How to interpret financial statements


Investors that are interested in purchasing stocks, will do so, by evaluating the company they intend to buy shares from. The financial statements are a good place to start, to see if an investment into shares of the company makes sense.

You’ll need to understand the 3 key financial statements:

  • The balance sheet
  • The income statement
  • The cash flow statement

If you want to learn more about how to interpret financial statements read on…


The Balance Sheet

The balance sheet shows in a particular moment in time:

  • What the company owns (Assets)
  • What the company owes (Liabilities)
  • What the company is worth (Shareholder’s Equity)

Assets

Assets are things that the company owns, such as cash in the bank, equipment, technology, furniture, everything that is used to produce goods and services.

Assets are organized into 2 groups:

  • Current assets
  • Non-current assets

Current assets are assets that are used within one year, for example, cash, inventory, accounts receivable (unpaid money that customers owe the company).

Non-current assets are assets that last longer than a year, for example, property, plant and equipment, technology, patents, and trademarks. In this category assets are further grouped into:

  • Tangible assets: Physical assets such as for example power plant and equipment.
  • Intangible assets: Virtual assets such as patents and trademarks.

The total of current and non-current assets forms the total assets of the business, on the left side of the balance sheet.

Liabilities

Liabilities are things that the company owes to suppliers or other entities.

Liabilities are organized into 2 groups:

  • Current liabilities
  • Non-current liabilities

Current liabilities are liabilities that are due within a year, such for example inventory purchased on credit, which is payable within 30-90 days.

Non-current liabilities are liabilities that are due in more than a year, such for example long-term debt (long term loans for example).

The total of current and non-current liabilities forms the total of liabilities.

Shareholder’s equity

Shareholder’s equity shows how much the business is worth after all liabilities have been paid off.

At the beginning of the business, the shareholder’s equity is the initial amount that was paid to the company. This is also referred to as shareholder capital. The investors get common shares for providing capital to the business.

After that, as soon the company generates profits or losses, the equity will go up or down accordingly.

If the company can generate profits, then the net income will be counted towards the shareholder’s equity as retained earnings. The retained earnings can remain on the balance sheet, or a part can be paid out as dividends to shareholders. This will of course reduce the retained earnings.

If the company has losses, then this will reduce the retained earnings account, and with it the shareholder’s equity.

Retained earnings can be therefore seen as a running total that shows how much profit the company has generated, after deduction of losses and dividends payments.

The shareholder’s equity has to be equal to the total of assets, minus the total of liabilities.


The income statement

The income statement, sometimes also referred to as the statement of profit & loss or statement of operations shows in a particular moment in time:

  • What the company has earned (Revenue)
  • What the company has paid as expenses
  • What the resulting profit or loss is

The cash flow statement

The cash flow statement shows in a particular moment in time:

  • How much cash entered the company.
  • How much cash exited the company.

The cash flows are divided up into 3 categories and shows inflows and outflows of cash through:

  • Operating activities
  • Investing activities
  • Financing activities

It shows how much cash is moved through the company.

The balance sheet has to balance

The balance sheet must balance between the total assets and total liabilities + equity. All transactions that take place will be recorded in two places on the balance sheet. This is referred to as double-entry accounting.


Recording Transactions

There are two options to record transactions:

  • Transactions are recorded on both sides of the balance sheet: If the company for example uses cash to purchase goods, then the cash will be deducted from the “Current Assets – Cash” balance. On the liabilities side, an entry is recorded under “Current Liabilities – Short Term Debt”, if the actual payment will be paid within the next 30-90 days.
  • Transactions are recorded on the same side of the balance sheet: If the company for example purchases machinery equipment, then again “Current Assets – Cash” will be deducted, but this time, as machinery equipment is counted as an asset, the amount will be added to “Non-Current Assets – Equipment”.

Example

Let’s look at the following scenario below and go through step by step:

  • The shareholders of the company pay 500 in cash into the company.
  • Machinery equipment is bought for 200.
  • Inventory is bought for 150.
  • The company takes up a loan of 150.
  • Full inventory is sold for 400.
  • Salaries are paid for 100.

Pay in 500 in cash into the company

Assets

On the assets side, 500 is added to Current Assets. This is money that will be used in less than a year.

ItemAmount
Current Assets
– Cash

500
Non-current assets
Total500

Liabilities

On the liabilities side, the 500 is added to Shareholder’s equity as “Common Stock”.

ItemAmount
Current liabilities
Non-current liabilities
Shareholder’s equity
– Common Stock

500
Total500

The assets and the liabilities side balance with each 500.

Buy machinery equipment for 200

Assets

On the assets side, cash is reduced by 200, and Equipment is increased by 200. Equipment is a non-current asset, as the machinery will be usable for several years.

ItemAmount
Current assets
– Cash

300
Non-current assets
– Equipment

200
Total500

Liabilities

Nothing changes on the liabilities side.

ItemAmount
Current liabilities
Non-current liabilities
Shareholder’s equity
– Common Stock

500
Total500

The assets and the liabilities side balance again with each 500.

Buy inventory for 150

Assets

On the assets side, cash is reduced by 150. Inventory is declared as a current asset, as the inventory will be sold within a year. So we add 150 as Inventory to the Current Assets section.

ItemAmount
Current assets
– Cash
– Inventory

150
150
Non-current assets
– Equipment

200
Total500

Liabilities

Nothing changes on the liabilities side.

ItemAmount
Current liabilities
Non-current liabilities
Shareholder’s equity
– Common Stock

500
Total500

The assets and the liabilities side balance again with each 500.

Take up a loan of 150

Assets

On the assets side, the cash increases by 150, when we receive the loan.

ItemAmount
Current assets
– Cash
– Inventory

300
150
Non-current assets
– Equipment

200
Total650

Liabilities

On the liabilities side, we add the loan as a long-term loan to the Non-current liabilities section, as we intend to pay back the loan over 5 years.

If we would pay off the loan within a year or less, then we would add the loan to the Current liabilities as a “Short-term Loan”.

ItemAmount
Current liabilities
Non-current liabilities
– Long-term Loan

150
Shareholder’s equity
– Common Stock

500
Total650

The assets and the liabilities side balance again with each 650.

Full inventory is sold for 400

Assets

On the assets side, as the full inventory is sold, the Inventory drops to 0. As we receive cash for the sales, the cash increases by 400.

If the customer would have purchased the inventory on credit, the 400 would have been added to “Accounts receivable” under “Current assets”.

ItemAmount
Current assets
– Cash
– Inventory

700
0
Non-current assets
– Equipment

200
Total900

Liabilities

On the liabilities side under Shareholder’s equity – Retained earnings, the revenue of 400 is added, as this is what the inventory was sold for. The cost of sales is the cost of the inventory which was 150 initially. The cost of sales is subtracted from the revenues, and this leaves us with retained earnings of 250 (Revenues – Cost of sales).

If we now add the long term loan, the common stock, and the retained earnings total (250), then we get to a total of 900.

ItemAmount
Current liabilities
Non-current liabilities
– Long-term Loan

150
Shareholder’s equity
– Common Stock
– Retained earnings
Revenues
Cost of sales

500
250
400
(150)
Total900

The assets and the liabilities side balance again with each 900.

Salaries are paid for 100

Assets

On the assets side the cash reduces by 100.

ItemAmount
Current assets
– Cash
– Inventory

600
0
Non-current assets
– Equipment

200
Total800

Liabilities

On the liabilities side a section called “Salary” is added under retained earnings with a negative balance of 100.

ItemAmount
Current liabilities
Non-current liabilities
– Long-term Loan

150
Shareholder’s equity
– Common Stock
– Retained earnings
Revenues
Cost of sales
Salaries

500
150
400
(150)

(100)
Total800

The assets and the liabilities side balance again with each 800.

Conclusion

We have seen that under Shareholder’s equity – Retained earnings not only positive values are registered, but also negative ones. We register the revenue, so all the money for which the inventory was sold for, and then deduct the costs, which includes the cost of sales (in our case the amount for which we purchased the inventory), salaries, and interest, we have to pay for the loan that we took. the interest would also be added as a negative cost under retained earnings, and would be deducted from the cash position on the assets side.

Chris

Chris is an IT Project Portfolio Manager within the financial industry. Due to the nature of his role, he is engaged to study Financial Markets and is an active investor.

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