If you read the prior two installments, you’re primed to get into the various components that comprise the financial statements of a company. Just in case, let’s start with a refresher.
Running a business (at least doing so well) requires certain financial information to be tracked so it can be studied to help make forecasts about the future. Potential investors, buyers, lenders, suppliers, and customers want to see different types of financial statements, depending on their objectives, to help them protect their interests. All this information is commonly compiled into certain documents which, collectively, are called financial statements.
Stated another way, financial statements are a formal record of the financial activities (revenues and expenses) and financial position (assets, liabilities, and equity) of a person, business, or other entity.
If you are still having trouble with the concept, think about your own personal financial statements. If you have ever applied for a bank loan or a credit card, you’ll remember that you had to gather some basic financial information — assets you own and outstanding liabilities as of a specific date, annual income, and annual expenses. All of this information, whether you knew it or not, constituted your personal financial statements.
Under Generally Accepted Accounting Principles or GAAP (discussed in Installment #3), a company’s financial statements comprise:
Many smaller, non-public companies do not hire an accountant and thus their financial statements cannot include an accountant’s report or auditor’s opinion letter.
Indeed, there is no requirement for a privately owned company to prepare any specific financial statement, except indirectly in as much as a company has to file tax returns. Doing so is pretty difficult without the information contained in the various financial statements.
Regardless of any legal requirements, most lenders and some other third parties with whom a company wants to do business will require financial statements. Therefore, the vast majority of companies prepare several types of financial statements. Many do not use an accountant or auditor, but again, some third parties may require a company to do so before they will do business with it.
When an accountant is used, the accountant may or may not provide a level of assurance to the financial statements. There are three levels of assurance an accountant can provide:
The balance sheet is a snapshot of the assets, liabilities, and owners’ equity at a specific date. Just as the title states, the balance sheet balances. The formula is
assets = liabilities + equity
If you don’t like that formula you can apply just the lightest touch of math to make it read
assets – liabilities = equity
which was always more intuitive to me.
One of the limitations of a balance sheet is that the amounts are generally stated as historical values (i.e. what the company paid for an asset) less depreciation rather than fair market values (i.e. the price the company would be paid if the asset were sold today).
The income statement presents revenues, expenses, and net income or loss. Sometimes the income statement is referred to as the profit and loss (P&L) statement, statement of earnings, statement of income, or statement of operations (this last name is sometimes used when the company has a net loss).
A typical income statement contains the following items:
The statement of changes in owners’ equity provides details about the increase or decrease in equity for the period. Capital contributions and net income are increases to equity. Distributions, dividends, and net losses are decreases to equity.
The statement of cash flows shows the changes in the balance sheet for the period. The changes are broken down into operating, investing, and financing activities.
The footnotes to such financial statements give the reader a further understanding of accounting policies and procedures the company used, as well as a more robust description of certain numbers represented in the specific financial format being used. Specific disclosures that may appear in footnotes may include related party transactions, commitments, and contingencies.
As a threshold matter, keep in mind that financial statements are interrelated; they should be read together because information on one ties to information on another.
There are many ways to analyze the numbers in financial statements. These include
We’ll describe each of these methods of analysis in later installments.
There is an expression that is chock full of truth: cash is king. If you get nothing else from this series, I hope you walk away from reading the next installment understanding why cash is king and why failure to really understand this may be the most likely reason a business you own or a business you invest in will fail.
Browse all installments of Know Thy Numbers/Know Thy Business, starting at the beginning with ‘Know Thy Numbers’ Installment #1 – Welcome to the Jungle, an Introduction to the Series.
[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):
This is an updated version of an article originally published on November 13, 2019.]
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Since graduating from the University of Michigan in film and screenwriting, Kristina Parren has worked as a copywriter and grant writer across multiple industries, including healthcare, finance, manufacturing, and travel. In addition to her work as an editor and copywriter, she is an avid wildlife conservation activist, involved in conservation and reintroduction projects throughout Africa.
Jonathan Friedland is a principal at Much Shelist. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer”, by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts Magazine; Smart Business Magazine; The M&A…
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