Once you start learning how to analyse public companies, you will quickly come across financial statements at some point. Financial Statements are one of the most important things you will need to understand. However, they can feel like an impenetrable mass of jargon and numbers. So how do you get started?
The first thing to understand is that there are three major parts of financial statements: The Income Statement, The Balance Sheet, and the Cash Flow Statement. These are three separate statements that show different things, but who work together to give you a good picture of how the business is performing. Here’s the function of each statement.
The Income Statement shows the profit or loss of the company, and how that is made up from its income and expenses.
The Balance Sheet shows what the business owns, and what the business owes.
The Cash Flow statement shows how the business has used, and how the business has spent cash.
If you approach the statements from this perspective, they become relatively easy to understand. I won’t spend the this post going through line by line how to understand each statement. That is better served in separate posts for each. Instead, it will go through how the statements give us an understanding of the business.
The important thing to understand when it comes to the income statement is the concept of accrual accounting. In accrual accounting, we recognise revenue and expenses when they are incurred/earned, not when the cash flows in or out of the business. So if you sell something on credit, meaning the person is going to pay you back at some point in the future, you get to recognise that revenue now, rather than having to wait. This allows for two things:
- Non-cash income and expenses can be included in the business profit and loss
- Revenues and expenses can be incurred in the correct periods.
The reason we need to understand this, is because it allows us to understand that the profit a business makes does not necessarily equal the cash it makes. Here is what you need to understand:
Income = increase in assets or decrease in liabilities
Expense = decrease in assets or increase in liabilities
Here we can see a link between the income statements and the balance sheet. The balance sheet ends with a profit or loss. This is the difference between our income and expenditures.
The balance sheet lists all of the assets of the business and how they are financed. Financing is a tricky topic, but essentially means how are all of the assets paid for.
Assets can be paid for in one of two ways: equity or debt. Equity is simply any money that is put into a business by its owners. When a company sells its shares to the public through an IPO, those proceeds become equity.
Debt comes from loans that the business takes out. This can be directly from banks, or it can be from the public through instruments like bonds.
The important thing to understand about the balance sheet, and probably the most important equation in accounting is this:
Assets = Liabilities + Equity
Every asset needs to be funded by something. You can’t even have cash in the business unless the owner put that cash into the business.
Cash Flow Statement
The Cash Flow statement is the most straight forward financial statement. All it tells us is how the company got cash, and where it spent cash. Most companies will split up the cash flow statement into three sections
- Cash from operations
- Cash from investing
- Cash from financing
Cash from operations includes any cash used during the normal course of business. If a business buys and sells cars, then all of the cash directly related to that is included in operations. This includes wages paid to staff, rent, bills and admin costs.
Cash from investing includes anything that relates to long term assets. Things like buying buildings or land, or machinery. Proceeds from selling these things also gets included here.
Cash from financing includes everything related to debt or equity. Taking out loans will be a cash inflow, while paying out debt will be a cash outflow.
The ending cash balance for a period is what is reflected on the balance sheet.