You will learn why financial statements matters. Who are the users, and why are they interested in analyzing the company’s financial statements. You will gain insight into what the parts of a financial statement are and how they are related. In addition, you will also know why when a company reports high profits, it doesn’t always make a lot of money.
What is a financial statement?
Financial statement is a document containing company financial information for external users. Its main sections include a balance sheet, income statement, cash flow statement, and statement of changes in equity.
Furthermore, for the year-end report, it also presents the auditor’s report. This section shows you the quality of the company’s financial statements. So, you should read this section first before checking the numbers in the financial statements.
Next, the company presents assumptions, accounting policies, and so on in the notes to the financial statements. This section explains why the numbers in the main section appear.
Companies publish financial reports regularly, usually quarterly or annually. For public companies, the annual financial statements are audited.
Guide to Understanding and Analyzing Financial Statements
Why are financial statements important?
Financial performance should reflect the company’s business performance. And, you will not be able to assess financial performance without looking at the financial statements.
Analyzing financial statements is an integral part of understanding how healthy a company is. Companies produce goods or provide services to generate profits and money. Whether the company succeeded in doing so or not, it should also be reflected in the financial figures reported by the company.
Competitive advantage is a prerequisite for successful business performance. However, it is ultimately also measured by its financial results, i.e., does the company generate above-average returns for every capital invested? We then compare the return on invested capital (ROIC) of several companies to see which of them has a competitive advantage.
Specifically, you can answer the following questions when reading and analyzing financial statements:
- How much money does the company make?
- How profitable and efficient is the company in making money?
- How much is the company dependent on debt in its capital structure?
- How capable is the company of meeting its short-term obligations?
- Can the company pay all of its long-term obligations?
- How much profit is paid out as dividends? How regularly does the company pay for it?
Who uses financial statements?
Financial statements are strategic for external users. It becomes a publicly available source of financial information. Without it, it is difficult to make economic decisions regarding the company.
Creditors such as banks and bond investors. Through financial statements, they assess whether the company has sufficient cash to pay the interest and principal of the loan or not.
Competitor. Combined with operational data, financial statements help competitors understand where a company’s competitive advantage comes from. They can then track where the company is making profits from and how efficiently it is doing so.
Owner (shareholder). Financial statements help them make decisions about their investment in the company. They try to assess how much return they get if they invest money in the company.
Government. They use financial information to calculate corporate taxes.
Employees. They have an interest if their company’s financial performance is healthy. It makes them more optimistic about their job security and income.
Stock analyst. They use financial statements to evaluate the company’s stock price, is the current price underpriced, fair, or overpriced? It is useful for making a buy, hold or sell decisions.
Credit analyst. They use financial statements to assess default risk and assign credit ratings.
How do companies prepare financial statements?
Financial reporting goes through a series of accounting processes, a procedure for recording, preparing, and analyzing financial transactions to be presented in financial statements. The company develops an accounting system to collect and report financial transactions. How transactions are recorded, there are two methods:
- Single-entry bookkeeping records each transaction as a line item in the general ledger.
- Double-entry bookkeeping records each transaction as a debit and a credit in separate accounts.
From identifying accounting events and transactions to putting them in accounting reports, the series of steps is called the accounting cycle. In general, it includes:
- Identifying transactions. Accountants record transactions using journal entries and sort out what should be recorded and which should not.
- Analyzing transactions. Accountants determine the effect of transactions on the financial position. If using a double-entry system, the accounting will record every transaction into at least two bookkeeping accounts. Thus, the financial position will always be balanced as the accounting equation.
- Recording transactions in the journal. Accountants record all transactions chronologically during an accounting period in a journal.
- Posting to the ledger. Accountant transfer all transactions to the general ledger, which contains details of all transactions according to the accounts in the financial statements.
- Preparing trial balance. Accountants consolidate the balances in the general ledger into a trial balance. The total debits must equal the total credits.
- Preparing an adjusting entry. Accountants make adjusting entries; if any, some transactions have not been entered or are incorrect and need adjustment.
- Preparing an adjusted trial balance. This process is to accommodate previous adjustments. The accountant adjusts the general ledger with the entries in the adjusting journal, then moves the accounts to a new trial balance.
- Preparing financial statements. Accountants compile the main parts of financial statements, such as income statements, retained earnings statements, balance sheets, to cash flow statements.
- Preparing a closing journal. This stage is to delete all temporary accounts and transfer their balances to permanent accounts.
What are the important accounting concepts and assumptions?
Double-entry accounting is an accounting system by recording every transaction or event into at least two accounts. Thus, the following accounting equation remains in balance.
Assets = Liabilities + Equity
For example, if a company sells products for cash, the accountant records it in the cash and revenue accounts. Cash is part of assets. Meanwhile, revenue goes to equity through retained earnings.
Accrual accounting refers to an accounting method by which companies recognize revenues and expenses when they are incurred, regardless of whether they have received or paid cash or not. This method recognizes economic events regardless of when cash transactions occur. It differs from cash accounting, where revenues and expenses are recognized when cash has been received or paid.
A company sells products on credit in June and will receive payment in early July. For example, at the end of June:
- The company records revenue in the income statement and accounts receivable in the assets – under accrual accounting. At the end of July, it will recognize an increase in cash and a decrease in accounts receivable in the assets with the same nominal value.
- The company does not record revenue – under cash accounting. At the end of July, it reported an increase in cash in the assets and recorded revenue on the income statement. Accounts receivable does not appear in cash accounting because it is an accrual entry.
What are examples of accrual entries?
Unbilled revenue refers to revenue earned but not yet billed to customers at the end of the accounting period. Also known as accrued revenue.
- The company recognizes revenue but has not yet received cash payments.
- The company reports revenue in the income statement and accounts receivable in the assets.
- Once paid, cash increases, and account receivable decreases by the same amount.
Unearned revenue is when the company has received payment but has not delivered goods or services at the end of the accounting period. Also called unearned income, deferred revenue, or deferred income.
- The company reports unearned revenue in liabilities and cash in assets at the same nominal value.
- After the goods have been delivered, the company recognizes the revenue in the income statement and deducts the same amount from the unearned revenue.
Prepaid expenses are incurred when the company has paid suppliers but has not received goods or services.
- The company reports prepaid expenses in assets and records a decrease in cash at the same amount.
- When it has received goods or services from suppliers, the company deducts prepaid expenses and recognizes the expenses in the income statement.
Accrued expenses arise when the company has received goods or services but has not paid them at the end of the reporting period.
- The company records accrued expenses in liabilities and expenses in the income statement.
- When it has been paid, the company deducts accrued expenses and cash at the same amount.
Going concern assumes the company will maintain its business activities in the future. If a company is not operating, normal accounting principles do not apply.
What makes financial statements useful to external users?
Qualitative characteristics refer to the criteria that make financial statement information useful for its users to make economic decisions regarding the company. The two main characteristics are:
- Relevance – should be useful for making predictions, evaluating previous decisions, and confirming or correcting prior expectations.
- Faithful representation – must represent the underlying economic phenomena and provide a clear picture of the company’s finances, free from any bias and without errors or omissions in describing economic phenomena.
Then, four additional qualitative characteristics to enhance the usefulness of financial information are:
- Comparability – allows users to identify similarities and differences between two sets of economic phenomena or analyze two or more competing companies that adopt the same accounting standards. Thus, the information in financial statements must be consistent over time and among companies to facilitate comparisons.
- Verifiability – accounts can be traced back through valid evidence.
- Timeliness – available to the user at the right time.
- Understandability – can be easily understood by users with basic business and accounting knowledge.
What are the elements of financial statements?
A complete financial report presents the following sections:
- Balance sheet – provides information about the financial position and resources owned by the company.
- Income statement – describes the company’s financial performance during the accounting period.
- Cash flow statements – presents how much money is coming in and going out of the company’s business activities.
- Statement of changes in shareholder equity – shows changes in the interest of shareholders in the company during the reporting period.
- Management’s responsibility for financial statements – a formal statement of responsibility by management regarding the integrity and objectivity of financial statements.
- Auditor’s report – contains the independent auditor’s opinion on the quality of financial statements and internal controls.
- Notes to financial statements – present information about selected accounting policies and clarify and expand the items presented in the financial statements.
The first three are the main sections, which are the focus of external users when analyzing financial statements. In addition, to get a more detailed picture, they will also examine financial notes.
The balance sheet provides detailed information on assets, liabilities, and shareholders’ equity. This section provides insight into the company’s financial position and how the company finances its assets. Also called a statement of financial condition or statement of financial position.
The three parts of the balance sheet are related to each other through the following accounting equation:
Assets = Liabilities + Shareholders’ equity
Assets refer to the economic resources owned by the company. Meanwhile, liabilities and equity represent claims on these resources, both by creditors and shareholders.
Companies may present assets on the left side of the balance sheet, and on the right side, they list liabilities and shareholders’ equity. We call this presentation an account form.
Or companies present assets, liabilities, and equity in one column. Assets are at the top, followed by liabilities and shareholders’ equity. This is known as a report form.
Then, companies usually present assets and liabilities into two groups: current and noncurrent. In each section, the company presents the accounts in order of liquidity. For example, the company presents cash on the top line in current assets, followed by other less liquid accounts.
Assets represent company resources. It shows you what the company owns, which will generate future economic benefits.
Assets are generally listed based on how quickly they will be converted to cash, except for accrued items such as prepaid expenses. They are divided into two groups:
- Current assets. Also known as short-term assets.
- Noncurrent assets. Also known as long-term assets.
Companies expect to convert current assets into cash within one year or one operating cycle – the time it takes the company to convert funds into inventory and then into cash through sales. For manufacturers, this section includes items such as:
- Cash equivalents
- Marketable securities
- Accounts receivable
- Prepaid expenses
Cash in this section relates assets to the cash flows statement. It is the sum of the previous period’s cash balance plus net cash on the cash flows statement.
Ending cash balance = Beginning cash balance + Net cash change
Ending cash balance = Beginning cash balance + Net cash from operating activities + Net cash from investing activities + Net cash from financing activities
Noncurrent assets include illiquid items, and to convert them into cash, it takes more than one year or one operating cycle. Fixed assets are usually the main item, sometimes named property, plant, and equipment (PP&E). The company uses them to run a business, but it is unavailable for sale. In addition to fixed assets, other items in current assets are:
- Long-term investment such as property investment.
- Intangible assets such as patents, trademarks, licenses, copyrights, and goodwill.
Liabilities represent the company’s obligations from previous transactions, such as to suppliers and creditors, resulting in an outflow of future economic benefits. Outflows of economic benefits can be monetary payment obligations such as loans to banks, bonds payable, money owed to raw material suppliers, and deferred taxes. Alternatively, it represents an obligation to provide goods and services in the future, for which the company has received payment.
As with assets, the company divides them into two groups:
- Current liabilities or short-term liabilities.
- Noncurrent liabilities or long-term liabilities.
Current liabilities mature within one year into the future. They may consist of:
- Accounts payable
- Notes payable
- Short-term debt
- Unearned revenue
- Current portion of long-term debt
Meanwhile, noncurrent liabilities mature more than one year. They can be:
- Long-term debt
- Long-term deferred tax liabilities
Shareholders’ equity is the owner’s residual claim on the company’s assets. It represents the money left to the owner if all assets are liquidated and all liabilities are paid off. Sometimes called net worth. Its component consists of the amount invested by the shareholders plus or minus the company’s profit or loss since its inception. In this section, you’ll see accounts like:
- Paid-in capital
- Additional paid-in capital
- Retained earnings
- Accumulated other comprehensive income items
Retained earnings link between the income statement and the balance sheet, through the equation:
Ending retained earnings = Initial retained earnings + Net profit – Dividends
The income statement presents the company’s financial performance during the accounting period. In this section, you’ll find out how much profit the company generates. Also called statements of operations or profit and loss statements. It is also referred to as a statement of comprehensive income if the company has other comprehensive income, which may be presented as a single or separate statement.
Remember: profit is not equivalent to the money made by the company under accrual accounting. Companies present non-cash items here, such as depreciation expenses.
The income statement details how much revenue is earned and what expenses are associated with earning that revenue. The difference between the two is profit.
Profit = Revenue – Expense
A standardized report might look something like this:
– Cost of goods sold (COGS)
= Gross profit
– Operating expenses
= Operating profit
+ Interest income
– Interest expense
+ Other non-operating income
– Other non-operating expenses
= Profit before tax
– Tax expense
= Net profit
Operating expenses comprise selling, general and administrative expenses (SG&A expenses)
Companies sometimes present depreciation expenses on the income statement, and sometimes they don’t. You can search for it in the notes to the financial statements in the fixed assets section.
If the company has a non-controlling interest, the net income is further broken down into net income attributable to minority interests and net income attributable to the parent.
Earnings per share (EPS)
The income statement usually includes EPS. We calculate it by divide net income by the number of common shares outstanding. Thus, it shows you how much roughly money would be received for each share if the company distributed its net income.
If it has dilutive securities such as convertible bonds, the company will typically present two EPS:
- Basic EPS – without taking into account dilutive effects.
- Diluted EPS – considers the dilution effect by adjusting the divisor. The divisor is equal to the number of ordinary shares outstanding if all dilutive securities are exercised.
Cash flow statement
A cash flow statement reports how much money came in and went out during a quarter or a year. This section is important because you will know how much of the company’s profits will eventually turn into cash. Some companies may have high profits but poor cash because, for example, most sales are on credit. As a result, the company reports high revenue, but most of it goes to accounts receivable instead of cash.
Cash flow statements are divided into three groups according to the company’s business activities.
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
The final row shows the net cash from each activity. The sum of the three net cash represents the change in net cash for a year or a quarter. If you add that up with the previous period’s cash balance, you get the ending cash balance, which appears on the top line of current assets.
Cash flow from operating activities reports incoming and outgoing cash related to the company’s core business. They become part of daily business functions such as selling products or providing services. For example, suppose it is a manufacturer. In that case, it reports items such as sales, payments to suppliers, and payments to employees.
For mature companies, operating cash flow should be positive. This is because they generate money from its core business, which it can use to invest in capital goods and pay off its obligations. If not, it could indicate a problem.
In contrast, for young firms, cash flow from operating activities is usually negative. This is because they are still dependent on financing to fund day-to-day operations and cannot yet rely on revenue from selling goods or providing services.
Cash flows from investing activities are related to the company’s long-term operations, including capital expenditures to purchase fixed assets or investments in other companies. Capital expenditure is usually a concern because it affects the company’s productive capacity and takes up a significant portion.
Cash flows from financing activities represent cash inflows and outflows associated with raising and repaying capital for equity and debt capital. Items include money from the issuance of bonds or shares, money to pay off bonds or buy back shares, and money to pay dividends.
The auditor’s report reports the findings by the external auditor. In this section, the auditor expresses an opinion on the quality of financial statements and, often, internal controls. To arrive at the results, they apply standard audit procedures to establish reasonable assurances about the company’s financial statements, whether they contain material errors or not. For this reason, when you use financial statements, you should read this section first because it shows how convincing the accounts presented are.
- Unqualified opinion – the financial statements are free from omissions and material errors and have been fairly presented by applicable accounting standards. It is an opinion for the highest quality financial statements.
- Qualified opinion – the financial statements qualify. However, the auditor made an exception for finding some irregularities, even though they did not damage the fairness of the financial statement.
- Adverse opinion – the financial statements are not presented fairly or following applicable accounting standards, including those relating to the entity’s financial position, results of operations, or cash flows.
- Disclaimer of opinion – the auditor is unable to provide an audit opinion due to lack of evidence or independence. The auditor disclaims any opinion regarding the company’s financial condition. It occurs for reasons such as the auditor may not be permitted or be unable to complete all the planned audit procedures.
Internal control refers to the process carried out by the company to provide reasonable assurance regarding financial reporting.
Notes to the financial statements, or financial notes, detail aspects in other parts of the financial statements. Here, the company discloses significant accounting policies, methods, and estimates applied to describe the company’s financial condition and results as presented in the balance sheet, income statement, and cash flow. Other aspects presented include:
- Business acquisitions and disposals
- Commitments and contingencies
- Legal proceedings
- Related party transactions
- Detailed revenue and expenses
- Business and geographic segments
- Financial instruments and the risks arising from them
- Company profile such as domicile and legal form, office address, and description of the entity’s operations