Accounting Basics: Financial Statements

Financial statements present the results of operations and the financial position of the company. Four main statements are commonly prepared by publicly-traded companies: balance sheet, income statement, cash flow statement and statement of changes in equity.

Balance Sheet (Statement of Financial Position)

The balance sheet tells you whether the company can pay its bills on time, its financial flexibility to acquire capital and its ability to distribute cash in the form of dividends to the company's owners. In short, it is a view of the company’s financial positions as of the date it is prepared.  

The balance sheet shows the company's assets, liabilities and shareholders' equity. Each is defined in Statement of Financial Accounting Concepts No. 6, but to summarize:

• Assets are items that provide probable future economic benefits
• Liabilities are obligations of the firm that will be settled by using assets.
• Equity (variously called stockholders equity, shareowners equity or owners equity) is the residual interest that remains after you subtract liabilities from assets and represents what is left for the shareholders.

The key balance sheet accounting equation is Assets = Liabilities + Owners Equity, or A=L+OE

In the most common format, assets on a balance sheet are listed on the left; they ordinarily have debit balances unless the balance is negative or a contra-asset, an offset to a basic asset account is shown separately. Liabilities and owner’s equity is shown on the righthand side, and these accounts typically have credit balances. These three main categories are separated and further divided to show important relationships and subtotals.

Assets are broken down into current and noncurrent (or long-term). Assets are listed from top to bottom in order of decreasing liquidity, i.e., how quickly they can be converted to cash. (For more on this see, Reading The Balance Sheet.)

Current assets are cash and other assets that are expected to be used during the normal operating cycle of the business, usually one year. They typically include cash and cash equivalents, short-term investments, accounts receivables, inventory and prepaid expense. Noncurrent assets will not be realized in full within one year. They typically include long-term investments: property, plant and equipment; intangible assets and other assets.

Liabilities are listed in order of expected payment. Obligations expected to be satisfied within one year are current liabilities. They include accounts payable, trade notes payable, advances and deposits, current portion of long-term debt and accrued expenses. Noncurrent liabilities include bonds payable and the portion of long-term debt such as loans maturing in period longer than a year.

The structure of the owners' equity section depends on whether the entity is an individual, a partnership or a corporation. Assuming it's a corporation, the section will include capital stock, additional paid-in capital, retained earnings, accumulated other comprehensive income and treasury stock.

Balance sheet data can be used to compute key indicators that reveal the company's financial structure and its ability to meet its obligations. These include working capital, current ratio, quick ratio, debt-equity ratio and debt-to-capital ratio. (To learn more read, Testing Balance Sheet Strength.)

Analysts, potential creditors and investors can learn a lot from reviewing a company’s balance sheet. For example:

• How risky is the firm’s capital structure? How does it compare to other companies in the same industry? Too much debt in the capital structure can pose a risk during rough periods in the economy, too little debt might be a sign that too little leverage is being used possibly limiting the company’s ability to grow as quickly as their competitors.
• How liquid is the company? This can be assessed by looking at the firm’s current assets relative to their current liabilities.
• The balance sheet in combination with other financial statements is a key tool in reviewing a company’s financial picture and its financial viability.

Income Statement

The income statement (also known as the profit and loss statement or P&L) tells you both the earnings and profitability of a business. The P&L is always for a specific period of time, such as a month, a quarter or a year. The periodic nature of the income statement is essential as this allows users to compare results for the company over similar periods of time, and to the results of other firms for the same period. Depending on the industry, year over year comparisons that eliminate seasonal variables can be especially useful.

The format of the income statement has been determined by a series of accounting pronouncements; some of these are decades old, others released in the past few years. Like the balance sheet, the income statement is broken into several parts:

• Income from continuing operations
• Results from discontinued operations (if any)
• Extraordinary items (if any)
• Cumulative effect of a change in accounting principle (if any)
• Net income
• Other comprehensive income
• Earnings per share information

Income from continuing operations is the heart of the P&L. It includes sales (or revenue), cost of goods sold, operating expenses, gains and losses, other revenue and expense items that are unusual or infrequent but not both, and income tax expense.

This section of the income statement is used to compute the key profitability ratios of gross margin, operating margin, and pretax margin that help readers assess the ability of the company to generate income from its activities.

Results from continuing operations are of primary interest because they are ongoing and can be predictive of future earnings; investors put less weight on discontinued operations (which are about the past) and extraordinary items (unusual and infrequent, thus unlikely to recur).

Companies thus have an incentive to push negative items that belong in continuing operations into other categories. (For further reading on the income statement see Find Investment Quality In The Income Statement.)

Net income is the "bottom line"; it is expressed both on an actual and, after comprehensive income, on a per share basis. If a company has hybrid securities, like convertible bonds, there is the potential for additional shares to be created and earnings to be diluted. Earnings per share may therefore be presented on basic and diluted bases, in accordance with the complex rules of FAS 128.