UNDERSTANDING financial statements is very important if you are looking to invest, become a consultant, work as a CEO or in upper management, or want to start and run your own business. Understanding financial statements will allow you to assess a company’s current financial strength, and determine its profitability and creditworthiness. This article provides an overview of the four key financial statements that you need to understand.
There are four basic financial statements that you need to understand in order to evaluate a company, including the:
- Balance Sheet;
- Profit and Loss Statement;
- Cashflow Statement; and
- Statement of Retained Earnings (Owner’s Equity).
The Balance Sheet presents the financial position of a company at a given point in time. It is made up of three parts: Assets, Liabilities and Equity.
Assets are the economic resources that a company uses to operate its business: e.g. cash, inventories, and equipment.
Liabilities represent the debts of the company, the claims that creditors have on the company’s resources.
Equity represents the net worth of a company, and equals Assets minus Liabilities. Equity holders are the owners of the business.
It is important to notice that Equity is defined as a residual amount. As a rule, companies do not promise to pay back Equity holders. An Equity holder’s investment is more risky than a loan given by a bank because their investment is not guaranteed. In the event of insolvency, bank loans and other debts are repaid before Equity; Equity holders receive the residual amount after all the debts of the company have been paid.
The Profit and Loss Statement measures the success of a company’s operations; it provides investors and creditors with information to determine the profitability and creditworthiness of the enterprise.
The Profit and Loss Statement presents the results of operations of a business over a specified period of time (e.g. one year, one quarter, one month); it is comprised of Revenues, Expenses, and Net Profit (Loss).
Revenue is the income that is generated from trading, i.e. when the company sells goods or services. Although, it might also come from other sources, for example, selling off a piece of the business or a piece of equipment. It is important to note that, revenue is recorded when the sale is made as opposed to when the cash is received.
Expenses are the costs incurred by a business over a specified period of time to generate the revenues earned during the same period. It is important to distinguish Assets from Expenses. A purchase is considered an asset if it provides future economic benefit to the company, while expenses only relate to the current period. For example, monthly salaries paid to employees for services that have already been provided are expenses. On the other hand, the purchase of a piece of manufacturing equipment would normally be classified as an asset.
Net Profit (Loss) is equal to the revenue a company earns minus its expenses during a specified period of time.
The Profit and Loss Statement does not provide information about the actual receipt and use of cash generated during a company’s operations.
The Cashflow Statement presents a detailed summary of all of the cash inflows and outflows over a specified period of time; it is divided into three sections based on three types of activity:
1. Cash flows from operating activities: includes the cash effects of transactions involved in calculating net profit (loss).
2. Cash flows from investing activities: involves items classified as assets in the Balance Sheet; it includes the purchase and sale of equipment and investments.
3. Cash flows from financing activities: involves items classified as liabilities and equity in the Balance Sheet; it includes the payment of dividends as well as the issuing and payment of debt or equity.
The Statement of Retained Earnings shows the retained earnings at the beginning and end of the accounting period. It breaks down changes affecting retained earnings such as profits or losses from operations, dividends paid, and any other items charged or credited to retained earnings.
The Statement of Retained Earnings uses the net income information from the Profit and Loss Statement and provides information to the Balance Sheet. Retained earnings are part of the Balance Sheet under Owner’s Equity.
The general equation for calculating Retained Earnings can be expressed as following:
Retained Earnings (year end) = Retained Earnings (beginning of the year) + Net Income – Dividends Paid