Account Basics

8/12/2019 Account Basics

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Beginners' Guide to Financial

Statements

The Basics

If you can read a nutrition label or a baseball box score, you can learn to read basic

financial statements. If you can follow a recipe or apply for a loan, you can learn basicaccounting. The basics arent difficult and they arent rocket science.

This brochure is designed to help you gain a basic understanding of how to read financial

statements. Just as a CP class teaches you how to perform the basics of cardiac pulmonaryresuscitation, this brochure will explain how to read the basic parts of a financial statement.It will not train you to be an accountant !"ust as a CP course will not make you a cardiac

doctor#, but it should gi$e you the confidence to be able to look at a set of financialstatements and make sense of them.

%ets begin by looking at what financial statements do.

Show me the money!

&e all remember Cuba 'ooding Jr.s immortal line from the mo$ieJerry Maguire, ()how me

the money*+ &ell, thats what financial statements do. They show you the money. Theyshow you where a companys money came from, where it went, and where it is now.

There are four main financial statements. They are !-# balance sheets !/# income

statements !0# cash flow statements and !1# statements of shareholders e2uity. 3alancesheets show what a company owns and what it owes at a fixed point in time. Income

statements show how much money a company made and spent o$er a period of time. Cash

flow statements show the exchange of money between a company and the outside worldalso o$er a period of time. The fourth financial statement, called a (statement of

shareholders e2uity,+ shows changes in the interests of the companys shareholders o$ertime.

%ets look at each of the first three financial statements in more detail.

Balance Sheets

4 balance sheet pro$ides detailed information about a companys assets, liabilities and

shareholders e2uity.


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4ssets are things that a company owns that ha$e $alue. This typically means they caneither be sold or used by the company to make products or pro$ide ser$ices that can be

sold. 4ssets include physical property, such as plants, trucks, e2uipment and in$entory. Italso includes things that cant be touched but ne$ertheless exist and ha$e $alue, such as

trademarks and patents. 4nd cash itself is an asset. )o are in$estments a company makes.

%iabilities are amounts of money that a company owes to others. This can include all kindsof obligations, like money borrowed from a bank to launch a new product, rent for use of abuilding, money owed to suppliers for materials, payroll a company owes to its employees,

en$ironmental cleanup costs, or taxes owed to the go$ernment. %iabilities also includeobligations to pro$ide goods or ser$ices to customers in the future.

)hareholders e2uity is sometimes called capital or net worth. Its the money that would beleft if a company sold all of its assets and paid off all of its liabilities. This lefto$er money

belongs to the shareholders, or the owners, of the company.

The following formula summarizes what a balance sheet shows:

ASSETS = LIABILITIES + SHAREHL!ERS" E#$IT%

A com&an'"s assets ha(e to e)ual* or balance* the sum of its liabilities an,

sharehol,ers" e)uit'-

4 companys balance sheet is set up like the basic accounting e2uation shown abo$e. 5n the

left side of the balance sheet, companies list their assets. 5n the right side, they list theirliabilities and shareholders e2uity. )ometimes balance sheets show assets at the top,

followed by liabilities, with shareholders e2uity at the bottom.

4ssets are generally listed based on how 2uickly they will be con$erted into cash. Current

assets are things a company expects to con$ert to cash within one year. 4 good example isin$entory. 6ost companies expect to sell their in$entory for cash within one year.

7oncurrent assets are things a company does not expect to con$ert to cash within one yearor that would take longer than one year to sell. 7oncurrent assets include fixed assets.

8ixed assets are those assets used to operate the business but that are not a$ailable forsale, such as trucks, office furniture and other property.

%iabilities are generally listed based on their due dates. %iabilities are said to be eithercurrent or long9term. Current liabilities are obligations a company expects to pay off within

the year. %ong9term liabilities are obligations due more than one year away.

)hareholders e2uity is the amount owners in$ested in the companys stock plus or minus

the companys earnings or losses since inception. )ometimes companies distribute earnings,instead of retaining them. These distributions are called di$idends.

4 balance sheet shows a snapshot of a companys assets, liabilities and shareholders e2uityat the end of the reporting period. It does not show the flows into and out of the accounts

during the period.


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Income Statements

4n income statement is a report that shows how much re$enue a company earned o$er a

specific time period !usually for a year or some portion of a year#. 4n income statement alsoshows the costs and expenses associated with earning that re$enue. The literal (bottom

line+ of the statement usually shows the companys net earnings or losses. This tells youhow much the company earned or lost o$er the period.

Income statements also report earnings per share !or (:P)+#. This calculation tells you how

much money shareholders would recei$e if the company decided to distribute all of the netearnings for the period. !Companies almost ne$er distribute all of their earnings. ;sually

they rein$est them in the business.#

To understand how income statements are set up, think of them as a set of stairs. epreciation is also deducted from gross profit. >epreciation takes into account the wearand tear on some assets, such as machinery, tools and furniture, which are used o$er the


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long term. Companies spread the cost of these assets o$er the periods they are used. Thisprocess of spreading these costs is called depreciation or amorti?ation. The (charge+ for

using these assets during the period is a fraction of the original cost of the assets.

4fter all operating expenses are deducted from gross profit, you arri$e at operating profit

before interest and income tax expenses. This is often called (income from operations.+

7ext companies must account for interest income and interest expense. Interest income is

the money companies make from keeping their cash in interest9bearing sa$ings accounts,

money market funds and the like. 5n the other hand, interest expense is the moneycompanies paid in interest for money they borrow. )ome income statements show interest

income and interest expense separately. )ome income statements combine the two

numbers. The interest income and expense are then added or subtracted from the operatingprofits to arri$e at operating profit before income tax.

8inally, income tax is deducted and you arri$e at the bottom line net profit or net losses.!7et profit is also called net income or net earnings.# This tells you how much the company

actually earned or lost during the accounting period. >id the company make a profit or did it

lose money@

Earnings Per Share or EPS

6ost income statements include a calculation of earnings per share or :P). This calculationtells you how much money shareholders would recei$e for each share of stock they own if

the company distributed all of its net income for the period.

To calculate :P), you take the total net income and di$ide it by the number of outstandingshares of the company.

Cash Flow StatementsCash flow statements report a companys inflows and outflows of cash. This is important

because a company needs to ha$e enough cash on hand to pay its expenses and purchaseassets. &hile an income statement can tell you whether a company made a profit, a cash

flow statement can tell you whether the company generated cash.

4 cash flow statement shows changes o$er time rather than absolute dollar amounts at a

point in time. It uses and reorders the information from a companys balance sheet andincome statement.

The bottom line of the cash flow statement shows the net increase or decrease in cash for

the period. 'enerally, cash flow statements are di$ided into three main parts. :ach partre$iews the cash flow from one of three types of acti$ities !-# operating acti$ities!/# in$esting acti$ities and !0# financing acti$ities.

erating "cti#ities

The first part of a cash flow statement analy?es a companys cash flow from net income orlosses. 8or most companies, this section of the cash flow statement reconciles the net

income !as shown on the income statement# to the actual cash the company recei$ed from


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or used in its operating acti$ities. To do this, it ad"usts net income for any non9cash items!such as adding back depreciation expenses# and ad"usts for any cash that was used or

pro$ided by other operating assets and liabilities.

In#esting "cti#ities

The second part of a cash flow statement shows the cash flow from all in$esting acti$ities,

which generally include purchases or sales of long9term assets, such as property, plant ande2uipment, as well as in$estment securities. If a company buys a piece of machinery, the

cash flow statement would reflect this acti$ity as a cash outflow from in$esting acti$itiesbecause it used cash. If the company decided to sell off some in$estments from an

in$estment portfolio, the proceeds from the sales would show up as a cash inflow fromin$esting acti$ities because it pro$ided cash.

Financing "cti#ities

The third part of a cash flow statement shows the cash flow from all financing acti$ities.

Typical sources of cash flow include cash raised by selling stocks and bonds or borrowingfrom banks. %ikewise, paying back a bank loan would show up as a use of cash flow.

$ead the Footnotes

4 horse called (ead The 8ootnotes+ ran in the /AA1 Bentucky >erby. e finished se$enth,but if he had won, it would ha$e been a $ictory for financial literacy proponents e$erywhere.

Its so important to read the footnotes. The footnotes to financial statements are packed

with information. ere are some of the highlights

)ignificant accounting policies and practices = Companies are re2uired to disclose the

accounting policies that are most important to the portrayal of the companys

financial condition and results. These often re2uire managements most difficult,sub"ecti$e or complex "udgments.

Income taxes = The footnotes pro$ide detailed information about the companys

current and deferred income taxes. The information is broken down by le$el =

federal, state, local andDor foreign, and the main items that affect the companyseffecti$e tax rate are described.

Pension plans and other retirement programs = The footnotes discuss the companys

pension plans and other retirement or post9employment benefit programs. The notescontain specific information about the assets and costs of these programs, and

indicate whether and by how much the plans are o$er9 or under9funded.

)tock options = The notes also contain information about stock options granted to

officers and employees, including the method of accounting for stock9based

compensation and the effect of the method on reported results.


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$ead the %&"

iscussion and 4nalysis of 8inancialCondition and esults of 5perations.+ 6>E4 is managementsopportunity to pro$ide

in$estors with its $iew of the financial performance and condition of the company. Itsmanagements opportunity to tell in$estors what the financial statements show and do notshow, as well as important trends and risks that ha$e shaped the past or are reasonably

likely to shape the companys future.

The ):Cs rules go$erning 6>E4 re2uire disclosure about trends, e$ents or uncertainties

known to management that would ha$e a material impact on reported financial information.The purpose of 6>E4 is to pro$ide in$estors with information that the companys

management belie$es to be necessary to an understanding of its financial condition,changes in financial condition and results of operations. It is intended to help in$estors to

see the company through the eyes of management. It is also intended to pro$ide contextfor the financial statements and information about the companys earnings and cash flows.

Financial Statement $atios and Calculations


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In$entory Turno$er atio F Cost of )ales D 4$erage In$entory for the Period

If a company has an in$entory turno$er ratio of / to -, it means that the companys

in$entory turned o$er twice in the reporting period.

Operating margincompares a companys operating income to net re$enues. 3oth of

these numbers can be found on a companys income statement. To calculateoperating margin, you di$ide a companys income from operations !before interest

and income tax expenses# by its net re$enues, or

5perating 6argin F Income from 5perations D 7et e$enues

5perating margin is usually expressed as a percentage. It shows, for each dollar ofsales, what percentage was profit.

P/E ratiocompares a companys common stock price with its earnings per share. To

calculate a companys PD: ratio, you di$ide a companys stock price by its earnings

per share, or

PD: atio F Price per share D :arnings per share

If a companys stock is selling at G/A per share and the company is earning G/ pershare, then the companys PD: atio is -A to -. The companys stock is selling at -A

times its earnings.

Woring !apita"is the money lefto$er if a company paid its current liabilities !that is,

its debts due within one9year of the date of the balance sheet# from its currentassets.

&orking Capital F Current 4ssets = Current %iabilities

Bringing It "ll Together

4lthough this brochure discusses each financial statement separately, keep in mind that

they are all related. The changes in assets and liabilities that you see on the balance sheetare also reflected in the re$enues and expenses that you see on the income statement,

which result in the companys gains or losses. Cash flows pro$ide more information aboutcash assets listed on a balance sheet and are related, but not e2ui$alent, to net income

shown on the income statement. 4nd so on. 7o one financial statement tells the completestory. 3ut combined, they pro$ide $ery powerful information for in$estors. 4nd information

is the in$estors best tool when it comes to in$esting wisely.

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Account Basics