, losses are added back in.
Cash from Investing Activities - investing activities are all activities the firm engages in to acquire assets which will generate future cash flows for the firm, or to sell previously acquired assets. This includes things like the purchase or sale of property, plant, or equipment, buying/selling debt or equity of another firm (as an investment), or extending loans to other parties (or receiving payment from those loans).
Cash from Financing Activities - financing activities are the activities that the firm uses to raise money for operations or investment, primarily related to the issuance or settlement of its own debt and equity. This includes cash inflows from stock sales or taking out loans, and cash outflows from buying back stock, paying dividends, and paying back loans.
Below is an example statement of cash flows for an organization.
As you can see, grouping the cash flows in these three categories allows readers to better understand what activities are responsible for generating cash in the organization and what activities are draining cash in the organization.
There are some limitations with the statement of cash flows. It doesn't represent a complete picture of the liquid position of the firm. To determine this, you have to use it in conjunction with the other two statements. Likewise, it isn't sufficient for forecasting the profitability of the firm as non-cash items are excluded from the operating activities section. Lastly management can influence it by timing payments to occur after the end of the reporting period to artificially inflate the numbers.
Hopefully now you have a better understanding of the three primary financial statements. You've seen what they each report, how they interact, and some of the limitations of each. To fully understand your business, you'll need to be familiar with each of these and review them regularly. Deeper insights can be gained from digging into the numbers, conducting some basic financial analysis, and looking for trends.
One final word of caution. There is an old concept in computer science known as the GIGO principle: Garbage In Garbage Out. If you aren't putting good information into a system, you will not get good information out of a system. Understand that when you look at your financial statements. They will only be as good as the information you put in them. If you lack reasonable accounting controls and processes, and don't maintain reasonable documentation and accounting practices, you should be wary of the numbers as reported. That goes doubly for any analysis you try to do using your financial statements. Furthermore, lack of documented and followed processes and controls also leaves you more vulnerable to fraud or other unwelcome financial surprises.
If you would like to learn more, or think your company could benefit from working with Augelli Consulting, LLC please contact us for a free initial consultation at email@example.com.