Guide to Financial Statements

Overview

Three major financial statements:

The Income Statement
The Balance Sheet
The Cash Flow Statement

Objectives:

Explain the underlying equation of each statement.
Understand the structure and purpose of each statement.

Why are they important?

Financial statements provide information about a company’s financial health.

Managers use them to strategize and identify areas that require their intervention.
Shareholders use them to ensure their capital is well managed
Outside investors use them to identify opportunities.
Lenders and suppliers use them to assess the creditworthiness of businesses they plan to deal with.
The government uses them for tax-collection and regulation purposes.

Understanding financial statements is important when

Making sound investment decisions
Dealing with companies
Managing a department
Starting your own business
Managing your personal finances
Taking a job with a company

Financial statements are commonly provided together, as part of a company’s annual report. You will often need to look at all three statements to fully answer a question or make a decision.

Income Statement

The Income Statement:

Specifies the financial results of a business over a defined period of time – usually a month, a quarter, or a fiscal year.
States whether a business is making a profit or not

Underlying equation:

Revenues – Expenses = Profit/Loss (Net Income)

Sales/Revenue:

Includes money generated by the company by selling

its products or services to customers

Sometimes referred to as sales
Only includes revenue associated with the company’s main operations

Expense Categories:

Cost of Goods Sold
Operating Expenses (including depreciation)
Interest Expense
Income Tax

The income statement – in addition to the balance sheet –

follows the accrual accounting system.

Accrual Accounting:

Revenues are recorded when earned and expenses are recorded when incurred.

Therefore, earned revenues may include sales on credit for which the company has yet to receive cash and expenses may include bills the company has not yet paid.

Cost of Goods Sold:

Includes all expenses directly related to making and storing a company’s goods

Examples: raw materials, warehousing, direct labor costs

Service companies do not have this section on their income statements, since they don’t produce products.

By deducting cost of goods sold from sales/revenue you arrive at gross profit.

Operating Expenses:

Include all costs incurred in operating the business

that are not directly related to the production and

storage of a company’s goods.

Examples: administrative salaries, research and development expenses, marketing cost
Cost of Goods Sold vs. Operating Expenses:
If an expense can be eliminated without affecting the production and storage of the company’s products, then it’s an operating expense and not part of the cost of goods sold.
Depreciation:
- Listed with operating expenses on the income
statement.
- Instead of including the full price of a fixed (longterm)
asset under operating expenses, its cost is
spread over the years it will be used and listed under
depreciation.
- The reason: The asset will benefit the company for
several years – not just during the year it was
purchased. Without depreciation, a company would be overstating its first-year expenses and understating its expenses over the following years during which the asset is used.
By subtracting operating expenses and depreciation from gross profit, you arrive at operating earnings. These earnings are also called earnings before interest and taxes, or EBIT for short.
Many companies and investors look at the ratio of EBIT to revenues as a measurement of profitability. Companies use this number to compare changes in their profitability over time and to compare their profitability to other companies in their industry. If the percentage is smaller than a competitor, it means the company is less profitable; if it is bigger, then the company is more profitable.

Interest Expense – interest paid by the company for loans it incurred

Income Tax – tax levied by the government for income

EBIT Sales X 100 = % Revenue that is Operating Earnings

REVENUE – EXPENSES = NET INCOME

Net Profit:

Revenue/Sales > Expenses

Net Loss:

Revenue/Sales < Expenses

OVERVIEW:

Income Statement:

Equation: Revenues – Expenses = Profit/Loss
Summarizes the financial results of a business over a

fixed period of time.

Tells whether a company is making a profit or not
Can help spot trends and turnarounds when compared

to previous periods

Sales/Revenue

– Cost of Goods Sold

= Gross Profit

– Operating Expenses

– Depreciation

= Operating Earnings (EBIT)

– Interest Expense

= NET INCOME