Financial statements are an important part of how individuals and businesses summarize and interpret accounting data and transactions, but they can be complicated for the uninitiated.
There are several types of statements with many different components.
Financial statements report on information such as income, expenses, cash flows, and shareholder’s equity. These statements are often included as part of a larger financial report. Financial statements are used to help represent a company or individual’s business standings and wealth in quantitative data.
A financial report can be one of the best ways to get a broad overview of a company or person’s financial business as well as detailed specifics of company operations. Read on to learn more about the type of information reported in financial statements.
Types of Financial Statements
The term “financial statement” is a word that can refer to several kinds of financial reports. Below you’ll find a breakdown of the major types of financial statements.
As a financial statement, a balance sheet is designed to deliver the following financial information:
- Assets: Assets are those things that are a part of a company that has value, which includes everything from raw materials in manufacturing to fleet vehicles and office equipment. Anything with a monetary value including trade patents and cash are considered assets.
- Liabilities: Liability is a term for the money that a company owes to other entities, such as individuals, vendors, or other companies. Some examples of liabilities are the company payroll or established business loans.
- Shareholder’s equity: The shareholder’s equity (also known as company capital) is the net difference between a company’s assets and a company’s liabilities. Shareholder’s equity is the money left over if a company were to sell all of its assets and pay off its liabilities.
The balance sheets of a company include the documentation that lists out and enumerates all of the companies assets, liabilities, and shareholder’s equity in one financial statement.
Unlike other more dynamic types of financial statements which can be used to determine how a company is performing over time, a balance sheet shows a single-frame point of reference to determine a company’s wealth at a certain point in time.
Balance sheets are organized so that each resource can be managed quickly in case of a financial emergency in the company where quick financial juggling is required. Assets are typically documented in order of how quickly they could be liquidated into cash, while liabilities are documented in order of how quickly they need to be paid off.
If a balance sheet is a snapshot of a business’s wealth in a single frame, then an income statement is a panorama.
Rather than one point in time, an income statement focuses on documenting the revenue that comes into a business throughout that fiscal period. Often, this documentation is rolled up with the costs and expenses associated with the generation of revenue. The resulting amount is the net income of the business.
Have you ever heard the phrase “that’s the bottom line”? This turn of phrase came from financial reporting. The bottom line on an income statement is the final resulting net income produced at the end of the period, which is usually measured in fiscal quarters.
The measurement that is used in income statements is called “earning by share”. This is the hypothetical number that would be arrived at if the company was liquidated and each shareholder of the company was allotted an equal portion of the proceeds.
Here are some of the financial data points that are tracked with an income statement (Source: U.S. Securities and Exchange Commission):
- Gross revenue: Gross revenue is the amount of income that a company has before removing any liabilities or other expenditures.
- Loss: Loss is the amount of money that a company expects to lose as a result of returned merchandise, damaged merchandise, or arranged discounts.
- Net revenue: Net revenue is the amount of income that a company has after losses are subtracted from gross revenue.
- Operating expenses: Operating expenses is the money that is spent by the company on payroll, utilities, building rentals, and other tools used in the operation of the business.
- Depreciation: Depreciation is the amount of income that is deducted from company profits to account for the wear and tear on equipment or tools related to the operation of the business. Companies calculate depreciation ahead of time and factor deductions for it into each fiscal quarter in a process called amortization.
- Operating profit: Operating profit is the amount of income that a company has in gross profits after loss, revenue, operating expenses, and depreciation have been taken into account.
- Net profit: Net profit is the amount of income that a company owns after it has paid its income taxes. This is the amount of capital that a company owns free and clear. This is the number that ultimately determines whether a company has lost or gained revenue over a fiscal period.
All of these data points put together over a fiscal period make up the income statement. The breakdown of the different factors that go into a company’s net profit makes it easier to see where they are taking hits to their bottom line.
Cash Flow Statement
A cash flow statement is a financial statement that covers all incoming cash exchanges within a business. Cash involves tracking currency, but it also often includes assets that could potentially be liquidated quickly if funds were needed.
Cash flow statements break cash flow down into three separate categories of reported information:
- Operations: Cash flow in operations is any cash flow that derives from the business conducted. For a retail vendor, for example, this would include all sales profits. Positive cash flow in operations is necessary for businesses to expand without bringing in outside investments.
- Investment: Investment is cash flow into the company from outside investors who put money into the company exchange for that stock’s shareholder equity. The investment section of a cash flow statement includes investments into the company as well as capital expenditures or instances in which the business invests in itself.
- Financing: When businesses borrow money, this is known as the financing portion of the cash flow. While it represents a positive income stream into the business, it must also be subtracted back out of the net profits of the company through liabilities deductions. The cash flow from financing is typically sent out to investors as part of an annual financial report.
When operations, investment, and financing cash are added together, this results in the data point known as net cash flow. This data can give investors a good indication of the types of transactions that a business makes over time. (Source: Investopedia)
It’s important to remember when looking at cash flow that you’re not just looking at the positive flow of cash into a business or corporation. Cash flow also includes losses associated with operations and investments, as well as any fees associated with financing large amounts of cash.
Statement of Shareholder’s Equity
A statement of shareholder’s equity is a financial statement that represents the amount of money that would be paid to each shareholder in a company if the company was liquidated. A statement of shareholder’s equity is designed, like a balance sheet, to give investors a quick overview of how the business is performing.
The shareholder’s equity in a company can be raised by three factors (Source: Business.com):
- Capital contributions
- Investor contributions
- Increased profits
While a statement of shareholder’s equity can tell investors exactly where they stand, these financial statements are also useful for business owners and operators. When measured in smaller fiscal periods such as weekly or monthly, they can give a sharp picture of which business investments are fruitful and which didn’t pay off.
As a financial report, statements of shareholder’s equity are used by companies of all sizes, not just large corporations. In small businesses, the statement of shareholder’s equity is interchangeable with the owner’s equity. These statements are a good financial statement for any company above a sole proprietorship to have since they clearly delineate who owns what within the company.
Financial Statements and Financial Reporting
Many business owners and investors may use the terms “financial statement” and “financial report” interchangeably, but these are two different terms.
Financial reporting is the process by which a business actively collects data in its daily activities to contribute to a financial statement. Financial reporting includes things like documenting payroll each week or reconciling a bank statement in Quickbooks.
In financial reporting, there are three main types of financial statement ratios that are examined:
- Operating margin: In business, an operating margin is the amount of money a company makes after the cost of sales have been subtracted from sales. In general, the higher the operating margin, the higher the net profit.
- Debt-to-equity ratio: A debt-to-equity ratio puts a company’s liabilities (or the money that they owe to others, such as vendors) up against the money the company is worth. This results in a net equity.
- Working capital: Working capital consists of funds in a business that exist after all short-term liabilities have been paid off. Working capital is the money that is used by businesses to conduct their daily business operations as well as invest in business-related supplies and equipment.
Whether these financial statements are gathered for investors or just for the information of the business financial managers, the information reported in financial statements paints a comprehensive picture of a company’s overall financial health. Business owners and investors use this information to make financial decisions such as securing financing or seeking out new investments.
Footnotes and Financial Reporting
If you go over a financial statement, you’ll be sure to notice a bunch of fine print at the end of the documentation. These notes are known as the financial footnotes, and they provide a written explanation of how a company’s financial reporting is conducted.
Financial statements can be full of very dense data depending on how large the company is, the length of the fiscal period, and how detailed the breakdown of the financial transactions is. Footnotes provide a way for people setting up a financial statement to lay out the financial reporting practices of the business.
Here is some of the information that you may find reported in a financial statement footnote:
- Basis of presentation: The basis of presentation in financial footnotes involves setting up the basis for setting up the financial report. Examples of this include Other Comprehensive Basis of Accounting or US Generally Accepted Accounting Principles. These frameworks act as a template for financial statements to be laid out in a commonly accepted fashion.
- Accounting policies: The accounting policies are the explicit protocols that a company’s financial advisers use to collect their financial data. These policies include things like systems of measurement, describing accounting methodology, and setting disclosure procedures.
- Depreciation of assets: Depreciation is the planned value reduction of a company’s fixed assets to help account for the depreciation of value in those assets. Depreciation is measured by a variety of methods depending on the type of assets being accounted for. (Source: Corporate Financial Institute)
- Value of inventory: A value of inventory footnote is a footnote that indicates the value of a company’s inventory based on either what it cost to acquire or what it would be worth on sale.
- Subsequent events: Subsequent events consist of any financial data that is taken after the financial statement is balanced and dated, but before the statements are released. This could include many kinds of data such as the details of a business merger or a major loss such as damage or theft.
- Intangible assets: Many companies deal in valuable commodities that don’t have tangible value, such as patents or trade secrets. These things are still included in financial statements as part of the footnotes to keep financial documentation thorough.
Taken together with the quantitative data in a financial statement, the financial footnotes can help provide a much clearer understanding of how the financial reporting data breaks down. Checking the footnotes is always a good place to start when investing in a company’s financial report before you get into the nitty-gritty of the numbers.
The MD&A (also known as management discussion and analysis) is an important part of the data in the footnotes of a financial statement because it explains in plain terms how the company is performing from fiscal period to period. The MD&A provides a good jumping-off point for financial executives and investors to discuss the health of the business.
MD&As are usually passed out as part of an annual financial statement to investors to detail how well (or not) the company is doing. Based on this information, shareholders can make joint executive decisions about the company.
MD&As are examined by the Security and Exchange Commission to ensure that they present all of the necessary information on the health of the company and projections for its performance going forward into the next fiscal period.
Financial MD&As also add in supplementary information that may be important for shareholders to take into consideration that might impact the performance of the company such as a global pandemic, civil unrest, financial recession, or other political factors.
Financial Ratios in Financial Statements
Other than working capital ratios and debt-equity ratios, several other financial ratios can often be found in financial statements. Here are a few of the other financial ratios that you can expect to find in financial statements:
- Quick ratio: A quick ratio is the number that takes a company’s current assets, subtracts the company’s inventory, and then divides that number into the company’s liability figure. A quick ratio (also known as an acid test) is a good way for companies to tell if they have enough easily-liquidated funds to cover their current debts at any given time.
- Return on equity ratio: Return on equity ratio is determined by the net earnings of the company minus dividends and divided by common equity dollars (the worth of the company to all shareholders). Return on equity ratios tells investors and business owners how well the investment of capital in the company is paying off in returned profits.
- Price-earnings ratio: A price-earnings ratio is the company share price divided by the earnings per share number. This ratio shows investors how much they have to spend to keep the company in the black compared to every dollar of the company’s annual earnings.
- Leverage ratio: A leverage financial ratio is a financial ratio that is used to help determine the overall debt level of a company. There are several types of leverage ratios including debt ratios, debt-to-equity ratios, and interest coverage ratios.
- Efficiency ratio: Efficiency ratios are exactly like they sound—they’re ratios that are used to help determine how efficiently a company manages its assets and resources in operation. Efficiency ratios can be a bit more difficult to calculate than some other financial ratios, but they give a unique insight into the business that owners or managers can use to tweak operations.
Financial ratios are a great way for companies or business owners to understand the ebb and flow of profit a on different levels. This allows them to make targeted strategies to increase their profit moving forward.
Who Uses Financial Statements?
There are many different groups of people who use financial statements other than corporate financial officers and business owners. Financial statements are important documentation in several different industries across society.
These are just a few of the people who use financial statement (Source: Wikiaccounting):
- Company shareholders: Financial statements are used by company shareholders to both make decisions about the company at the executive level as a manager or a business owner. It is also used to take stock of the status of the company by lesser shareholders.
- Venture capitalists: Financial statements are used by corporate financial managers to help convince new venture capitalists to invest in the company. Companies may also publish what is known as an audit report to declare their financial health and attract new investment.
- Bankers: Financial statements are used by bankers to reconcile the assets held by a company with their outgoing expenses. A bank may be willing to extend a loan or defer payments for a company if they have a strong line of credit and a financial statement that reflects strength in the company.
- Creditors: Companies who lend credit look at business financial statements as a way to see if the business is healthy enough to be good for a return on their investment in it. Creditors may offer a loan based on the level of the company’s assets compared to what they have outgoing in liabilities.
- Internal Revenue Service: Financial statements are crucial for companies to keep on hand in case they are audited by the IRS. The tax division of the government uses these documents not only to determine how much taxes a company has to pay, but also whether the company is conducting its business without fraud.
- Vendors: Vendors and suppliers of companies often allow those companies to run a charge account that is reconciled from month to month. The information in a company’s financial statement is what helps vendors determine the amount of credit they’re willing to extend, and also gives them an idea of how consistent the company is with paying its liabilities back.
- Competing companies: Competing companies look at their competitor’s financial statements to determine their strength in the market and how to follow suit. One company may also try to take advantage of another company’s financial weakness by facilitating a merger or takeover.
Financial statements tell different types of people different things, but they are one of the best ways to get an idea of how well a company is running in any given fiscal period.
Tips for Reading Financial Statements
For those who are still new to the practice of reading financial statements and reports for investment, there are a few things to keep in mind that can make the process a lot easier to get into. Trying to look into too many avenues and companies all at once can lead to you feeling overwhelmed and not learning any good information.
Here are some tips for getting the most out of reading financial statements:
- Be selective in what you read. Many company financial reports are packed to the gills with information that may be irrelevant to the average investor, such as interviews with the top executives or propaganda for the company. Stick to analyzing the cold numbers and the footnotes to get a better idea of the company’s financial situation.
- Work on your accounting. Getting the hang of all of the different ratios and formulas necessary to analyze a financial report can take time. Try keeping cheat sheet of important information concerning the company so you can help keep everything straight.
- Take notes. If you’re researching several companies at once for financial investment, investing in a binder and some other stationery to keep notes on your findings can not only help you learn how to read financial statements more easily, it can give you a reference to look back on as you progress in your investments.
- Focus on business health. How do the sales revenues for the business look from one fiscal period to the next? How strong is their margin ratio? What is the difference between the top line and the bottom line of the balance sheet? It’s also important to keep in mind that a company’s performance may dip or spike in accordance with current economic events.
- Check out anomalies. If there are any strong deviations in the pattern of a company’s transactions, and these deviations can result in anything from a building fire to a lawsuit or natural disaster. If you analyze a company’s statements over time, patterns in these unusual gains or losses can sometimes be found.
- Check out liabilities. A company that is holding a large amount of long-term debt may be in poor financial health if it doesn’t have the profit margins to cover the difference. A company that has a large ratio of liability may end up being a risky investment if it isn’t an established stock.
- Keep track of a company over time. Looking at a balance sheet can be a good way to get an overview of a company quickly, but tracking them over weeks, months, or even years can be a better way to get a broader picture of the company’s long-term performance.
When you first start investigating potential investment stocks, it’s a good idea to start slow and work your way up. It’s better to work with just a few companies at first until you become more experienced and then work your way up to a larger portfolio.
Financial Statements Are Powerful
While someone who isn’t versed in investment might find it difficult to read some of the more complex financial statements at first, it’s well worth taking the time to learn the ins and outs of different types of statements. These documents can help people make better business and investment decisions no matter what level of the company they’re at.