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Updated: May 20, 2022Written By: Kent ThuneReviewed By:
Table of Сontents
- What Are Financial Statements?
- How Are Financial Statements Used?
- 3 Most Popular Financial Statements
- Income Statement
- Financial Balance Sheet
- Cash Flow Statement
- What Else Do Financial Records Include?
- Tips for Understanding a Business's Financials
- Bottom Line
The three main types of financial statements are the income statement, the balance sheet, and the cash flow statement. Learn more about these documents and how investors can use them to make more informed investing decisions.
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What Are Financial Statements?
Financial statements are formal documents that display a record of a company's financial activities at either a moment of time or over a period of time. The three main financial statements are the income statement, balance sheet, and the cash flow statement. Public companies release financial statements on a quarterly basis.
How Are Financial Statements Used?
Financial statements can be used by management, government agencies, investors, or creditors, to evaluate the company’s financial health. When evaluating financial statement data, the parties mentioned above often compare results to previous reporting periods and to industry peers.
Financial statements are also used to meet certain regulatory requirements. Publicly-traded companies are required to release their financial statements every quarter.
3 Most Popular Financial Statements
The three main financial statements are:
- Income Statement
- Balance Sheet
- Cash Flow Statement
Tip: To see how the financial statements are linked, investors can follow net income, starting with the "bottom line" of the income statement. From there, net income is added to retained earnings in the balance sheet and net income appears as a line item in the cash flows from operating activities section of the statement of cash flows.
Income Statement
Also called a profit and loss statement, the income statement reports a company’s income, expenses, and resulting profits over a specific period, usually a quarter or fiscal year. The end result, or bottom line of the income statement, is net income and the primary purpose of the statement is to assess the profitability of a company.
What’s Included?
- Revenue: This includes sales revenues plus any other income from asset sales, lawsuits, royalties, or other sources.
- Expenses: Can be reported in several ways such as by cost of goods sold, overhead, wages, payments to suppliers, sales commissions, and even expenses such as inventory charges, theft, and legal costs.
- Gross Income: Also known as gross profit, gross income is the amount of money that a business makes after taking into account the cost of manufacturing and selling the company's products or services. Gross income is calculated by subtracting the cost of goods sold, or COGS, from a company’s total sales.
- Operating Income: Also known as operating profit, operating income is the amount that a company makes after subtracting COGS, as one does with gross income, but then also subtracting other operating costs such as utilities and wages.
- Net Income: Also known as net profit, net income is derived by subtracting all remaining expenses not accounted for in the gross profit and operating profit calculations.
Income Sheet Example
Operating revenue
Sales of products
500,000
Sales of services
500,000
Cost of goods and services
(600,000)
Gross profit
400,000
Operating expenses
Selling expenses
Wages
100,000
Advertising
5,000
Shipping
5,000
Administrative expenses
0
Rent
50,000
Office supplies
5,000
Office equipment
5,000
Total operating expense
170,000
Operating income
230,000
EBITDA
230,000
Non-operating or other
Interest revenue
10,000
Gain on sale of equipment
10,000
Interest expense
(20,000)
Depreciation
(10,000)
Total non-operating items
(10,000)
Income before taxes
220,000
Taxes
20,000
Net income
200,000
Financial Balance Sheet
The balance sheet reports a company’s assets, liabilities, and shareholders' equity at a single point in time. It can be used to evaluate a company’s working capital, assets, and the amount of its capitalization that is debt versus equity.
What's Included?
- Assets: Can include things like real property, inventory, equipment, pre-paid taxes and expenses, accounts receivable, cash, marketable securities, and more. Assets can also include intangibles, such as patents, trademarks, and other intellectual property.
- Liabilities: Can be anything a company might owe another entity, including payroll, rent, utility payments, debt obligations, accounts payable, taxes, legal judgments, or bonds payable.
- Net Worth: Measures how much a company is worth after their liabilities have been subtracted from their assets. A businesses’ net worth is often called stockholders' equity, or shareholder’s equity, and represents the figure that would be left over if a company sold off all their assets and paid their liabilities.
Balance Sheet Example
Assets
($)
Current Assets
Cash and cash equivalents
100,000
Inventory
50,000
Accounts receivable
50,000
Investments
10,000
Prepaid expenses
10,000
Total current assets
220,000
Property and equipment
Land
500,000
Buildings and improvements
400,000
Equipment
150,000
Less accumulated depreciation
(50,000)
Other Assets
Intangible assets
20,000
Less accumulated amortization
(20,000)
Total assets
1,220,000
Liabilities
($)
Current Liabilities
Accounts payable
40,000
Notes payable
50,000
Accrued expenses
50,000
Deferred revenue
10,000
Total current liabilities
150,000
Long-term debt
400,000
Total Liabilities
550,000
Shareholders equity
Common stock
380,000
Additional paid-in capital
10,000
Retained earnings
300,000
Treasury stock
(20,000)
Total liabilities and shareholders’ equity
1,220,000
Cash Flow Statement
The cash flow statement accounts for the cash moving in and out of the company. Reports on three areas of business activities, including operations, investments, and financing, and it reflects the cash impacts of revenues, expenses, capital investments, financing, and other items.
What's Included?
- Cash Flows From Operations: Begins with net income (total revenues - total expenses) and adds back depreciation, amortization, and deferred income taxes along with other prepaid items. Any increases to accounts receivable and inventories are subtracted while increased accounts payable and deferred revenue result in positive additions.
- Cash Flows From Investing: May reflect cash outlays into a manufacturing plant, major equipment, and other real estate, or even capital investments into a subsidiary or joint venture. Divestitures are also accounted for in the Cash Flows From Investing section. The higher the capital expenditure, the bigger drag it has on overall cash flow for the measurement period.
- Cash Flows From Financing: Accounts for dividend payments, new stock or bond issuances, as well as stock and bond repurchases. This section summarizes to investors whether the company has been increasing its capital base.
Cash Flow Statement Example
Cash Flow From Operations
($)
Net income
200,000
Additions to Cash
Depreciation
10,000
Increase in Accounts Payable
8,000
Subtractions from Cash
Increase in Accounts Receivable
(50,000)
Cash from Operations (or CFO)
+168,000
Cash Flow From Investing
Purchase of new equipment
(12,000)
Cash Flow From Investing (or CFI)
(12,000)
Cash Flow From Financing
Notes payable issued
7,500
Cash Flow From Financing (or CFF)
+7,500
Net Change in Cash (CFO + CFI + CFF) =
+163,500
What Else Do Financial Records Include?
Other than the most common line items found in financial statements, investors can also read the lesser known items, such as the footnotes, which can include useful information about accounting policies and practices, accounting changes, income taxes, pension plans, and stock options.
Some of the items included in financial statement footnotes are:
- Accounting policies and practices: Describes account principles followed to portray the company's financial condition and results.
- Accounting changes: The nature and reasoning for a change in accounting principles, including any impacts resulting from the change.
- Income taxes: Includes detailed information about the company's current and deferred income taxes, typically broken down by federal, state, local and/or foreign tax levels.
- Pension plans: Includes various elements of the company pension or other retirement and post-employment benefits. The notes may contain specific information about the assets and costs of these programs, including whether or not they are under-funded or over-funded.
- Stock options: Notes may include any stock-based compensation granted to officers and employees. The footnotes may also include the method of accounting for stock options and the effect of the method on reported results.
Tips for Understanding a Business's Financials
Reviewing a company's financial statements for one period may not be sufficient for evaluating the financial strength of a company. To gain a meaningful understanding of a business's financials, it's important to measure a number of items, including financial ratios, and comparisons to previous periods and to industry trends.
General items to consider when analyzing financial statements include:
- Financial ratios: When evaluating a company's financial statement data, the company's finance team, stakeholders, or potential investors may employ a number of analyses, such as financial ratios like the P/E ratio, leverage ratios, or liquidity ratios.
- Historic trends: To measure a company's current financial health or performance, comparisons can be made to previous periods to spot trends, such as growth in earnings per share and how efficiently the company uses cash.
- Industry benchmarks: As is the case with investment securities like stocks, mutual funds, or ETFs, performance is best measured against appropriate benchmarks. For example, a company in the retail industry may track its profit margins and cost of goods sold, or COGs, and measure performance by comparing their numbers to their industry retail peer averages.
Financial Statement Limitations
The numbers reported in financial statements alone may not go far enough to meaningfully measure a company's financial strength and performance. Thus, investors need to be aware of certain financial statement limitations. For example, in isolation, revenue on an income statement doesn't tell an investor if there's a decline in operating profit.
Financial statement limitations include:
- Only covers a specified time: Financial statements show results for a period of time occurring in the past, such as the recent calendar quarter or fiscal year.
- No industry comparison: A company's financial statements may appear to show relative strength or weakness in isolation, but when compared to industry averages, the results could tell a different story.
Bottom Line
The three main financial statements are the income statement, balance sheet, and statement of cash flows. Investors can use these statements to measure a company's financial health by comparing results to previous periods and to industry peers.
This article was written by
Kent Thune, CFP®, is a fiduciary investment advisor specializing in tactical asset allocation and portfolio management with a focus on ETFs and sector investing. Mr. Thune has 25 years of wealth management experience and has navigated clients through four bear markets and some of the most challenging economic environments in history. As a writer, Kent's articles have been seen on multiple investing and finance websites, including Seeking Alpha, Kiplinger, MarketWatch, The Motley Fool, Yahoo Finance, and The Balance. Mr. Thune's registered investment advisory firm is headquartered in Hilton Head Island, SC where he serves clients all around the United States. When not writing or advising clients, Kent spends time with his wife and two sons, plays guitar, or works on his philosophy book that he plans to publish later in 2022.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours.