Understanding financial statements is like learning the language of business. Whether you're an investor, entrepreneur, or just curious about how companies track their money, mastering financial statements can unlock a world of insights.
But let’s be honest - they can look overwhelming at first for people with non-financial background. This guide simplifies the essentials so you can read, analyze, and make sense of financial statements with confidence. By the end of this article, you’ll know how to interpret and create the Balance Sheet, Income Statement, and Cash Flow Statement.
What are Financial Statements?
Financial statements are the backbone of any company’s financial health. They provide a snapshot of a company’s performance and position at a specific point in time or over a defined period. Think of them as a report card for businesses, showing how much money they made, what they own, and how they manage cash.
Stakeholders - like investors, analysts, creditors, and management - rely on these statements to make informed decisions. They’re prepared regularly (monthly, quarterly, or annually) and must follow standardized rules such as GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards).
Why Are Financial Statements Important?
Here’s why financial statements are crucial for anyone involved in business:
Assess Financial Performance: Learn if the company is profitable or struggling by looking at its revenues, expenses, and net income.
Evaluate Financial Position: See what the company owns (assets), owes (liabilities), and what’s left for owners (equity).
Make Informed Decisions: Investors can decide whether to buy, hold, or sell shares, or make an investment. Creditors assess if the company can repay loans.
Plan for the Future: Management uses these documents for budgeting and forecasting.
Ensure Compliance: Companies use them to meet regulatory and tax requirements.
3 Types of Financial Statements
Let’s explore each of the 3 essential financial statements:
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Balance Sheet: A Snapshot of Financial Health
The Balance Sheet provides a snapshot of a company’s financial position at a given moment i.e. it shows what a company owns (assets), owes (liabilities), and the remaining value left (equity) for owners at a specific date. Investors review Balance Sheets to evaluate liquidity position, solvency, and financial stability of a business.
Components of a Balance Sheet
The Balance Sheet . It answers: “What does the company own (assets), owe (liabilities), and what’s left (equity) for the owners?” Its 3 main components are:
1. Assets: Resources the company owns or controls, which have monetary value. Asset must always = Liabilities + Shareholder's Equity.
Assets are of 2 types:
Current Assets (Short-Term): Can be converted to cash within a year. E.g., cash, accounts receivable, inventory, etc.
Non-Current Assets (Long-Term): Used for more than a year. E.g., property, equipment, patents, etc.
2. Liabilities: Obligations or debts the company owes to others. They’re of 2 types:
Current Liabilities (Short-Term): Due within a year. E.g., accounts payable, short-term loans, etc.
Non-Current Liabilities (Long-Term): Payable over a longer period. E.g., mortgages, bonds payable, etc.
3. Equity: The difference between assets and liabilities representing the company's net worth. Formula: Equity = Assets - Liabilities. It includes:
Share Capital: Money invested by shareholders.
Retained Earnings: Profits reinvested into the business. Calculated as: RE of last period's balance sheet + this year's Net Income.
By balancing the 3 sections with the formula: Assets = Liabilities + Equity, it ensures everything is accounted for.
Income Statement: Tracking Profitability
The Income Statement, or Profit and Loss Statement gives a clear picture of a company’s profitability / losses over a specific period of time, such as a month or a year. It lists revenues (money it made), expenses (money it spent), and the resulting net profit or loss.
Simply, put it answers the question: “Is the company making money or losing it?”
Investors review P&L to evaluate a company's profitability and operational efficiency over a period of time.
Components of an Income Statement
Here's a breakdown of its key components:
a. Revenues (Sales or Income)
This is the money a company earns from selling its products/services. E.g., sales revenue from products, service fees, or rental income.
Think of it as the company’s gross earnings before deducting any costs.
b. Cost of Goods Sold (COGS)
Represents the sum of all direct costs associated with making a product. E.g., raw materials, labor costs directly involved in production.
Formula: COGS = Opening Inventory + Purchases - Closing Inventory
c. Operating Expenses (aka SG&A)
These are the costs necessary to run the business but not tied directly to producing goods. E.g., salaries for office staff, rent, utilities, marketing expenses, and administrative costs.
d. Operating income (aka Earnings Before Interest & Taxes - EBIT) is a company's profit after subtracting operating expenses from its revenue.
Formula: Operating income = Gross income – (Operating expenses + Depreciation)
Where, depreciation is used to calculate the decrease in value of a physical asset over time due to wear and tear. Examples of physical assets include inventory, manufacturing equipment, and business vehicles, etc.
d. Interest Expenses: The cost of borrowing money, such as interest paid on loans or bonds.
e. Taxes: The amount the company pays in corporate taxes based on its taxable income.
f. Net Income (or Net Loss): The bottom line - added to "Retained Earnings" on the Balance Sheet, and calculated as:
Net Income = Revenues - COGS - Operating Expenses - Interest - Taxes
If revenues exceed all expenses, it’s Net Income (profit).
If expenses are greater than revenues, it’s Net Loss.
Cash Flow Statement: Following the Money
The Cash Flow Statement shows the inflow and outflow of cash during a specific period. It helps to evaluate a company's ability to generate cash and manage its cash resources. Simply put, it answers the question: “Where is the money coming from (i.e. sales) and going to (i.e. expenses and investments)?”
Investors review it to assess the company's ability to pay its bills, debts, and other financial obligations.
Components of a Cash Flow Statement
The Cash Flow Statement is divided into 3 key activities:
a. Operating Activities: Cash inflow and outflows from the company's main business activities. E.g.,
Inflows: Cash from customers for sales.
Outflows: Payments for raw materials, salaries, utility bills, etc.
This section reflects the company’s ability to generate cash from its core operations. Check, if this is positive or negative?
Cash Flow from Operations - Capital Expenditure = Free Cash Flow (FCFF)
b. Investing Activities: Cash used for / earned from investments in assets. E.g.,
Outflows: Buying equipment, property, or other long-term assets. Check, how high is this compared to Operating Cash Flow?
Inflows: Selling old equipment or investments (including M&A).
c. Financing Activities: Cash raising from investors or paying back to creditors. E.g.,
Inflows: Borrowing from banks or issuing shares.
Outflows: Repaying loans or paying dividends.
Is the company issuing or repaying debt?
The ending Cash Balance goes on to the Balance Sheet.
By analyzing all 3 sections of a cash flow statement, you get a full picture of how much cash is generated in the end, and how well a company manages its cash.
3 Financial Statements - An Example
3 Financial Statements Explained in 1-image.
Summary: Simplifying Financial Insights
To sum up:
Balance Sheet reveals what a company owns, owes, and the value left for owners at a specific moment.
The Income Statement shows how much profit (or loss) the company made during a given period.
The Cash Flow Statement highlights the inflow and outflow of cash, helping you see if the company can sustain itself financially.
By combining insights from these 3 statements, you gain a clear picture of a company’s overall health and performance. Whether you’re an investor, entrepreneur, or just curious, mastering these documents will help you make smarter financial decisions.
Refined the Original Content and Images Source: Brian Feroldi.
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