It's not enough to just claim that your company is doing well, you've got to have the numbers to show for it. While key success metrics can hook the interest of shareholders, most serious professionals need to see these numbers formalized into financial statements. The three financial statements model – which includes the balance sheet, the income statement, and the cash flow statement – remains as the tried-and-true representation of financial data across all industries. This trio of financial statements not only allows executive leaders and shareholders to peer into a company's performance, but also uncovers the story and reasons behind those numbers.
The general protocol for financial statements and their formatting are designed to ensure clarity, consistency, and comparability across different periods and entities. This adherence to structure makes financial statements a credible way to present a company's performance. Financial statements are also a requirement in companies' annual 10-K filings to the SEC.
The balance sheet discloses a company's assets and obligations at a glance and gives a clear view of its financial standing at any given moment. This allows stakeholders to assess the company's ability to meet its short-term obligations and its financial leverage. The income statement details the company's revenues, expenses, and profits over a given period, highlighting its operational efficiency and profitability. This statement shows how well the company generates revenue from its operations and manages its expenses. Finally, the cash flow statement traces the single thread that runs through every business success — liquidity. This statement can be used to assess the company's liquidity and its ability to generate cash to fund operations, invest in growth, and return value to shareholders. Tying it all together are the financial ratios. They provide sharper insight into the company's financial health when it comes to areas such as liquidity, solvency, and profitability.
Now, let's go over each financial statement to understand how it's structured and what its numbers represent. Just a quick note: Financial statements are typically formatted to include a title that identifies the statement, the name of the company or entity, and the period of time the statement covers. Additionally, any number that is to be subtracted is usually enclosed by parentheses.
When it comes to the balance sheet, remember: assets equals liabilities plus equity. This graph visualizes the relationship between key components of the balance sheet. The balance sheet provides a snapshot of a company's financial standing at a specific point in time. It captures what the company owns and what it owes.
The balance sheet begins with assets, which are resources controlled by the company from which future economic benefits are expected. Current assets, such as cash, inventory, and receivables, are expected to be converted into cash within a year. These assets support the company's day-to-day functioning and are a vital indicator of its ability to cover short-term obligations.
On the other hand, non-current or fixed assets can include long-term investments, property, plant, and equipment (PP&E), and intangible assets such as patents. These assets represent the company's long-term investments and operational tools. They are crucial for sustained growth and are usually depreciated over time to reflect usage and aging.
On the other side of the equation are liabilities. Current liabilities, such as accounts payable and short-term loans, are obligations the company expects to settle within a year. These liabilities are directly linked to the company's operational activities and short-term financing needs. Long-term liabilities, such as bonds payable and long-term lease obligations, reflect the company's longer-term financing strategies and growth initiatives.
This brings us to the final part of the equation: shareholders' equity. This can include common stock, which indicates the initial contributions of shareholders; Paid-in capital, which are additional investments made by shareholders beyond the par value of the stock; and retained earnings, which are the accumulated earnings not distributed as dividends. The equity section is essentially the net worth attributable to the shareholders. Note that for each year, the "Total assets" equal to the "Total liabilities and equity".
The income statement is sometimes also referred to as the P&L statement, which stands for Profit and Loss. It's essentially a dance between revenues, expenses, and the resulting income, as visualized by this waterfall chart.
The statement starts with revenue. This is straightforward: it's just the total earnings from goods sold or services provided. From here, subtract the cost of goods sold (COGS), which are the direct costs associated with production. This yields the gross profit, which is a preliminary indicator of profitability that reflects the margin between sales and production costs.
Next, we deduct operating expenses, including selling, general, and administrative expenses (SG&A). This subtraction results in Earnings Before Interest and Taxes (EBIT), which shows the company's operational profitability before the influence of financial structure and tax policies.
Then, by subtracting interest expense from the EBIT, we arrive at pretax income. This figure indicates the company's earnings before the impact of tax obligations. Finally, after subtracting taxes, we reach net income. This is the bottom line that represents the company's earnings available to shareholders after all expenses have been accounted for. This progression from revenue to net income shows the company's efficiency in managing its production, operational, and financing costs relative to its revenue-generating capabilities.
Additionally, EBITDA, or "earnings before interest, taxes, depreciation, and amortization", is also an excellent measurement of the operating business's profitability. In order to calculate EBITDA, we simply add depreciation and amortization to the EBIT.
The cash flow statement reconciles the beginning and ending cash balances. The inflows and outflows of cash are typically categorized into operating activities, investing activities, and financing activities.
This statement begins by adjusting the net income from the Income Statement for non-cash expenses like depreciation and changes in working capital, such as accounts receivable, inventory, and accounts payable. This adjustment reveals the cash flow from operating activities, which is the amount of cash generated or consumed by the company's core business operations.
Cash flow from investing activities reflects the company's long-term strategy. This can be cash spent on capital expenditures for property, plant, and equipment, or proceeds from the sale of such assets. This section indicates how much of the company's cash is being reinvested into the business for future growth.
Cash flow from financing activities shows the net flows from raising and repaying capital and distributing dividends. It includes issuing new shares, repaying debt, or paying dividends to shareholders. This part of the statement illustrates the company's financial strategy in terms of how it finances its operations, growth, and returns value to shareholders.
The culmination of these activities results in the ending cash balance, which is indicative of a company's liquidity. The cash flow statement and its particular details can also be visualized as charts. Such as this one that shows the annual post-tax cash flow with inflows above the line and outflows below the line. Or this cumulative cash flow diagram, which incorporates the payback period.
Finally, financial ratios tie everything together and act as a fine-tuning tool for the data-heavy financial statements. After examining the intricacies of financial statements, it's time to render complex numbers into digestible metrics.
Liquidity Ratios such as current ratio, quick ratio, and net working capital ratio assess a company's ability to meet short-term obligations. Solvency Ratios such as Debt to Equity evaluate a company's long-term debt-paying ability and financial leverage. Market Ratios such as the Price to Earnings provide insights into the company's market value relative to its earnings. Profitability Ratios including Return on Assets, Return on Equity, and Return on Invested Capital measure how effectively a company uses its resources to generate profits.
There's definitely a lot to consider when it comes to all the accounting in financial statements. So it really helps to have a standardized format or template as a reference point. The ability to create and interpret financial data and understand their importance and implications hold enormous strategic value for managers, executives, and shareholders. While they might not look like the shiniest objects, financial statements and their corresponding ratios are essential threads that pull a company's financial ecosystem together.
