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The Best Ideas Simplified

How to Use
Financial
Statements
A Guide to Understanding the Numbers

Summary Overview

Financial statements are often seen as difficult to read

if you don’t have the professional knowledge to do so.
By James Bandler This book aims to take what looks like a complicated
task and make it simple. It takes you through the three
report which make up a financial statement: Balance
CONTENTS Sheet, Income Statement and Cash Flow Statement.
What Are Financial
Statements
Page 2 The summary covers the basic principles and issues
The Balance Sheet surrounding the creation of financials statements.
Page 3
The Income Statement
Finally, you will learn the basic tools of financial
Page 4 analysis and the limitations of financial statements.
The Cash Flow Statement With this knowledge, you should be able to read and
Page 5
Intangible Assets and
understand your own financial statements.
Amortization
Page 7
What Are the Rules
Governing Preparers of
Financial Statements?
Page 8
Summary of Significant
Accounting Policies
Page 8
Some Basic Tools of
Financial Analysis
Page 9
The Limitation of
Financial Statements
Page 11

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What Are Financial Statements and What do They

Tell Us?
Financial statements tell you how well a company has been doing. Each statement tells
one side of your company’s story. They consist of three parts:
1. The Balance Sheet: This gives you a quick picture of a company’s financial
health at any point in time. It lists assets versus liabilities and owners’ equity.
2. The Income Statement: This shows the company’s profit during a specified
time. Information includes net profits, expenses, and revenue.
3. The Cash Flow Statement: Showed you how much cash the company earned
during the period of time covered by the income statement, and how it was spent.

Who Uses Financial Statements and What Do

They Look For?
• Business owners: They are usually most interested in the company’s profits, and
concentrate on the income statement.
• Lenders: They care most about a company’s cash flow, and tend to focus on the
cash flow statement.
• Managers: Managers, like owners, need financial statements to assess their
company’s strengths and weaknesses.
• Suppliers: Suppliers usually get deferred payment. They want to determine a
company’s ability to pay, and tend to be concerned with the cash flow statement.
• Customers: When buying from suppliers and other providers, business customers
want to know they’re choosing a company that will last.
• Attorneys: When planning to litigate, lawyers want to be sure their target can
pay. They usually are most concerned with the balance sheet.
• Employees and job applicants: Employees and future employees need to know a
company’s health, including its ability to fund retirement plans.
An Introduction to the Accrual Concept
To understand financial statements, you must understand accrual accounting. Accrual
accounting reports revenue as it is earned and expenses as they are incurred—regardless
of whether you’ve actually received or spent the money yet.
Cash Basis Financial Statements
• On a cash basis financial statement, you don’t record earnings you haven’t yet
received. For example, if you’re a construction contractor and you do an $8,000
job toward the end of the fiscal year—but you don’t actually receive the paycheck
for that job until the beginning of the next year—you don’t record the money.
• In addition, you don’t record business expenses you haven’t paid out yet. If you
had to hire a subcontractor to help you finish the work—but you don’t send out
the paycheck until the beginning of next year—you don’t record the expense.
• This can distort the picture of your company’s finances. Remember that financial
statements try to match up earnings with the expenses incurred to secure those
earnings. For example, you might pay the subcontractor long before the job is

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finished—but you still don’t get paid until after the fiscal year is over. So you
have an expense and no earnings to match it with.
Accrual Accounting Financial Statements
• Accrual accounting records earnings and expenses as they are incurred—not when
the cash changes hands.
• When you spend money under accrual accounting, the expense is recorded as
soon as you’ve benefited from the money you’ve spent by using the product or
service you’ve bought.
• When you earn money under accrual accounting, you record it when you send the
invoice—not when you get the money.
Depreciation
• Expenses must be matched to the revenue they earn. When it comes to an
expensive, long-lasting item such as a building, vehicle, or piece of machinery,
this leads to depreciation.
• With accrual accounting, the item’s entire cost is not recorded the year it was
bought. Instead, it is spread out over the life of the item.
• The cost of the item is matched against the revenue it generates over a specific
length of time.
The Price of Sold Goods
• The money it cost to buy or produce the products you sell is not recorded during
the time you spent that money.
• Instead, it is recorded when you sell the product.

The Balance Sheet

The balance sheet shows you the owners’ equity, the assets, and the liabilities of a
company. The amount of assets should always equal the amount of the equity plus the
liabilities.
The Purpose of Balance Sheets, and Why They Must Balance
• A balance sheet should give you an idea of the fiscal health of the company.
• Assets are what you need to start and run a business. But you need to get those
assets from some source. The only way to do this is to:
1. Contribute it in the form of capital.
2. Earn it through company profits.
3. Borrow it as a liability.
• To learn what your company is actually worth, you must take what you owe (your
liabilities) away from the money you have (your assets). This will leave you with
your net worth (owners’ equity).
• The relationship between the three can be summarized this way:
Assets – Liabilities = Owners’ Equity OR Assets = Owners’ Equity + Liabilities
Parts of a Balance Sheet
1. Assets.

• A company’s assets include cash, items that can be converted to cash, and things
that are not easy to convert themselves, but that are needed to earn cash. They are

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usually listed in order from easiest to convert into cash to hardest—beginning

with actual cash.
• Current assets are items that are cash or will be converted to cash within the year.
• Non-Current Assets are items you can’t easily convert to cash, but you need to
operate your business. These can include your building, factory equipment, plant,
or vehicles.
Liabilities
• Liabilities include debts, unpaid bills, and expenses owed by the company.
• Current liabilities are expenses incurred within the year.
• Long-term debts are not expected to be paid during the year. They can include
the noncurrent part of debt owed to banks and publicly traded bonds and notes.
Owners’ Equity
• This is what remains after all liabilities have been paid for that year. It is the
owner’s claim of the company’s profits, and is not to be considered an asset.

Leverage is the amount of liabilities versus the amount of owners’ equity at the end of the
year. If a company has high liabilities in relation to its owners’ equity, it is highly
leveraged. These companies have less ability to absorb losses during downturns.

The Income Statement

The income statement shows how much money a company is making and spending. It
subtracts all of that year’s overhead costs from the earnings made that year.
Parts of an Income Statement:
Revenues
• For companies that sell products, revenues can take the form of “net sales.”
However, they can also include rentals, commissions, interest earned, or any other
money that a company accumulates over the year.
Cost of Sold Goods
• All costs related to sold goods that year, including inventory costs, labor,
manufacturing costs, shipping, and materials.
Gross Profit
• This is the figure you get when you subtract your cost of goods sold from your
revenues.
Operating Expenses
• These are the costs of running the company. These costs are necessary from day
to day, and would be the same amount regardless of how many items are
produced and sold that day.
• They may include management and office-employee salaries, property and
equipment, advertising, non-production utilities, and office supplies.
Provision for Income Taxes
• This figure represents the percentage the company is taxed. This varies from
company to company.
Net Income
• This is the figure left over after all costs, liabilities and taxes are paid for the year.

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How the Income Statement Affects the Balance Sheet:

• Whether you earn an income or suffer a loss will affect your owners’ equity.
Profits and losses are generally added or subtracted from the owners’ equity.
• Increases in profit also increase owners’ equity and assets, or reductions in
liability.

The Cash Flow Statement

The statement of cash flow is a relatively new development in accounting. It arose out of
the fact that all payments are not received exactly when they are earned, and all payments
are not made exactly when they are incurred. The cash flow statement converts profits or
losses into cash flow.
Conceptual Basis for the Cash Flow
The cash flow statement starts with your net income: the figure you have at the end of
your income statement. It then assumes that all your deductions and earnings were made
with cash, and makes changes to show where cash was actually earned and spent.
Calculating Cash Flow
• On a cash flow statement, earnings and expenses do not have to match up. It
shows the actual flow of cash in your company during the fiscal year.
• Your depreciation should be added back to your net income, as it is not
considered a cash expense.
• Accounts receivable indicate customers who owe you money—and who have not
yet paid. These must be deducted from the net income, as they are not cash in
hand.
• The sales cost of any unsold inventory should be deducted from the net income.
On an income statement, all inventory for that year is assumed to be sold. In
reality, this may or may not be the case. If you have inventory left over, you
cannot identify it as cash in hand.
• Purchasing pre-paid items such as property and equipment are counted as spent
cash, and deducted.
• Your company’s financial activities such as debt payments or new debt acquired
can also affect your cash flow statement. Debt payments will be subtracted, while
new loan funds will be added.
Alternative Cash Flow Statements
• Another method of compiling a cash flow statement is intended to show how
much revenue is earned from sales, and how much is spent on production and
operating expenses.
• At each step, revenues and spending are converted to cash spent or earned.
First, add accounts receivable to the beginning of the period—even when they
were collected last period. They are your starting cash for this period.
• Add in all revenues as if they had all been collected. Subtract accounts receivable
at the end of the period.
• Cost of goods sold are subtracted as spending for production.
• Operating expenses should be adjusted so that the cost of the last quarter is added,
and the cost for the end accrued expenses is subtracted.

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Using the Cash Flow Statement

Cash flow statements are a useful tool, but they can also be deceptive. If the bottom line
number is used merely to support the case that a company is strong or weak, you may not
be getting the whole story. Cash flow statements are most effective when the whole
picture is taken into account.

Following a Transaction Through the Financial

Statements
There are accounting rules and issues that can give additional meaning to different facets
of any financial statement. Inventory purchases, sale of inventory, revenue collection,
and other payments can all have an effect on a financial statement.

The cash flow statement, balance sheet, and income statement are all affected by a
company’s growth or decline, its ability to generate income, its operational efficiency,
and its ability to pay its debts.

Special Inventory Valuation and Depreciation Reporting Issues

The rules for reporting financial statements are generally standardized. However, there is
some latitude between methods of reporting. The accountant must always disclose in
footnotes the method he is using. Inventory valuation and depreciation are two areas
where the accountant has some reporting latitude.
Variations in Reporting Inventory Valuation
• FIFO (First-In, First-Out): Determines cost-of-sale based on the cost of the first
inventory unit bought.
• LIFO (Last-In, First-Out): Sets cost-of-sale numbers based on the cost of the
last unit bought.
• Average cost: Uses the average cost of the inventory over the year to determine
the cost of sale.
Issues in Reporting Depreciation
• The crucial issue with depreciation is the life of the asset, and the increments by
which it decreases in value.
• The projection of useful life may be figured by the length of time the asset will
function before the cost of repairs becomes higher than the replacement cost.
• It can also be affected by obsolescence: the length of time it can operate
economically before improved technology renders it obsolete.
• If a company overestimates the useful life, it can result in losses when the
company retires or attempts to sell the equipment.
• If a company underestimates the useful life, it can have a distorting effect on the
financial statement.
Types of Depreciation Reporting
• Straight-line depreciation: the incremental depreciation of the asset’s value is
distributed equally over the asset’s projected lifespan.
• Accelerated depreciation assumes that the asset loses more value toward the
beginning of its life.

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Intangible Assets and Amortization

Some intangibles can affect the financial statements in important ways.
1. Amortization. This is the cost accrued in developing intangible benefits to a company
such as goodwill, branding, intellectual property rights, and so on.
2. Intangible assets. These are assets that cannot be touched or held, but that are
nevertheless valuable to a company.
• These can include innovation, branding, patents, intellectual property, and so on.
• On the balance sheet, it is difficult to estimate the value of these items.
• They are sometimes reported according to the cost to achieve them, but it is
difficult to say whether that cost reflects the value.
• Often, these intangibles are worth much more than companies pay for them.
3. Goodwill. Goodwill can arise when one company buys another for more than the
company’s net asset value. While this has no tangible benefits to the buyer, they are
considered to produce considerable goodwill and benefit the buyer.
Service Companies
Service companies often have more complex and innovative methods of accounting than
the more straightforward manufacturing companies do. Some major differences are as
follows:
• They generate revenues by providing services, not goods.
• They do not show inventory or cost of goods sold on their financial statements.
Instead, they show cost of services provided.
• This method of accounting does not require a beginning and end inventory.
Financial Services Companies
These companies often show small owners’ equities and large amounts of loans and
investments on their balance sheets. They feel they need less equity because of the
confidence they have in their ability to estimate and realize the values of their
investments.
• Banks’ assets usually consist mostly of loans; and their liabilities are largely
deposits.
• Their income is usually in the form of earned interest; their costs in paid interest.
• Insurance companies invest heavily in funds they feel will give them the ability
to pay out on claims. Their liabilities are often claims they have paid or estimates
of claims they may pay out in the future. Revenues come from investments and
policy payments.
• Securities brokerage firms invest most of their assets in securities. Their
liabilities and assets are both financing and investment arrangements.
Commissions to brokers are a large cost.
Capital-Intensive Companies
The revenues for these companies come mostly from properties, equipment, and
factories. These include airline companies, hotels, hospitals, public utilities, public
transportation companies, and so on.
• They often have significant amounts of noncurrent assets due to their heavy
investment in long-lived, expensive items.
• Their expenses often involve heavy depreciations.
People-Intensive Companies

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These companies provide professional services and their value is invested mainly in their
employees. They include law firms, accounting firms, advertising agencies, and
architectural firms.
• They often have large accounts receivables, and no inventory.
• They have little in the way of noncurrent assets, and little long-term debt.
• They have large payroll expenses.

What Are the Rules Governing Preparers of

Financial Statements?
GAAP and GAAS
The rules that govern how people prepare financial statements are called the Generally
Accepted Accounting Principles (GAAP) and the Generally Accepted Auditing Standards
(GAAS). These state that preparers have the following responsibilities:
1. Follow the rules laid forth in GAAP and GAAS.
2. Disclose all information that will enable the reader to understand the statements. This
is included in footnotes and in an opinion letter that is included with the statement.
3. According to the rules, there are differences across industries in when revenue may be
recognized. But companies in similar industries usually follow the same rules.
4. In areas where there are a range of acceptable methods, the preparer must disclose to
the reader what method has been used.
Types of Disclosures:
General:
• An outline of the nature of the business and its practices.
• This is useful because it makes it easier to understand a company’s accounting
practices if you know the type of the business.

Summary of Significant Accounting Policies

• Principles of consolidation: The companies included in the statement, and the
accounting rules for their inclusion. Subsidiaries are usually consolidated.
• Revenue recognition: The criteria followed in determining how the revenue is
recognized and reported.
• Treatment of “excess purchase price over net assets of business acquired.” Is
goodwill being amortized? If so, what is the time period involved?
• Property and equipment. Categorize property and equipment, showing the
methods of depreciation and estimating useful life.
• Inventory. What method of inventory method is being used: FIFO, LIFO, or
average cost?
• Research and development cost. How are research and development costs
recorded as expenses, and how are their values arrived at?
• Definition of cash equivalents. Definition of short-term investments that can be
liquidated for cash.
• Warranties or other terms of sale. Is there a warranty involved in the sale of
the company’s products or services? If so, it may lead to future expenses.
Description of Credit Facilities

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• How much can the company borrow? What are the terms?
Description of Terms and Funding of Employee Benefit and Retirement Plans
• Who is eligible for benefits? What are the current costs of those benefits?
Estimated future costs? How is the company funding benefits and retirement?
Reconciliation of Income Tax Expenses to Statutory Federal and State Tax Rates
• What effects do the timing discrepancies between reporting federal and state
income taxes have on the statements?
Long-Term Debt Maturities
• How much long-term debt must be paid in the next five years, and how much
after that?
Property and Casualty Insurance
• Is the company sufficiently covered?
Transactions with Insiders or Related Entities
• This discusses the nature of any business transactions with managers, directors, or
business entities owned or directed by company insiders.
Major Customers/Suppliers
• Discusses any major outside companies that are critical to this company’s
operation, including major customers and suppliers. Discusses the risk to the
company if these other companies close down.
Industry Segment Information
• The amount of sales by product line or geographical information.
Current Costs and Replacement Value of Nonmonetary Assets
• Discusses the costs and value of nonmonetary assets such as inventory, property,
and intangibles.
Contingent Liabilities
• Discusses new developments that may obligate the company in the future. These
are usually lawsuits or changing government regulations.
Events Subsequent to the Report Date
• Discusses other events that may have an effect on the financial statement after it
has been finalized, in enough detail so that the reader may form an opinion on
how it will likely affect the statement.
Opinion Letters
• The letter must be from a third party. It states that the statement has been
prepared in accordance with GAAP. It discusses whether the statement has been
audited. Audited statements have the highest level of assurance; but not all
financial statements must be audited.

Some Basic Tools of Financial Analysis

To understand a company’s strengths and weaknesses based on its financial statements,
you must be able to understand the relationships between different facets of data
presented in the statements. To do this, accountants and others use a system of ratios.
• Leverage Ratio. This is the ratio of total liabilities against owners’ equity. A
high leverage ratio (high total liabilities) indicates a company that may not be able
to absorb losses or handle new debts.

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• Current and Quick Ratio. These ratios measure a company’s liquidity. The
quick ratio is the ratio of the company’s total cash, accounts receivable, and short
term marketable securities against its current liabilities. The current ratio is the
total current assets vs. the total current liabilities.
• Debt Coverage Ratio. This is an indication of whether the company’s cash flow
can cover its debts. It’s found by adding the total noncash charges and net
income, then dividing by the current maturities of a company’s long-term debt.
• Accounts Receivable Collection Period. This tells whether a company can
collect its debts receivable within a reasonable timeframe. You find it by dividing
the accounts receivable by the period’s sales, multiplied by the number of days in
the period.
• Days Inventory Supply: Is the company carrying enough inventory to meet
market demand and the company’s sales level? Find it by dividing the inventory
by the cost of goods sold, then multiplying by the number of days in the period.
Too much inventory indicates that the inventory isn’t selling at the company’s
prices, and may not sell. Too little indicates the company needs to increase its
stock.
• Return on Assets: Are the company’s assets producing enough in income
relative to other investment opportunities? To find it, divide the net income by
total assets. The number you get should exceed the amount you’d earn on other
investments.
• Return on Equity: Is the company earning enough to be promising to investors?
To find it, divide net income by owners’ equity. The number should be above the
risk-free rate of return investors would get elsewhere.

The Limitation of Financial Statements

It’s trendy to state that management matters more than financial statements. But financial
statements provide a concrete record of a company’s fiscal health—and helps figure out
how to maximize profit and eliminate problems. While management may make changes
that have an effect on cash flow, a company with severe financial problems is difficult to
save even with the best management.

However, financial statements are only historical documents. The only solid information
they contain is information about the past. The rest is made up of assumptions, forecasts,
and conjecture. While the historical information contained in a financial statement may
make such forecasts quite accurate, there are no guarantees. They are highly useful tools
in analyzing a company’s strengths and weaknesses—but only if their limitations are
fully known.

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