The Keys to Fiscal Literacy
Understanding Financial Statements
Whether you are a new investor, a business owner, a manager, an executive, a nonprofit director, or just trying to keep track of your personal finances, understanding how to read and analyze your financial statements will give you an advantage. In fact, overlooking these documents can almost be equated to riding a bicycle blindfolded.
A Quick Summary
There are three main financial statements – the balance sheet, income statement (also known as a profit and loss statement or “P&L”) and cash flow statement.
A balance sheet shows a snapshot of a company’s assets, liabilities and shareholders’ equity at the end of the reporting period. It does not show the flows into and out of the accounts during the period. You should look to the balance sheet to determine your company’s book value based on what the company owns and what it owes to external sources. Book value does not necessarily equate to market value, but at least it’s a start.
The income statement serves as a summary of a company’s operating activities over a period of time, whereas the balance sheet is just the financial position at a specific moment in time. The income statement will show you how much revenue a company has earned, as well as the expenses or costs that are associated with earning that revenue. You may have heard people refer to the “bottom line” when discussing whether or not to invest in a company. That “bottom line” is literally the bottom line of the income statement and tells you what a company earned or lost, (typically referred to as net earnings or losses), during the period of time reflected on the income statement.
Cash is king, and although the income statement can show you if your company has made a profit or a loss, the cash flow statement will show you if cash was generated. The cash flow statement is the most overlooked of the three statements, but if you want to identify how you made your money and how you spent it, a glance at the cash flow statement can answer many of your questions. With the company’s activities typically broken into three categories: operating, investing and financing, it is easy to see where the money flows in and out.
There are 3 main financial statements;
- Balance Sheet (A snapshot of a company’s assets, liabilities and shareholders’ equity)
- Income Statement (A summary of a company’s operating activities over a period of time)
- Cash Flow Statement (The company’s activities, typically broken into three categories: operating, investing and financing, makes it easy to see where the money flows in and out)
A Few Things Worth Looking At
Once you know what purpose each statement serves, you can look a little deeper into the financial statements by looking at a few of these details:
Using the financial statement data to compare your business to other companies or to its previous years’ performance can be very useful. There are numerous ratios that can give an investor or an owner insight, such as the debt-to-equity ratio, the gross profit percentage, return on investment and earnings per share.
You can find an explanation of a company’s financial performance in a section of the quarterly or annual report entitled, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” MD&A is management’s opportunity to provide investors with its view of the financial performance and condition of the company. It is management’s opportunity to tell investors what the financial statements show and do not show, as well as important trends and risks that have shaped the past or are reasonably likely to shape the company’s future.
The footnotes will provide you with more useful information. They disclose the accounting policies that are most important to the portrayal of the company’s financial condition. There may also be discussion about the company’s pension plans and other retirement or post-employment benefit programs. The notes can also contain information about stock options granted to officers and employees, including the method of accounting for stock-based compensation and the effect of the method on reported results.
Financial statements provide a wealth of knowledge to their reader, but if you don’t know what to look for you can easily get lost. By using the information above to navigate through the statements, you will be able to hold your company or potential investment accountable for how money is being earned and spent down to the last detail.
Amy Persaud is a staff auditor for Whittaker Cooper Financial Group in Melbourne, (321) 723-3352.