Anatomy of The Financial Statements

The Financial Statements are a picture of a company. Some people can pick companies that make
them hundreds of thousands, or millions of dollars. But what exactly makes up the financial
statements of a company? How do they work together?
Here are the basics. There are three main financial statements. The Balance Sheet, the Income
Statement, and the Statement of Cash Flows. These three statements are linked intimately to each
other, and reflect different ways that we can view a company.

The Balance Sheet

The Balance Sheet gives us a snapshot in time at the liabilities, assets and equity of a company. We
can get an idea of the capital structure of the business, and what types of assets the business may
have. For example, a company may have $300 of assets, but that $300 is going to have different
value if that is long term loans that are receivable, or if it is cash in the bank.
The first section on the balance sheet is the Assets section. This represents anything that the
company owns, or any future entitlement to economic benefits.
The liabilities are essentially the opposite of assets. They represent money, or economic benefits
that the company must pay out.
The last section of the balance sheet shows the ownership of the company, or the equity. This is
where we discern what the capital structure of the company is.
On the balance sheet, we have an equation that must hold. That is, Assets = Liabilities + Equity.
Essentially, what this is saying is that all of the assets of a company must be funded either by debt to
someone else, in some form, or equity of the owners.

The Income Statement

The Income Statement is exactly what it sounds like. It details all of the income and expenses of the
company, and the bottom line will show us the Net Income of the company.
The important thing to remember, however, is that the income statement shows the earnings on an
accrual accounting basis. Therefore, the income that we see on the income statement may not
actually represent any cash in the pockets of the owners.

The Statement of Cash Flows

The Statement of Cash Flows details all of the cash that is used and received by the company. This is
a more ‘real’ view of the company’s earnings.
There are two ways of showing a cash flow statement. The direct method essentially lists all the
different sources of cash, and uses of cash. It then adds them all up, and shows the total change in
cash for the period.
The indirect method starts with the net income from the income statement, and performs a series of
adjustments to bring reflect the final cash income or loss. While this doesn’t show where the cash is
used, it does make a more intimately linked set of financial statements.
In Australia, companies will use the direct method as it gives us a clear picture of what cash is being
used for. In other countries, the indirect method may be used, and details about specific cash uses will be included in different schedules throughout the notes. When the direct method is used, an
indirect cash flow statement can still be derived. It is more difficult to do this the other way around.

Accompanying the financial statements will always be a series of notes. These will usually be linked to the statements themselves through a series of annotations and callouts. The purpose of the notes is to provide full disclosure of the company’s information. While this information it critically important to understanding how the company works, its financial health, it may not fit within the three main statements.

Other sections of the financial statements may include the director’s reports and information about how the directors of the company are compensated.

Reading financial statements

Financial statements should not be read from front to back. They should always be read purposefully, and with a goal in mind. For example, if you wanted to know about the cash flows of a company, you would not go digging around in stock based compensation breakouts.

It is quite simple to create an excel spreadsheet with the information from several years of financial statements on it. If you have access to a service like Bloomberg of CapIQ, you can certainly also find ready made spreadsheets. The advantage with a spreadsheet (provided it is well linked) is that you can very quickly find information you might need, and manipulate that information within formulas.

It is also helpful to gain access to a PDF version of the company’s financial statements. If you use a PDF viewer such as Acrobat (from Adobe), you can use shortcuts such as Ctrl+F to search for terms. If you have the contents page, you can also use Ctrl+Shift+N to open up a dialog to type the page number you wish to jump to.

In terms of reading the numbers themselves, you can generally find three good pieces of information pretty quickly:

  1. The debt-to-equity ratio can be found the balance sheet, giving you some idea of how leveraged the company is.
  2. You can determine if the company is making a profit or not from the income statement.
  3. You can determine if that profit translates to cash inflows on the cash flow statement.

Further reading into the statements will provide information about why the three factors shown above are the way they are.

At the end of the day, every person and their dog has a different opinion on how to read financial statements. Sometimes you may be looking for a specific piece of information, and other times you may simply be evaluating companies and looking for some good deals. Whichever applies to you, it is always a good idea to have a plan and a structure for how you go about it, otherwise you may waste a lot of time reading information you don’t need to know about.

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