‘Know Thy Numbers’ Installment #3: Types of Financial Statements

Components of a Company’s Financial Statements

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.

• Your listing of your assets like cash, investments, and your home along with liabilities like credit card balances and mortgages – this was your balance sheet.
• Your listing of income and expenses – this was your income statement.

The Types of Financial Statements and What They Tell Us

Under Generally Accepted Accounting Principles or GAAP (discussed Installment #3), a company’s financial statements are comprised of:

1. Accountant’s report or auditor’s opinion letter
2. Balance sheet
3. Income statement aka statement of operations
4. Statement of changes in owner’s equity
5. Statement of cash flows
6. Footnotes
7. Supplemental information (if applicable)

The Accountant’s Report

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:

• A compilation provides no assurance from the accountant. These reports are cheaper to acquire, and they specifically say that they do not offer an opinion on the financial statements.
• A review provides limited assurance that the financial statements are free of material misstatements and in conformity with GAAP. If the creditor allows it, a company can choose this option as an alternative to an audit in order to save money.
• An audit provides the highest level of assurance, and it gives an independent opinion on the accuracy and fairness of the company’s financial statements. The audit opinion can be unqualified, qualified, adverse or a disclaimer of opinion.

But what do those opinions mean?

• Unqualified is a good thing. It means that the financial statements are in accordance with GAAP or another basis of accounting, and there are no material issues.
• Qualified opinions are given when the financial statements have a particular account balance, or another item may be materially misstated, or GAAP is not being followed.
• An Adverse Report is issued when there are material misstatements in the financial statements.
• A Disclaimer of Opinion is used when the accountant is not independent or the audit can not be completed.

The Balance Sheet

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

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:

• Sales revenue
• Cost of Goods Sold (COGS) or costs associated with selling a product to generate sales
• Net income or gross profit (Net Income = Revenue – COGS)
• Income taxes
• Additional expenses (e.g., marketing, salaries, research and development, etc.)
• Depreciation (to spread out the cost of an asset over time)
• Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) or general and administrative expenses subtracted from gross profit

The Statement of Changes in Owners’ Equity

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

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.

• Operating activities are the primary activities of the business. This includes the changes in the accounts receivable, inventory and accounts payable, as well as adjustments for non-cash operating activities such as depreciation, amortization, bad debts, and gains from the sale of investments or property and equipment.
• Investing activities represent cash flows from the purchase and sale of assets other than inventories.
• Financing activities are for cash flows related to equity and debt activity, such as proceeds from bank loans or distributions to shareholders.

The Footnotes

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.

Analyzing Financial Statements: An Introduction

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:

• Ratio analysis
• Benchmarking
• Comparing to industry averages
• Horizontal analysis
• Variance analysis
• Common-size analysis

We’ll describe each of these methods of analysis in later installments.

What’s Next?

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: 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.

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!]