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 commonly 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 Installment #3), a company’s financial statements are comprised of:
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 that a company has to file tax returns, and doing so is pretty difficult without the information contained in the various financial statements.
Also, regardless of any legal requirements, most lenders and some other third parties with whom a company wants to do business will require financial statements, and so the vast majority of companies prepare several types of financial statements. Many, however, do not utilize an accountant or auditor in so doing, 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:
But what do those opinions mean?
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 generally are 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 the accounting policies and procedures the company used in preparing the financial statements, as well as a more robust description for 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 the 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.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Finance and Accounting 101, EBITDA and Other Scary Words and How to Read a Balance Sheet – And Why You Care!]
Jonathan Friedland is an attorney and entrepreneur. He founded DailyDAC in 2010 and launched Financial Poise in 2013. For more information on his legal practice, click here.
Kristina Parren is an associate editor with Financial Poise. Since graduating from the University of Michigan in film and screenwriting, she 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,…
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