How to read financial statements (with types and guides)
By Indeed Editorial Team
Updated 10 December 2022
Published 28 April 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
A company's financial statement measures its health and stability, which also helps the owners, shareholders and potential investors in their decision-making process. Financial statements also reveal a company's or organisation's profitability and help identify loopholes. Knowing how to read financial statements is essential if you're in a business or planning to venture into one. In this article, we explain what a financial statement is, how to read financial statements, types of financial statements and provide a guide to understanding an organisation's financial documents.
What is a financial statement?
A financial statement is a full report of an organisation's financial activities and performance that helps it to analyse the present and predict the future. A financial statement consists of three parts: income statement, balance sheet and cash flow statement. The balance sheet summarises assets, liabilities and equity, while the income statement covers the revenues and expenses of the company over a given period. The cash flow statement shows the capacity of the company to generate cash for operating costs, debt settlement and investment management.
How to read financial statements
Financial statements cover three parts, and while you can prepare them separately, reviewing them together is essential. This helps in making logical decisions about the business in question. Below you can learn how to read financial statements in three steps
1. Reading a balance sheet
A balance sheet reveals the assets and liabilities of a company and what it has and owes. Some things under assets are cash, equipment and investment, while liabilities can include accounts payable, mortgages and loans. The balance sheet presents details that determine the return on investment and spread of debt and equity. The formulas for carrying out this accounting equation are:
Assets = liabilities + owners' equity.
Liabilities = assets + owners' equity
Owners' equity = assets - liabilities
Assets refer to anything that a company possesses that has measurable value. They're usually tangible and physical, such as real estate, goods and furniture. They may also be intangible, such as computer software, licences and copyrights. Liabilities refer to everything a company owes. They're usually loans, expenses, mortgages, bank overdrafts, income taxes and payable interest. Owner's equity refers to a valuable percentage of a company's assets that go back to owners and shareholders after the company pays the liabilities.
2. Reading an income statement
Accountants often prepare income statements to show a company's profit and loss over a specific period. They can prepare the statement monthly, quarterly or annually. Income statements show the effect variables like gross profit, depreciation, expenses, revenue and costs of sold goods have on the company's financial health. Some of the information an income statement contains include:
Revenue: This is the amount of money a business makes and is different from profit.
Expenses: Expenses are the amount of money a business pays out. Examples are the purchase of office equipment, mortgage, wages and utilities.
Cost of goods sold (COGS): Businesses accrue expenses to produce their goods, referred to as COGS. Examples are the cost of raw materials, the average cost of advertising and the cost of the sales force.
Depreciation: This refers to a reduction in the value of tangible assets, like machines a business owns. Any piece of equipment wears out over time because of usage.
Gross profit: Gross profit is the total revenue after subtracting the cost of sold goods. It shows the true financial health of a company.
Net income: This is the amount a company truly makes after subtracting taxes, costs and other allowances. Companies calculate net income by subtracting expenses like taxes from gross income.
3. Reading a cash flow statement
The cash flow statement shows the inflow and outflow of cash over a given period, which is called the accounting period. A cash flow statement has three parts: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities.
Cash flow from operating activities: This is the inflow and outflow of cash as the company carries out operational activities like manufacturing and distribution of goods and services. By reading the cash flow statement, you can make informed financial decisions.
Cash flow from investing activities: The inflow and outflow of cash as the company sells or buys assets like real estate, equipment and intellectual properties.
Cash flow from financing activities: This is the inflow and outflow of cash as the company finances debt, loans, and equity, which may be positive or negative. A positive cash flow is when a company has an inflow of cash that exceeds the outflow, while a negative shows the outflow of cash that exceeds the inflow.
Types of financial statements
Below are the four different types of financial statements:
A balance sheet shows a company's financial position at the time specified in the sheets. It uses the basic formula of assets = liabilities + equity. On the left side of the sheet, there's a list of assets, and on the right side, there's a list of liabilities and equity. It's also possible to find the balance sheet arranged in a ranking order such that assets are listed at the top, followed by liabilities and equity. Assets have three categories: fixed assets, current assets and non-current assets.
An income statement shows the company's revenue over a stated period alongside the expenses the company had to bear. Another term for this is profit-and-loss account, which presents how much a company earned or lost in a business period. At the top of the statements, you can see the total income from sales, while the bottom shows the true state of income. When reading income statements, you can deduct the expenses from the earnings at each step. When you have done this throughout, you arrive at the net profit or loss.
An earning per share (EPS) is another section in the income statements. It explains how much will go to shareholders if the company decides to share the net earnings. To calculate EPS, divide the total net income by the number of shares the company owns.
Cash flow statements
Cash flow statements are the cash report that comes in and goes out of the company's account. This report is important to help the company manage cash for expenses like mortgages, loan servicing and equipment management. It's important to note that there's a difference between income statements and cash flow statements. Income statements show whether a company is profitable or unprofitable, while cash flow statements show whether it's generating cash.
Statement of shareholders' equity
The statement of shareholders' equity reports the changes in the value of shareholders' equity from the beginning of an accounting period to the end, usually a year. The statement helps a company to make informed decisions about issuing shares in the future and allows the shareholders to evaluate how their equity is performing. Contained in the statement of shareholders' equity are the following:
Preferred stock: Based on ranking, holders of the stock have a higher claim to the company's earnings and assets than any other shareholders. Preferred stockholders receive regular dividends and payments first in case of bankruptcy.
Common stock: The holders of this stock have voting rights on corporate decisions but can only receive payment after preferred stockholders. Dividends payable to common stockholders may be unpaid in case of bankruptcy.
Treasury stock: This refers to the stock the company buys again from its holders. This happens to prevent a hostile takeover or increase stock value.
Contributed capital: This is the additional fee investors pay above the unit value of a company's stock. It's paid to gain higher stakes in a company.
Retained earnings: This shows a company's earnings that have yet to distribute to shareholders. You can derive retained earnings from the amount the company has paid as shareholders' dividends minus the company's revenue since its business year.
Unrealised gains or losses: An unrealised gain or loss is an increase or decrease in the value of an asset that an investor holds.
Tips for understanding financial documents
The purpose of reading financial statements is to tell how well a company is doing. You need answers to whether it's a viable business to invest in, whether the stock is worth buying or whether the cash flow has been impressive. Unless you're a finance professional or have credentials in bookkeeping and accounting, it may be challenging to understand the documents on your own. Below is a guide for understanding an organisation's financial documents:
Understand basic accounting terms like equity, cash flow, liquidity, net income, and profit margin.
Employ the help of a finance professional, especially if you're making a business investment decision.
Take your time to review the financial statements and ask questions from the company's representatives.
Build your financial literacy skills, as reading financial documents is important to being an effective business leader, investor and shareholder who makes smart decisions.
Read business magazines, articles, white papers, and annual reports of businesses to familiarise yourself with the finance world.
Please note that none of the companies, institutions or organisations mentioned in this article are affiliated with Indeed. The model shown is for illustration purposes only and may require additional formatting to meet accepted standards.
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