Understanding Financial Statements:

Balance sheet

The term balance sheet refers to a financial statement that reports a company's assets, liabilities, and
shareholder equity at a specific point in time. Balance sheets provide the basis for computing rates
of return for investors and evaluating a company's capital structure.

In short, the balance sheet is a financial statement that provides a snapshot of what a company owns
and owes, as well as the amount invested by shareholders.

The balance sheet adheres to an equation that equates assets with the sum of liabilities and
shareholder equity.

Fundamental analysts use balance sheets to calculate financial ratios.

Investors can get a sense of a company's financial well-being by using a number of ratios that can
be derived from a balance sheet, including the debt-to-equity ratio and the acid-test ratio, along with
many others.

This formula is intuitive. That's because a company has to pay for all the things it owns (assets) by
either borrowing money (taking on liabilities) or taking it from investors (issuing shareholder
equity).

Assets
Accounts within this segment are listed from top to bottom in order of their liquidity. This is the
ease with which they can be converted into cash. They are divided into current assets, which can be
converted to cash in one year or less; and non-current or long-term assets, which cannot.
Here is the general order of accounts within current assets:

• Cash and cash equivalents are the most liquid assets and can include Treasury bills and
short-term certificates of deposit, as well as hard currency.
• Marketable securities are equity and debt securities for which there is a liquid market.
• Accounts receivable (AR) refer to money that customers owe the company. This may
include an allowance for doubtful accounts as some customers may not pay what they owe.
• Inventory refers to any goods available for sale, valued at the lower of the cost or market
price.
• Prepaid expenses represent the value that has already been paid for, such as insurance,
advertising contracts, or rent.

Long-term assets include the following:

• Long-term investments are securities that will not or cannot be liquidated in the next year.
• Fixed assets include land, machinery, equipment, buildings, and other durable, generally
capital-intensive assets.
• Intangible assets include non-physical (but still valuable) assets such as intellectual property
and goodwill. These assets are generally only listed on the balance sheet if they are
acquired, rather than developed in-house. Their value may thus be wildly understated (by
not including a globally recognized logo, for example) or just as wildly overstated.

Liabilities
A liability is any money that a company owes to outside parties, from bills it has to pay to suppliers
to interest on bonds issued to creditors to rent, utilities and salaries. Current liabilities are due
within one year and are listed in order of their due date. Long-term liabilities, on the other hand, are
due at any point after one year.

Current liabilities accounts might include:

• Current portion of long-term debt is the portion of a long-term debt due within the next 12
months. For example, if a company has a 10 years left on a loan to pay for its warehouse, 1
year is a current liability and 9 years is a long-term liability.
• Interest payable is accumulated interest owed, often due as part of a past-due obligation such
as late remittance on property taxes.
• Wages payable is salaries, wages, and benefits to employees, often for the most recent pay
period.
• Customer prepayments is money received by a customer before the service has been
provided or product delivered. The company has an obligation to (a) provide that good or
service or (b) return the customer's money.
 • Dividends payable is dividends that have been authorized for payment but have not yet been
issued.
• Earned and unearned premiums is similar to prepayments in that a company has received
money upfront, has not yet executed on their portion of an agreement, and must return
unearned cash if they fail to execute.
• Accounts payable is often the most common current liability. Accounts payable is debt
obligations on invoices processed as part of the operation of a business that are often due
within 30 days of receipt.

Long-term liabilities can include:

• Long-term debt includes any interest and principal on bonds issued

• Pension fund liability refers to the money a company is required to pay into its employees'
retirement accounts
• Deferred tax liability is the amount of taxes that accrued but will not be paid for another
year. Besides timing, this figure reconciles differences between requirements for financial
reporting and the way tax is assessed, such as depreciation calculations.

Retained earnings are the net earnings a company either reinvests in the business or uses to pay off
debt. The remaining amount is distributed to shareholders in the form of dividends.

Treasury stock is the stock a company has repurchased. It can be sold at a later date to raise cash or
reserved to repel a hostile takeover.
Income Statement

The income statement gives an account of how the net revenue realized by the company gets
transformed into net earnings (profit or loss). This requires reporting four key items:
revenue, expenses, gains, and losses. In each line, the income statement does not differentiate
between cash and non-cash receipts (sales in cash vs. sales on credit) or cash vs. non-cash
payments/disbursements (purchases in cash vs. purchases on credit).

Operating Revenue
Revenue realized through primary activities is often referred to as operating revenue. For a
company manufacturing a product, or for a wholesaler, distributor, or retailer involved in the
business of selling that product, the revenue from primary activities refers to revenue achieved from
the sale of the product.

Similarly, for a company (or its franchisees) in the business of offering services, revenue from
primary activities refers to the revenue or fees earned in exchange for offering those services.

Non-Operating Revenue
Revenue realized through secondary, noncore business activities is often referred to as
nonoperating, recurring revenue. This revenue is sourced from the earnings that are outside the
purchase and sale of goods and services such as income from:

• Interest earned on business capital in the bank

• Renting business property
• Strategic partnerships like royalty payments
• Advertisements placed on business property

Gains
Also called other sundry income, gains indicate the net money made from other activities like the
sale of long-term assets. These include the net income realized from one-time nonbusiness
activities, such as a company selling its old transportation van, unused land, or a subsidiary
company.

Primary-Activity Expenses
These are all expenses incurred for earning the average operating revenue linked to the primary
activity of the business. They include the cost of goods sold (COGS); selling, general, and
administrative (SG&A) expenses; depreciation or amortization; and research and
development (R&D) expenses. Typical items that make up the list are:

• Employee wages
 • Sales commissions
• Utilities
• Transportation

Secondary-Activity Expenses
These are all expenses linked to noncore business activities, like interest paid on loan money. They
may be recurring or happen only once.

Losses as Expenses
These are all expenses that go toward a loss-making sale of long-term assets, one-time or any other
unusual costs, or expenses toward lawsuits.

the single-step income statement as it is based on a simple calculation that sums up revenue and
gains and subtracts expenses and losses.

In a multi-step income statement for a large corporation, the measures of profitability are reported at
four different levels in a business's operations: gross, operating, pretax, and after-tax.
What Is a Cash Flow Statement?
A cash flow statement is a financial statement that provides aggregate data regarding all cash
inflows that a company receives from its ongoing operations and external investment sources. It
also includes all cash outflows that pay for business activities and investments during a given
period.

The cash flow statement is believed to be the most intuitive of all the financial statements because it
follows the cash made by the business in three main ways:

• Operating activities: These include revenue and expenses derived from regular goods and
services.
• Investment activities: These involve purchasing or selling assets—anything from real estate
to patents—using free cash, not debt. They include both gains and losses.
• Financing activities: These involve debt and equity financing.

There are two different methods of accounting. They are:

• Accrual accounting: This method recognizes income when it’s earned, not when it’s
received, and expenses when they are incurred, not when they are paid. It means that
the income statement is not the same as the company’s cash position. Most public
companies use accrual accounting.
• Cash accounting: This method recognizes income when the cash is actually received and
expenses when they are paid. The cash flow statement is focused on cash accounting.

The first section of the cash flow statement covers cash flows from operating activities (CFO) and
includes transactions from all operational business activities. The CFO section begins with net
income, then reconciles all noncash items to cash items involving operational activities. In other
words, it is the company’s net income, but in a cash version.

This is the second section of the cash flow statement. It looks at cash flows from investing
(CFI) and is the result of investment gains and losses. It also includes cash spent on property, plants,
and equipment. It is where analysts look to find changes in capital expenditures.
Positive cash flows within the CFI section, which can be generated in such ways as selling
equipment or property, can be considered good. However, investors usually prefer that companies
generate their cash flow primarily from business operations.

Cash flows from financing (CFF) is the last section of the cash flow statement. It provides an
overview of cash used in business financing and measures cash flow between a company and its
owners and creditors. The cash normally comes from debt or equity, such as selling stocks and
bonds or borrowing from a bank. These figures are generally reported annually on a company’s 10-
K report to shareholders.

Analysts use the CFF section to determine how much money the company has paid out via
dividends or share buybacks. It’s also useful to help determine how a company raises cash for
operational growth. Cash obtained or paid back from capital fundraising efforts and loans is listed
here.

When the cash flow from financing is a positive number, it means there is more money coming into
the company than flowing out. When the number is negative, it may mean the company is paying
off debt or making dividend payments and/or stock buybacks.