Reading financial statements empowers you to understand the health of your business and, really, to speak the language of business.
It may not be the thing you most love about business, but it is an important part of financial literacy and helps you as a business owner.
Although financial statements may seem like a very complex series of numbers and documents, anybody can learn to read them–the three main financial statements all follow standard approaches and contain the same data pieces.
If you can read the balance sheet of Company X, you can read the balance sheet of Company Y.
That’s the value of financial statements–they provide standard tools for understanding all businesses, no matter what size or what industry. In accounting, this important feature of financial statements is known as ‘comparability.’
In the context of investing, Warren Buffet has a great quote on the value of being able to read financial statements. Accounting is the ‘language of business’ he says, and the value holds true for business owners as well as investors:
You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting–how to read and interpret financial statements–you really shouldn’t select stocks yourself.’
Part of the value of being able to read financial statements is that it starts to get you thinking about your business like many outsiders (loan officers, investors, buyers…) will.
From a business perspective, you must create financial statements to allow people to see the health of your company.
It is a version of accountability which can be used as a gauge to measure the progress being made toward a vision, mission, or goal.
This guide will take you through the basics of what you’ll need to know to understand the various financial statements which are published.
Keep in mind that the income statement is one of three statements used in both corporate finance and accounting. So, large public companies issue financial statements, just as small businesses have financial statements.
However, public corporations often issue other notes and data alongside their statements. We’ll cover those here, but you won’t find most of them very frequently when dealing with smaller businesses.
One other thing to keep in mind: financial statements reflect the practice of double entry bookkeeping. Double entry bookkeeping is the basis for modern accounting and explains how all accounts are related.
Understanding Balance Sheets
Balance sheets provide information about the liabilities, assets, and any shareholder equity which are part of a company’s financial picture.
Assets are items that have value that are owned by an organization. These items can usually be sold or used to provide a service or make a product. Physical properties, such as vehicles and inventory, are usually counted as assets.
Patents and trademarks are assets as well, as is cash. Real estate can be an asset too.
Liabilities are what a company owes as debt to someone else. Any debt that carries an obligation to repay is classified as a liability.
This includes a monthly lease payment or mortgage, payments owed to vendors, taxes, and lender products from a financial institution, like a loan.
The company’s payroll is classified as a liability. Any obligation to provide a future service or product to someone is placed in this section of the balance sheet too.
Shareholder equity is the net worth of the organization. It is a reflection of the money that is left in the company if all assets were sold and all debts paid off. The shareholders of a company would have a claim to this leftover money.
A shareholder can be an owner in a private company or a holder of stock in a public company
On the balance sheet, the company must be able to have the assets balance the sum of the equity and liabilities.
When you look at the balance sheet, you’ll typically see assets listed in a specific order.
Most companies place the assets which can be liquidated quickly at the top of the balance sheet, then the most difficult items to turn into cash are left at the bottom.
There are three different types of assets that you’ll find listed on the average balance sheet.
These are assets that a company plans to liquidate within the next 12 months. Inventory assets are typically listed here.
These items take longer than 12 months to convert into cash. It would also include items that a company does not intend to liquidate at all.
These are the items that are used to keep a business operational. This would include technology, office furniture, or real estate. Some fixed assets may be classified as non-current assets.
When you get to the liabilities section, you’ll find that the items on the balance sheet tend to be listed by the date payment is due.
There are two types of liabilities: current and future (long-term). Current liabilities are those that will be resolved in 12 months or less.
Future liabilities are obligations which are not due for 12 months or more.
Then there is the equity portion of the balance sheet.
This figure is the amount invested into the company over a specific time period. You may see a yearly equity summary, a quarterly summary, or a lifetime summary included on the balance sheet.
If the earnings are distributed over a specific time period, then these dividends are shared on a percentage basis. Shareholders (or owners) would receive their specific percentage of ownership.
For a publicly-traded company, if you owned 2% of it, then you’d receive 2% of the total dividend.
The balance sheet shows the overall picture of financial health. It will not show how money moves through each account.
It is also important to remember that a balance sheet is a snapshot. Your balances are going to change every day. That is why a specific time period is often covered, usually a quarter or a fiscal year, with this financial statement.
Sole proprietors may have a balance sheet which is a little more complicated.
A sole proprietor has the option of combining their personal and business finances together.
That means your balance sheet may have two different lines of income generation and two lines of expenses. The equity put into the business should be tracked separately, as should the money that is drawn out of the business for some reason.
Because of these complications, sole proprietors should consider setting up a separate account for their business funds.
That makes the creation of a balance sheet much easier because you won’t need to evaluate every purchase from a single account to determine if it was a personal or a business expense.
Understanding Income Statements
The income statement is a report that offers a look at the revenues a company was able to generate over a specific period of time.
Most income statements reflect a year’s worth of revenues, though some companies may put out a quarterly or biannual income statement in some situations.
In addition to the revenues generated, the income statement will list the various expenses a company encounters while generating sales.
These costs are then deducted from the revenues to create a “net” outcome.
There are two important figures to consider here: the “gross income” and the “net result.”
A company’s gross revenues are the total amount of sales generated. This is the income you’ve created with the business before any costs are taken away from it.
If you sell 200 items at $2 each, you would have $400 in gross revenues.
The net revenues of a company subtract the expenses from the gross revenues. You made $400 in sales, but it cost you $350 in labor, manufacturing, and marketing to create the product and eventually sell it.
That means the income statement would show a net earnings figure of $50.
If costs exceed the revenues generated, then the income statement would reflect a net earnings loss instead.
In addition to discovering how much an organization made or lost during the period covered by the income statement, a report on the earnings per share may be included with this financial statement as well.
This report, sometimes called the “EPS Report,” describes the amount of money each shareholder would receive in a distribution if the net earnings were offered as a dividend.
You may find other lines included on an income statement beyond these basics. Here are some examples of what you might see.
This figure is a representation of revenues that a company doesn’t expect to collect, even though a sale is generated.
An example of what might be listed here is a planned discount on a specific product or returns that were received after sales were made. This figure is deducted from the gross revenues when determining a net income or loss.
Some companies include their operating expenses with their cost of sales figures. For a financial statement, these figures should be kept separately.
That is because an operating expense does not have a direct link to production costs. You can subtract the operating costs from the gross revenues to create a figure that is called the “operational income.”
Some assets degrade over time as they are being used.
Tools, vehicles, and some forms of real estate all have these costs associated with them. Businesses are permitted to spread out these costs over time.
Smaller assets may be taken as a full depreciation in their first year at the company’s discretion.
The costs of depreciation are deducted from the gross revenues.
This is the amount a business pays in income tax for the year.
State taxes may be included with national taxes, though on a separate budget line, which would then be added to create one figure. Some businesses may list sales tax liabilities here as well if they do not keep the sales tax they collect in a separate account.
There is another form of income and expense that must be tracked on this statement which involves interest.
If a company earns money by keeping cash in a savings account which earns interest, then it must be reported as income earned. Interest expenses are funds paid to someone else because of money borrowed.
If you make 12 consecutive loan payments of $200, let’s say $180 of that goes toward the principal balance of the loan each month. The other $20 goes to interest. On the income statement, you would have a $240 interest expense registered.
Interest figures may be in their own section or listed in the appropriate income and expense categories.
Understanding Cash Flow Statements
These financial statements help you to see or report how the inflows and outflows of cash are moving through a company.
Cash flow statements make it possible for a company to know if it has enough cash available to it for expenses or purchases. Managing your cash flow is critical for the health of your business.
This is different from the income statement because you’re not trying to gauge profit or loss. You’re only trying to determine the amount of cash that is available at a specific point in time.
To create this information, cash flow statements will use the income statement and overall balance sheet to generate the information required to make a liquidity determination.
There are three primary components to the standard cash flow statement: operational activities, investment activities, and financing activities.
Cash flow statements will look at how money flows from the company’s net income or net loss.
It will take the net income and reconcile it with the actual cash that was received or is being used within the operational activities at that moment.
This part of the statement will make an adjustment to the net income for non-cash items that may be required, such as a depreciation reversal.
It will also account for cash assets that were used or produced by the company’s assets or liabilities.
For most businesses, this cash flow statement is a reflection of the long-term assets purchased over a specific time period.
Real estate and equipment are the two most common items listed here. Companies that put money into investment securities would also place that information here.
If you purchase a new truck for your business, that would become an outflow of cash because you used cash to complete the purchase.
If you sold your old truck because you don’t need two trucks, then the money from that sale would be listed as a cash inflow.
Not every company will include this financial component within their cash flow statements.
It is only necessary when there is cash movement because of stocks or bonds that are purchased or sold. The activity of paying a loan back would be included here as well, listed as a cash outflow.
Understanding Financial Statement Footnotes
Every financial statement includes a series of footnotes that must be reviewed.
These footnotes provide supplemental information to better understand the financial statements being reviewed.
The most important footnote to find is the one dedicated to the accounting policies and practices that are used by the company.
Each business is required to disclose their accounting policies. That is how the information provided in the financial statements becomes transparent.
There are two accounting standards currently practiced by a majority of companies.
They are the “Generally Accepted Accounting Principles” and the “International Financial Reporting Standards,” or GAAP and IFRS respectively.
In the United States, if a company distributes their financial statements outside of the organization, then it must follow GAAP.
This is also true for companies that have publicly-traded stock, along with any rules that may be in place from the Securities and Exchange Commission.
GAAP standards cover standards such as item classification, revenue recognition, and measurements for outstanding shares.
Non-GAAP measures may be reported financially, though they should be clearly identified in the financial statements and in every public disclosure made by the company.
IFRS standards offer general guidance for companies to follow when issuing their financial statements, which is a little different from GAAP, which is closer to industry-specific reporting. About 100 countries either require IFRS or permit its use when releasing their financial statements.
Once you’ve gone through the accounting policies and practices, you’ll want to look for these common footnotes within the financial statements.
If the income taxes were not broken down into line items in the other financial statements, then this information must be provided in the footnotes. You’ll see the 5 levels of tax possibilities listed here: local, county, state, national, and foreign. There should be a description of the items which affected the tax rate for the company over the time period in this footnote.
Pension plans and retirement programs can be current benefits or post-employment benefits. The footnote should contain information about whatever assets are under the control of the company, what the cost of the plans and programs happen to be, and the current funding status of each item.
If stock options are granted to employees, officers, or other individuals, then a footnote is required for them as well. The accounting method used for any compensation figures that are based in stock should be listed here as well, along with how they may affect the results which have been reported.
The number of footnotes that may be found on any given financial statement is indefinite.
The total number of possible footnote disclosures is a lengthy list, even if common footnote disclosures are the only ones being discussed.
Because the number of footnotes can exceed the length of the other financial statements, you may find that some pieces of information overlap one another. Since footnotes are manually generated, a lengthy disclosure can be a time-consuming venture.
That is why your business must budget an adequate time reserve to complete each financial statement.
Readers should also budget extra time to thoroughly review the published footnotes to gain a greater understanding of the business.
Understanding the MD&A Narrative
In a financial statement, MD&A stands for “Management Discussion and Analysis.” It is an overview, from the perspective of the company’s management, to discuss the current financial health of the company.
It is also an opportunity to discuss the pros and cons of current operations.
Managers often use this section to highlight key points in the financial statements which they feel may not show the whole picture of a company’s health.
Some financial statements use the MD&A narrative to talk about industry trends, unexpected events, or potential uncertainties which have an impact, both positive and negative, on the financial information that was reported.
The narrative has one basic goal: to help those who read the financial statements of a company to see the business through the eyes of its managers. It provides context.
There are several components which may or may not be included in the MD&A section. Here are some of the key points you’ll want to think about including with your financial statements or look for when reading statements published by other corporations.
Outlook and Overview
This section looks at the actual details of the business.
It will include the geographic locations of the business, over statistics about the net revenues, and provide details on focus areas that are important to the C-Suite.
This part of the MD&A looks at the results the company was able to produce over a specific time period.
It should include some of the important financial details found in other areas of the financial statements, such as net revenues, operational costs, price increases, or other important areas of interest.
Companies which have multiple locations or segments which are active simultaneously may list individual figures on net sales, operational profits, and other important figures.
The percentages of growth or contraction are often included to help readers understand the health of each geographic location.
Whatever information a business uses from a non-GAAP standpoint should be listed here for evaluation.
It should be clearly labeled as falling outside of the general standard. That process allows the C-Suite and readers of the financial statement to have a clearer picture of the overall performance achieved by the company.
Many MD&A narratives include a brief section on the available liquidity of resources. There may be specific figures listed in this section.
There might also be a brief overview of what the company expects to experience in the next period in terms of capital resource access.
Off-Balance Sheet Arrangements
If there are any unconsolidated special purpose entities which must be disclosed within a company’s financial statements, they will be included in this section.
Companies accepting orders in multiple currencies will include a section within the MD&A narrative to discuss cost controls, interest rates, and financial risks. It should describe how the business is managing their foreign currencies and what measures are being taken to control overall costs.
Many businesses use estimates as a way to report certain costs. How companies account for inventory management, using the FIFO and LIFO methods, should also be noted.
When the MD&A narrative is effectively written, it will provide financial statements with a better overview of a company’s financial health.
This narrative can address outside perceptions, discuss why some information is not reflected, and discuss current or future impacts that may affect the company in the future.
Understanding Ratios and Calculations from a Financial Statement
Several different ratios can be calculated from the information published within financial statements. Although these ratios do not usually appear on the financial statements themselves, investors use a handful of common ratios to track the health of a company.
What the ratios actually mean is open to interpretation. Different industries will typically have different levels of acceptability within the ratios as well.
Here is a look at some of the common ratios that are calculated from financial statements.
This ratio reflects the amount of debt that a company carries compared to the amount of money being invested into it by owners or shareholders.
If this ratio is 2.5:1, then the company has $2.50 in debt for every $1 invested. That means debt is being taken on at 2.5 times the rate compared to stakeholder investments.
Inventory Turnover Ratio
This ratio is calculated by taking the cost of sales and dividing it with the average inventory. If this ratio is 2.5:1, then the inventory for the business turned over two-and-a-half times over the reporting period of the financial statements.
This figure is determined by dividing operational income from net revenues. This creates a percentage which reflects how much of the cash generated by a sale is actual profit.
This ratio is determined by taking the price per share and dividing it with the earnings per share. If the stock of your company is currently trading at $30, and it is earning $3 per share, then the P/E ratio would be 10:1.
There is a total of 16 financial ratios which are commonly calculated from financial statements.
Each ratio offers a different way to analyze the different strengths and weaknesses which are being reported.
The Condensed Summary
Because financial statements can be very lengthy, some businesses provide a snapshot of their statements for people to review.
This summary is often a simplified look at the financial health of the business. It does not provide an in-depth look at the various information pieces provided by the financial statements, yet still provides enough data to provide an overview of what is being reported.
A condensed summary is a good way to report basic information for your business or learn more about what another business is doing.
For the average investor, it can even be a useful tool to determine personal interest in a specific company.
For the serious investor, however, the full financial statements should be reviewed to make an informed investment decision.
You can decide to read just the summary. You can decide to read some financial statements, but not others. What you decide to look at, however, will determine your final perception of a business.
That is why the entire set of financial statements should be reviewed. False impressions can lead businesses and investors toward unintended results.
Why Are Financial Statements So Important?
Financial statements provide a scorecard for a business.
They provide a simplified way for an investor to determine how healthy a business is, allowing them to make a decision to actively invest – or actively avoid investing.
From an internal perspective, having financial statements available to you is equally important. It can be easy to get lost in the routine of taking care of daily details when running a business.
These statements make it possible to see where you are performing well and where your business may need a little help.
Although it can be easy to understand the basics of the numbers being reported on financial statements, it is equally important to understand what a business does to truly understand the significance of those numbers and the potential opportunities or risks.
You’ll often hear talk of investors being optimistic about young companies (especially technology companies) that are not currently profitable.
The company was first traded publicly in 1997 and it didn’t turn a profit until 2001.
Several billion dollars were lost in the first years of the company. By reviewing the financial statements of the company alongside managements guidance on their strategy, the potential for eventual profits could be seen by many investors.
Each financial statement can be examined separately to glean bits of important information.
It is important to remember that all financial statements are also interconnected with one another. When you see changes in the assets or liabilities of a company, then there will be reflective changes in revenues or expenses respectively.
When combined, financial statements tell a powerful story about a company. That is why they are important to read and why your business should be generating this documentation on a regular rotation.