By Bob Schneider

Financial statements present the results of operations and the financial position of the company. Four statements are commonly prepared by publicly-traded companies: balance sheet, income statement, cash flow statement and statement of changes in equity.

Balance Sheet (Statement of Financial Position)
The balance sheet tells you whether the company can pay its bills on time, its financial flexibility to acquire capital and its ability to distribute cash in the form of dividends to the company's owners.

The top of the balance sheet has three items: (1) the legal name of the entity; (2) the title (i.e., balance sheet or statement of financial position); and (3) the date of the statement. Importantly, the financial position presented is always for the entity itself, not its owners. And the balance sheet is always for a specific point in time: instead of just a date of, say, December 31, 20XX, it would be more accurate to write December 31, 20XX, 11:59:59, or any particular moment on the 31st.

The balance sheet itself presents the company's assets, liabilities and shareholders' equity. Each is defined in Statement of Financial Accounting Concepts No. 6, but to oversimplify:

  • Assets are items that provide probable future economic benefits
  • Liabilities are obligations of the firm that will be settled by using assets
  • Equity (variously called stockholders equity, shareowners equity or owners equity) is the residual interest that remains after you subtract liabilities from assets

Hence the key accounting equation:

Assets = Liabilities + Owners Equity, or A=L+OE

In the most common format, known as the account form, the assets in a balance sheet are listed on the left; they ordinarily have debit balances. Liabilities and owners equity are on the right, and typically have credit balances. These three main categories are separated and further divided to show important relationships and subtotals.

Assets are broken down into current and noncurrent (or long-term). Assets are listed from top to bottom in order of decreasing liquidity, i.e., how fast they can be converted to cash. (For more on this see, Reading The Balance Sheet.)

Current assets are cash and other assets that are expected to be used during the normal operating cycle of the business, usually one year. They typically include cash and cash equivalents, short-term investments, accounts receivables, inventory and prepaid expense. Noncurrent assets will not be realized in full within one year. They typically include long-term investments: property, plant and equipment; intangible assets and other assets.

Liabilities are listed in order of expected payment. Obligations expected to be satisfied within one year are current liabilities. They include accounts payable, trade notes payable, advances and deposits, current portion of long-term debt and accrued expenses. Noncurrent liabilities include bonds payable and other forms of long-term capital.

The structure of the owners' equity section depends on whether the entity is an individual, a partnership or a corporation. Assuming it's a corporation, the section will include capital stock, additional paid-in capital, retained earnings, accumulated other comprehensive income and treasury stock.

Balance sheet data can be used to compute key indicators that reveal the company's financial structure and its ability to meet its obligations. These include working capital, current ratio, quick ratio, debt-equity ratio and debt-to-capital ratio. (To learn more read, Testing Balance Sheet Strength.)

Income Statement
The income statement (also known as the profit and loss statement or P&L) tells you both the earnings and profitability of a business. The P&L is always for a specific period of time, such as a month, a quarter or a year. Because a company's operations are ongoing, from a business perspective these cut-offs are arbitrary, and they result in many of the problems in income measurement. Nevertheless, periodic income statements are essential, because they allow users to compare results for the company over time and to the results of other firms for the same period. Depending on the industry, year over year comparisons that eliminate seasonal variables may be especially useful.

One way to think of the income statement is as one big Owners' Equity (OE) account. In essence, a $100 sale increases both assets and owners' equity:



Dr.

Cr.

Asset (Cash, A/R)

100



Owners Equity (Sales)



100

The recording of $100 in expense for cost of goods sold (CGS), supplies, depreciation, insurance, etc. decreases assets and owners equity:



Dr.

Cr.

Owners Equity (CGS, supplies, etc.)

100



Assets (Cash, Inventory, Equipment)



100

Of course, accounting is vastly more complicated than this representation, and debits and credits are recorded under many rules and treatments for many accounts. But ultimately, if all the credits to OE during a period are greater than the debits, you have net income and OE (in the form of retained earnings) increases; if there are more debits than credits, you have a net loss and OE decreases.

The format of the income statement has been determined by a series of accounting pronouncements; some of these are decades old, others released in the past few years. Like the balance sheet, the income statement is broken into several parts:

Income from continuing operations is the heart of the P&L. It includes sales (or revenue), cost of goods sold, operating expenses, gains and losses, other revenue and expense items that are unusual or infrequent but not both, and income tax expense.

This section of the income statement is used to compute the key profitability ratios of gross margin, operating margin, and pretax margin that help readers assess the ability of the company to generate income from its activities. Results from continuing operations are of primary interest because they are ongoing and can be predictive of future earnings; investors put less weight on discontinued operations (which are about the past) and extraordinary items (unusual and infrequent, thus unlikely to reoccur). Companies thus have an incentive to push negative items that belong in continuing operations into other categories. (For further reading on the income statement see Find Investment Quality In The Income Statement.)

Net income is the "bottom line"; it is expressed both on an actual and, after comprehensive income, on a per share basis. If a company has hybrid securities, like convertible bonds, there is the potential for additional shares to be created and earnings to be diluted. Earnings per share may therefore be presented on basic and diluted bases, in accordance with the complex rules of FAS 128.

Statement of Changes in Owners Equity
A separate Statement of Changes in Stockholders' (or Owners) Equity is also prepared that reconciles the various components of OE on the balance sheet for the start of the period with the same items at the end of the period. The statement recognizes the primacy of OE for investors and other readers of financial statements.

Statement of Cash Flows
The cash flow statement tells you the sources and uses of cash during the period (in fact, the term "sources and uses statement" is a synonym). It also provides information about the company's investing and financing activities during the period. (To learn more see Analyze Cash Flow The Easy Way and What Is A Cash Flow Statement?)

Under accrual accounting and the matching principle, accountants seek to record economic events regardless of when cash is actually received or used, with a view toward matching the revenues for the period with the costs incurred to generate them. But in addition to financial statements that include accounting entries that are theoretical in nature, users are vitally interested in the actual cash received and disbursed during the period. In fact, depending on the company and the user, the cash flow statement may be of prime importance. Like the income statement, the statement of cash flows is always for some period of time.

The format of a cash flow statement is typically:
  • Net cash flow from operating activities (sales, inventories, rent, insurance, etc.)
  • Cash flow from investing activities (e.g. buying and selling equipment)
  • Cash flow from financing activities (e.g. selling common stock, paying off long-term debt)
  • Exchange rate impact
  • Net increase (decrease) in cash
  • Cash and equivalents at start of period
  • Cash and equivalent at end of period
  • Schedule of non-cash financing and investing activities (e.g. conversion of bonds)

There are two methods for preparing the cash flow statement, direct and indirect. Using the direct method, the accountant shows the items that affected cash flow, such as cash collected from customers, interest received, cash paid to suppliers, etc. The indirect method adjusts net income for any revenue and expense item that did not result from a cash transaction. Under FAS95, the direct method is preferred, although the indirect method - the more traditional approach favored by preparers and less costly to prepare - is still widely used.


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