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Understanding Financial Statements

What are financial statements?

Financial statements are summary reports that indicate a company’s financial performance and position of a company. It answers questions like, how profitable it was in a given period? What were the costs & expenditures in that period? How much debt does it have to pay?

Why are they important?

Many stakeholders use financial statements, including the company’s management, investors, creditors, auditors & government institutions. The company management uses them to understand their plans’ success and make smart operational and financial decisions. Analysts & investors use historical financial statements to analyze a company’s fundamentals to articulate security’s fair value and benchmark the financial ratios with other peers.

Financial statements are a tool for investment decisions but must not be solely relied on for decisions. There may be other qualitative measures of what is happening at a company that you wish to consider when investing. Check our article on how to research stock to learn more about qualitative analysis.

The four major sections of the financial statement include 

  1. The Income Statement
  2. The Balance Sheet
  3. The Cash Flow Statement
  4. Statement of shareholder’s equity 

Income Statement

The income statement is also known as the profit & loss statement (P&L). It focuses on reporting the revenues and expenses of a company in a specific period. Theoretically, the income statement simply represents the following equation 

Profit (Loss) = Revenues – Expenses

It starts with adding the total revenues generated by the company operations (Sales revenue) in the specified period, then deducting the cost of goods sold (COGS). The result is called (gross profit), but our calculation doesn’t end here.

We also deduce other expenses like marketing & administrative costs, interest paid, etc., until we reach the net income, which any business aims to maximize. Here is what a simple income statement would look like. 

Balance Sheet

A balance sheet indicates a snapshot of the financial position of a company. It consists of assets, liabilities & shareholder equity.

Assets are what the company owns, like lands, equipment, cash, inventory, etc. Liabilities are what the company owes, like debt, loans, bills to pay, etc. Shareholders‘ equity is the amount of capital injected into the company by its owners and investors, plus the company retained earnings (or minus retained losses). 

In simpler words, balance sheets show the company’s assets and how it financed those assets, either by liabilities or by equity financing.

Thus, the balance sheet is represented through the following equation

Assets = Liabilities + shareholders equity

 A balance sheet has to be balanced as everything a company owns is either financed by liabilities or equity.

Unlike the income statement, which reflects the financial performance over a specific period, the balance sheet is like a snapshot of a company taken at a point in time.

Here is an example of a simplified balance sheet 

Cash Flow Statement

Cash flow statements are reports that provide information about the cash inflows that the company gets and the outflows that it pays. It is divided into 3 main sections, which are: 

  1. Cash flows from operating activities
  2. Cash flows from investment activities
  3. Cash flows from financing activities

Why cash flow statements are important?

A company can have a high net income but still suffer from not having enough cash, as they failed to manage their cash flows properly. This might happen if the company sells its products or services to customers but takes the payment at a later stage. These sales are recorded on the income statement as revenues, but the company will receive the actual cash after time. 

The purpose of cash flow statements is to track the cash inflows & outflows of the company. The cash flow statement includes cash movements made by the business through operations, investment, and financing that sum to net cash flows. The inflows and outflows of any money earned, but not yet received are not included. 

It is considered the most complex financial statement and the least intuitive. To get a better understanding of cash flow statements, check our article here.

Statement of shareholder’s equity.

Statement of shareholder’s equity reports how does the shareholders’ equity or ownership changes in a specific period. It reports information like the stock sales and repurchases by the company. These changes include the company’s stock sales repurchasing and the addition of retained earnings, etc.

The components of the statement of shareholder’s equity include 

  • Common stocks: which are a share of ownership in a company, that represent a claim on profits and confer voting rights. 
  • Preferred stocks: a different form of ownership, but gives no voting rights and 
  • Treasury stocks: is a stock purchased back by the issuing company
  • Retained earnings: are the portion of the company’s profit that is retained and not distributed to shareholders as dividends.