Introduction to Financial Statements

The financial statements are windows into a company's performance and health. This is a basic overview of these statements. We will go into detail later.

The Income Statement

What is it and why should I care? The income statement tells you how much money a company has brought in (its revenues), how much it has spent (its expenses), and the differnece between the two (its profit). The income statement shows a company's revenues over a specific time frame such as three months or a year.

The Income statement answers the question "How well is a company's business performing". Or "Is it making any money?". A firm must be able to bring in more money than it spends or it won't be in business too long. Firms with low expenses relative to revenues and thus high profits relative to revenues are very desireable investments because a bigger piece of the dollar in revenues the company brings in benifits the shareholders.

There are three main elements of an income statement:

1. Revenues. The revenue section is the simples part of the income statement. Often there is just one number that represents all of the money a company brought in during a specific time period, although big companies will break down their revenues by segements or geographical location. Revenues are commonly known as sales.

2. Expenses. Although there are many types of expenses, there are two main categories, the cost of sales, and selling, general and administrative expenses or SG&A. Cost of sales or cost of goods sold are the expenses directly related to generating revenue. For example, it may cost you $10 to make a shirt that you sell for $15. When it is sold, the cost of that shirt to you is the $10 that it took to make the shirt. Selling, general and administrative expenses are commonly known as operating expenses. This category includes all of the other cost of running a business, including marketing, salaries, management and technological expenses.

Profits. In its simplest form, profits are revenues minus expenses. There are subcategories of profits that you as an investor should be aware of. Gross profits is revenues minus cost of sales. It basically shows how much money is left over to cover operating expenses after a sale is made. Using the shirt example from above, the gross profit would be $5. That is the cost the shirt which is $10 minus the selling price which is $15, that leaves $5 left over to over operating expenses. This is number represents the profit a company made from its actual operation, and excludes certain expenses and revenues that may not be related to its central operations. Net income usually represents a company's income after all expenses, including financial expenses, have been paid. This number is called the bottom line and is refered to as "profits" or "earnings".

The Balance Sheet

The balance sheet, also known as the statement of financial condition, basically tells how much a company owns (its assets) and what it owes (its liabilities). The differnce between what it owns and what it owes is its equity , also commonly called its "net assets", "stockholders equity", or "net worth."

The balance sheets provides you with a snapshot of the company's financial health on they date of the balance sheet. Generally if a company has a lot of assets relative to its liabilities, its in good shape. Just as you would be cautious to lend money to a friend that is burdend with a lot of debt, a company that has large amounts of liabilities should be put under a microscope and scrutinized carefully.

Each of the main elements of a balance sheet are:

1. Assets. There are two main types of assets: current assets and noncurrent assets. There are many subcategories under current assets that will be explained later. Current assets are more than likely to be used up or converted into cash in one business cycle; usually one year. The food at your grocery store would be considered current assets because they will be sold within a year. Noncurrent assets are classified as anything that is not a current assets. The refrigirators and coolers that hold the groceries would be considerd noncurrent assets because they won't be sold within the next year.

2. Liabilities. Similar to assets there are two main types of liabilities. Current and noncurrent liabilities. Current liabilities must be paid back within one year. The grocery store may have received $10,000 worth of merchandise that must be paid for next month. That is a current liability. The grocery store may have an oustanding bank loan for $1 million that will be paid off in 10 years. That loan is a noncurrent liability.

3. Equity. Equity is the part of the company that is owned by shareholders. That's why it is called stockholder's equity. There are several categoies of equity, but the main two are paid in capital and retained earnings. Paid in capital is the amount of money the company brought in when it first sold its shares to the public. Retained earnings is the total amount of profits the company has earned since it began, minus whatever was paid out to shareholders in the form of dividends. Since it is a cummulative number, if a company has lost money over time, retained earnings can be negative and would be renamed "accumulated defecit."

Statement of Cash Flows

The statement of cash flows tells how much money went in and out of a company in a specific period usually a quarter or a year. The statement of cash flows is similar to the income statement. The differnce is in a complex concept called accrual accounting. Accrual accounting requires companies to record expenses and revenue when they occur, not when the money exchanges hands. It appears simple enough but it really is a big mess. The statement of cash flows help sort things out.

The statement of cash flows is very important to investors because it shows how much cash a company has generated. The income statement on the other hand often includes noncash revenues and expenses that the statement of cash flows exclude.

The most important trait to look for in a firm is its ability to generate cash. Many a company has shown profits on the income statement but stumbled later because of insufficent cash flows. A good look at the statement of cash flows will help you spot these kinds of troubled companies.

Because companies can generate cash and use it in different ways, the statement of cash flows is seperated into three different sections:

1. Operating activities. The cash flows from operating activities section shows how much cash was generated from its core business, as opposed to its peripheral activities such as investing and borrowing. An investor must look clesely at how much cash a firm is generating from its core activities because this paints the best picture of how well the firm is producing cash that will benefit shareholders.

2. Investing activities. The cash flows from investing activities section shows how much money the firm spent on investments. Investments are usually classified as capital expenditures-money spent to upgrade equipment or anything needed to keep the business going- or monetary investments such as the buying of selling of a money market fund.

3. Financing activities. The cash flows from financing activities section includes any activities between the company's owners and debtors. For example, cash flows from new debt or dividends paid to investors would be in this section.

Free cash flow is the amount of excess cash that a company generated, which can be used to enrich shareholders or invest in new opportunities for the business without hurting the existing operations. Although there are many methods of determining free cash flow, the simplest is taking the net cash flows provided by operating activities and subtracting capital expenditures (as found in the cash flows from investing activities).

The Financial Reality

You may think there are more exciting aspects of investing but you are wrong. Learning as much as you can about financial statements will be your bread and butter.

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