Understanding the three financial statements

By Roshan Pourghasemi

Abstract

The three financial statements are how investors evaluate a company’s financial health and its potential for growth. There are three financial statements, the balance sheet, income statement, and cash flow statement. These statements all convey information by themselves, but they also convey a lot in the context of the other statements. Understanding what each statement includes is imperative to becoming a smarter investor.

In order to evaluate a company’s current value and future potential, investors need a lens into how the company operates. Luckily, public companies are forced to release information about their current operations and financial health, and this information comes in the form of the three financial statements.

The Balance Sheet

The balance sheet provides a snapshot of the company’s assets, liabilities, and the amount of shareholder equity at a certain point in time. The date at the top of the balance sheet tells you when the snapshot was taken. Generally, this occurs at the end of the reporting period.

  • Assets

    • Cash and cash equivalents - liquid assets that a company owns, includes cash and things like Treasury bills and certificates of deposit.

    • Accounts Receivable - the amount of money that their customers owe the company for the sale of its products and services.

    • Inventory - the goods that a business hopes to sell. This can include finished products, works in progress, and raw materials.

    • Prepaid expenses - costs that have been paid in advance of when they are due. These are considered assets, because the company would receive a refund if the good or service is never delivered.

    • Property, Plant, and Equipment (PPE) - are capital that the company owns that helps their production in the long-term. Heavy machinery and factories are some of the things that can be included in this category.

    • Investments - companies can have investments, too! This category is for the investments a company owns for future growth.

    • Intangible Assets - assets that cannot physically be touched, like patents and trademarks, but they still have economic value

  • Liabilities

    • Accounts payable - the money owed from the company to its suppliers for goods and services the company has used but not paid for.

    • Wages - the amount the company owes its employees.

    • Notes Payable - debt instruments that are on record that show the official debt agreements and the schedule of repayment.

    • Dividends Payable - dividends that have been declared to be sent to shareholders but have not been paid out yet.

    • Long-Term Debt - includes a variety of obligations like mortgages or loans.

  • Equities

    • Shareholder Equity - the amount of money that would be returned to shareholders if all the assets were liquidated and all the liabilities were paid off.

    • Retained Earnings - are part of the shareholder’s equity and the amount of net earnings not paid out as dividends.

The balance sheet gives us an equation so important in accounting that it is simply called the “Accounting Equation”: Assets = Liabilities + Equities. This equation is the backbone to much of the book keeping being done.

Income Statement

The income statement usually covers a period of time, unlike the snapshot that the balance sheet provides. The income statements cover the revenue, expenses, net profit, and the earnings per share.

  • Revenue

    • Operating Revenue - the money that a company makes from their business activities. This is the revenue that is realized by selling the company’s goods and/or services.

    • Non-Operating Revenue - the income that is earned outside of the primary business activities of the company. Some examples of non-operating revenues include income from rental properties, royalty deals with other entities, income from interest earned on cash in the bank, etc.

    • Other Income - revenue earned from other activities like the sale of long-term assets.

  • Expenses

    • Costs of Goods Sold (COGS) - the direct cost of producing the goods or services that the company sells. This can include the purchase of raw materials and the labor expenses involved.

    • Selling, General, and Administrative Expenses (SG&A) - the costs of doing business. This can include rent, marketing and advertising costs, sales and accounting, and the wages of administrators.

    • Depreciation or Amortization - Amortization is the practice of spreading an intangible asset’s cost over its useful life. Depreciation considerations are the expense of a fixed asset to reflect the anticipated loss in value over the time period.

    • Research and Development (R&D) - the costs of innovating. This is the money that a company puts towards the creation of new products and services.

    • Losses from the sale of an asset are also included in the expenses of the company.

  • Net Income

    • The net income is the total revenue minus the total expenses.

    • The earnings per share, which is a very useful calculation when deciding if you should invest in a company, is the net income minus the dividends paid out divided by the total amount of outstanding shares. For example, if the net income was $55 million, the dividends paid out were $5 million, and there were 10 million outstanding shares, the earnings per share would be (55 - 5) / 10 = $5 per share.

Statement of Cash Flows

This statement measures how a company generates cash to pay for its expenses and investments. It allows investors to understand how a company operates and where the money is coming from for said operations. The cash flow statement has three sections.

  • Operating Activities - This includes any sources and uses of cash for operating the business. This includes many things such as manufacturing or selling goods, or providing services to its customers. These are the cash activities related to the net income of the company.

  • Investing Activities - This includes any source and uses of cash for the investing activities and long-term goals of the company. The purchase and sale of assets, loans given out or taken, or payments related to a merger or acquisition fall into this category. PPE is also included in this category.

  • Financing Activities - This includes the sources of cash from investors or banks and the uses of the cash that is paid back to shareholders.

One of the main purposes of the cash flow statement is to put the financial statements. For example, the cash flow statements show how the assets and liabilities in the balance sheet arise. Furthermore, some categories in each of the statements don’t give a fully accurate picture of the company’s health, and the other statements help illuminate the full picture.

Your Personal Financial Statement

Similar to the balance sheet, your personal financial statement is like a snapshot of your financial health at a certain point in time. Like the balance sheet, you should list your assets and liabilities and see what your finances are like. Examples of personal assets are cash, investments in securities, real estate, retirement accounts, and personal property like cars. Examples of liabilities include outstanding loans, credit card debt, and your mortgage.

You can calculate your net worth by subtracting your total liabilities from your total assets, an example of which is shown below.

Key Takeaways

  • The three financial statements are the balance sheet, income statement, and cash flow statement.

  • The balance sheet is a snapshot of the company’s assets, liabilities, and equities at a given time.

  • The income statement shows the revenue and expenses of a company over a period of time, usually annually or quarterly.

  • The cash flow statement goes further into how the cash is moved around a business for its operations and other expenses.

  • The three financial statements allow investors to understand the health of the company and work in harmony to illuminate how a company operates.