Financial Statements in a nutshell

A friend of mine recently had a problem with financial accounting and I wrote him an email explaining the topic in a "nutshell." I guess we all have problems relating to balance sheets, income statements, and cash flow statements, so I wanted to share the short "wrap up" with you.

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Financial statements are usually found in company reports. These reports consist of some verbal explanation of a company's circumstances, and four statements: balance sheet, income statement, retained earnings, and cash flow statement. I am focusing here only on three of them neglecting retained earnings, as this statement normally just shows the income earned and its distribution to shareholders. Keep in mind that company reports are always "past-oriented" meaning they (should) show what actually happened of the last period. Okay, so let's get started.

1) Balance Sheet

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A balance sheet represents a snapshot of the current financial position of a firm. The position is best described by showing what assets and what liabilities a company has and that's exactly what it does. So you usually have in the one corner "Liabilities" listing how and from what sources the company has money from. And in the other corner you will find the "Assets" or the stuff a company bought or used the cash for. Within the two classes we distinguish between current and long-term positions indicating that time matters, too. The liabilities have an additional section for "Owners’ Equity" because a company is not only e.g. liable to its banks, it has to pay also its owners.

Now, over time there are developments influencing the balance sheet. The best way to deal with those is to keep in mind that the sections all add up to the following equation: Assets = Liabilities + Owners’ Equity.  The equation has to be always in balance. That's useful for any problem you deal with - it's a check. So for instance if your company borrows money from a bank the equation is affected in "liabilities" (more of them) and due to the balance rule you already know that something else has to be affected. It's going to be in the assets section (cash). To get it back in equilibrium it's going to be: Assets (+) = Liabilities (+) + Owners’ Equity.  Maybe that's already too basic for you but it's good to keep in mind.

2) Income Statement

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An income statement shows what the company earned and it subtracts all the accrued costs leading to the net income. I won't go through all the positions here but one post is crucial to many financiers: EBITDA. This abbreviation stands for earnings before interest, depreciation, and taxes. So it's actually not what the company got out of its operation per se but it is often treated like that. Why? Because depreciation isn't paid in cash, it's a way of dealing with long-term assets value loss (write-off). And as we have to pay tax and interest anyways, the EBITDA can be indeed used to show how strong a company is.

A noteworthy aspect is that there are many other ways to state a company's income situation. I just want to list three of them here:

1. USGAPP (United States Generally Accepted Accounting Principles) way:
Revenues/Sales
-Cost of Goods Gold (cool accountants call them just "COGS")
=Gross Margin
-Selling Expenses
-Administration Expenses
-Tax & Interest
=Net Income

2. Contribution Margin way:
Revenues/Sales
-Variable Expenses (those ones that rise when you produce and sell a product, per "one new unit" if you will)
=Contribution Margin
-Fixed Expenses
=Net Income

3. Direct way:
Revenues/Sales
-Direct Expenses (those, er… you can relate directly to your sold product, difference to variable: some costs count as variable (rise per unit) but cannot be directly related to the product: classic "manufacturing overhead")
=Direct Margin
-Indirect Expenses
=Net Income

So you see there are different ways to get to the net income. It think it's good to know that there are different "ways to Rome." Different ways = different results. Hence, there are different "inter" results. Thus, different results to state on paper, to give to the tax office, and so forth. That all leaves room for interpretation, but there are usually entities telling you exactly how you should do it. In the US the Financial Accounting Standards Board agreed for instance on the GAAP rules applied above.

3) Cash Flow

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Now why would one need another statement if we could simply take a look on the income statement to figure out how much cash a company earned. Well, business activities can be non-cash: many are "just" claims or charges paid some other time. That's why in the cash flow statement we only deal with real cash in- and outflows. By the way, this principle is the reason why a company can face illiquidity but is actually solvent. It may have run out of cash but got tons of claims.

The cash flow statement divides into three sections: operating, investing, and financing. Some of the parts can be negative (i.e. investing) but normally this "red ink" part is trumped by operating and financing. They add up as follows: operating is the result of current assets and current liabilities; investing stems from long term assets; and financing refers to equity and long term liabilities.

Of course after you fully comprehend the statements you can analyze and interpret them. It offers valuable insights and you may even discover some window dressing. "Barter deals" and "Repo 105" come readily to mind. In essence these activities are ways to "cheat" for more revenues or less liabilities, etc. The results are often inflated and unsustainable balance sheets.

¹c.p.: Brigham & Ehrhardt, "Financial Management - Theory and Practice" 2005, Thomson.