The Basics of Understanding Financial Statements

---

💡 Key Takeaways

• The balance sheet provides a snapshot of a company’s financial position, with assets equal to liabilities plus equity.
• Assets include current assets (like cash and receivables), plant and equipment, and other assets (like patents).
• Liabilities encompass current and long-term obligations, such as accounts payable, accrued expenses, and long-term debt.
• Shareholder’s equity is what remains after deducting liabilities from assets, including capital stock, additional paid-in capital, and retained earnings.
• The income statement reflects a company’s profitability over a specific period, calculated as revenues minus expenses.
• Revenues, cost of goods sold, and operating expenses contribute to calculating gross profit, gross profit margin, and operating income.
• Net income, earnings per share, and return on equity are key indicators of a company’s profitability and financial health.
• The cash flow statement tracks cash movement through operating, investing, and financing activities, providing insights into a company’s liquidity and financial decisions.

✏ Top Quotes

Many people choose to invest their entire life savings into stocks, yet they do not take the time to learn basic accounting, which is the language of business.

The ability to understand basic accounting in order to read financial statements is just another tool in the toolbox for wise investors. It does not guarantee investment success; however, its lack almost certainly guarantees failure.

---

📝 Summary + Notes

Chapter 1: Balance Sheet

• The balance sheet is a financial statement that shows what a company owns, how much it owes, and what is left for the shareholders in the form of equity/mark>.
• It is a photograph of the company’s financial situation at a particular point of time.
• $ASSETS = LIABILITIES + EQUITY$

Assets

• Assets represent tangible items that the company owns.
• Assets are classified into: Current assets, plant and equipment and other assets.

Current assets

• Cash and cash equivalents, accounts receivable, inventory, and prepaid expenses, are called “current” because they are expected to be either converted into cash or their benefit received (in the case of prepaid expenses) within 12 months. These items are listed according to their liquidity, meaning that the most liquid assets, such as cash, are listed first.

Cash and cash equivalents

• Cash represents coins, paper bills, and on-demand bank deposits.
• Cash equivalents represent highly liquid, very safe, and short-term investments such as certificates of deposits, Treasury bills, and money market funds.
• A good way to analyze cash and cash equivalents is to compare them to total assets from quarter to quarter and year to year. For example, if every year for the past 10 years, cash and cash equivalents constituted 5 to 7 percent of total assets and this percentage jumps to 20 percent, this incident should be investigated more closely.

Accounts receivable

• The amount of money that the company’s customers owe to the company.
• The state of the relationship between accounts receivable to total net sales could serve as a warning sign that something is wrong. A sudden jump in accounts receivable in relation to net sales may mean that the company is having a tough time collecting from its customers, is extending credit to weaker customers, or is extending credit to current customers in order to make its sales targets.

Inventory

• What the company produces or buys to sell to its customers.
• May consist of more than just finished products and is divided into three categories: raw materials, work-in-progress, and finished goods.
• Depending on the business, a company’s inventory could become obsolete. If a restaurant manager orders more tomatoes than needed, they will rot and shareholders’ capital will be wasted. They will have to be discounted significantly to be converted to cash through the current asset cycle.

Prepaid expenses

• Expenditures that have already been made for benefits that the company will receive in the near future like advances for insurance policies, rent, and taxes.
• Are classified as current assets, not because they can be turned into cash, but because if they had not been prepaid, that cash would have to be spent within 12 months.

Property, plant and equipment

• All of the company’s assets that are not intended to be sold or resold to customers. Also referred as fixed assets. Examples are land, buildings, machinery, furniture, and tools.
• Companies that have to keep upgrading and replacing property, plant and equipment assets just to stay competitive are in worse shape than those that can keep using these assets until they completely wear out.
• In order to analyze how much money is spent on replacing and upgrading existing fixed assets, it is necessary to analyze the property, plant and equipment account on the balance sheet over many years, to read annual reports, and to analyze the cash flow statement.

Other assets

• Items such as patents, copyrights, goodwill, trademarks, trade names, secret processes, receivables.

Liabilities

• What the company owes to various groups or businesses such as employees, suppliers, customers, creditors, and governments.
• Liabilities are categorized into current liabilities and long-term liabilities.

Current liabilities

• The company’s obligations that are due within 12 months.

Accounts payable

• Amounts that a company owes its vendors or suppliers for which an invoice has been received.
• One company’s accounts receivable under assets is another company’s accounts payable under liabilities.

Accrued expenses

• Obligations to pay for products or services that are already received but for which an invoice has not been received.
• Once an invoice is received, an accrued expense becomes an account payable.
• Expenses can be accrued for various items such as employees’ salaries, sales tax, rent, attorneys’ fees, and interest on debt.

Current portion of long-term debt

• The amount of debt that matures, or is due, within 12 months. For example, if the company has $5,000,000 in debt and 20 percent of it matures every year, $1,000,000 would be reported as the current portion of long-term debt.
• This only includes the reduction of principal; it does not include the interest expense, which is included in accrued expenses.

Income taxes payable

• The tax obligation to the government.

Current ratio

• A popular measure called the current ratio to determine whether the company has enough current assets to satisfy current liabilities.
• $CURRENT\ RATIO = \frac{CURRENT\ ASSETS}{CURRENT\ LIABILITIES}$

Long-term debt

• Obligations that are not expected to be due and paid within 12 months, like loans, lease obligations, pension obligations, bonds, mortgage bonds, and junk bonds.
• A quick way to check to see if the company has taken on too much debt is to compare its net income to its total debt.

Shareholder’s equity

• What is left after total liabilities are subtracted from total assets. Also called net worth or book value.

Capital stock and Additional paid-in capital

• Represent the original capital invested into the business and any additional funds added later.
• When a company issues 1,000,000 shares of common stock and, as a result, raises $5,000,000, the balance sheet could show this transaction in the following manner: Common Stock, $0.01 par value, 1,000,000 shares issued $10,000 Additional paid-in capital $4,990,000

Retained earnings

• Profits that a company generated and did not pay out as dividends.
• It is the enterprise’s undistributed profits from all years in operation, not just a single year.

---

Chapter 2: Income Statement

• An enterprise’s success in terms of profitability.
• Unlike the balance sheet, the income statement is prepared for a given period such as a quarter or a year, versus a snapshot on a particular day.
• $REVENUES - EXPENSES = PROFIT\ or\ LOSS$

Revenues

• Also referred to as the “top line,” are recorded when the company earns them by either shipping the product or completing a service.

Cost of goods sold

• The direct expenditures associated with manufacturing a product (raw materials, labor, and manufacturing overhead).
• Only appears on the income statement when the company is actually “selling” or “reselling” its products or services.

Gross profit

• Is calculated by subtracting the cost of goods sold from revenues.

Gross profit margin

• Gross profit can be used to calculate the gross profit margin, which is useful for making side-by-side comparisons among a subject company’s current manufacturing efficiency, its past manufacturing efficiency, and that of its competitors.
• $GROSS\ PROFIT\ MARGIN =\frac{GROSS\ PROFIT}{REVENUES}$

Operating expenses

• The expenditures associated with operating or running a business (selling, general and administrative expenses, research and development, and depreciation).

Selling, general and administrative

• Sales commissions, management salaries, office supplies, advertising, and accounting and legal fees.
• If, a business is selling a product or service that is just average, and people do not really need it, a significant amount of resources needs to be spent convincing people to buy it.

Research and development

• Improve existing products or create new products.

Depreciation

• Through depreciation, the fixed asset is gradually transferred from the balance sheet to the income statement as an expense.

Operating income

• Achieved after all of the operating expenses are subtracted from the gross profit.
• Also referred to as EBIT, which stands for earnings before interest and taxes.

Interest expense

• Businesses borrow money to finance portions of their assets, and, as a result, they are required to pay interest — the cost of money.
• The amount of interest expense is directly correlated with the amount of debt.

Other income and expenses

• Interest income on cash balances at the bank, gains and losses from asset sales, and other nonrecurring items.

Provision for income taxes

• An estimate of the company’s tax expense for a given period of time.

Net income

• The measure of the company’s profitability.
• A company that consistently shows an upward trend in net income from one year to another is most likely reinvesting its earnings back into its operations by adding more assets, acquiring other businesses, and paying down debt.
• $NET\ PROFIT\ MARGIN=\frac{NET\ INCOME}{REVENUES}$
• An enterprise that consistently outperforms its competitors in terms of net profit margin may have some type of competitive advantage because it can either charge more for its products or control its cost structure better.
• $RETURN\ ON\ EQUITY\ = \frac{NET\ INCOME}{SHAREHOLDERS’ EQUITY}$

Earnings per share

• Net income divided by the number of shares outstanding.
• To be conservative, it is advisable to place more emphasis on the diluted earnings per share than the basic earnings per share.

---

Chapter 3: Cash Flow Statement

• Records the movement of cash through various sources and uses of cash.
• Is prepared for a set period of time, such as a quarter or a year.
• It answers the following:
  • What were the sources of cash?
  • Did the majority of cash come from operations or from the sale of fixed assets?
  • Did the company borrow money or issue more shares to increase the cash level?
  • How did the company spend its extra cash after all the operational bills were paid?
  • Did it invest in new equipment, repurchase shares, or pay dividends?

Operating activities

• Starts from net income of the Income statement , followed by several adjustments that are made to it.

Depreciation expense

• Depreciation is the gradual transfer of fixed assets from the balance sheet onto the income statement due to the use of the assets and the passage of time.
• Because the depreciation expense reduces net income but is a non-cash transaction, it must be added back to net income from the *Income Statement* to calculate net cash provided by operating activities.

Gain/loss on sale of fixed assets

• It must be added/subtracted back from the *Other income and expenses Income Statement* section.
• Gains and losses from the sales of fixed assets will be later reflected in the investing section.

Changes in operating assets and liabilities

• Transactions that do not affect net income (they only affect balance sheet accounts), but do affect the cash flow statement.

Accounts receivable

• It is the accounts receivable of the previous year (from the balance sheet) minus the accounts receivable of this year.
• Decrease means +positive.
• The company’s customers paid down their credit obligations and thus, provided the company with a cash inflow that is not reflected in net income.
• Therefore, a positive adjustment is made to net income on the cash flow statement.

Inventories

• Same as the above, but for inventories.
• Decrease means +positive.
• The company had to spend extra cash to purchase additional inventory, thereby increasing cash outflow that is not reflected in net income.
• Therefore, a negative adjustment is made to net income on the cash flow statement.

Prepaid expenses

• Same as above, but for prepaid expenses.
• Decrease means +positive.

Accounts payable

• Same as above, but for accounts payable.
• Decrease means -negative.

Accrued expenses

• Same as above, but for accrued expenses.
• Decrease means -negative.
• A decrease would mean that extra cash left the company to pay down the company’s obligation to providers of services.

Income taxes payable

• Same as above, but for income taxes payable.
• Decrease means -negative.

Net cash provided by operating activities

• The sum of the above.
• It is more valuable than cash coming from investing or financing activities because is can be sustained.

Investing activities

• Acquiring and disposing of fixed assets, other businesses, equity investments, and short-term investments.

Capital expenditures

• Whenever fixed assets/ are purchased, they are recorded as cash outflow during the period of acquisition regardless of the asset's life span.
• Remember, on the income statement these same assets are depreciated slowly over many years.
• The purchases of property, plant and equipment are also referred to as capital expenditures.
• They are divided (but not shown in the Cashflow Statement) into Replacement and Growth capital expenditures. They exists somewhere in the Annual Report.
• Replacement only maintain the firm’s productivity; they do not increase it.

Business acquisitions

• To determine whether acquisitions are benefiting shareholders, investors need to learn more about each particular deal by reading the company’s filings, listening to conference calls, and interviewing managers.

Purchase/sale of equity investments

• A company can also invest in common stocks.

Purchase/sale of short-term investments

• When short-term investments are liquidated, the cash flow effect is positive because cash is being received, and when they are acquired, it is negative because money is being spent.

Net cash used in investing activities

• The sum of the above.
• If the company is expanding, this will be negative.

Financing activities

• Activities involve transactions that affect the company’s owners or creditors.

Borrowing/repayment of long-term debt

• Self-explanatory.

Issuance of common stock

• When companies go public and issue or sell shares to shareholders or issues additional shares.

Stock repurchases

• Share repurchases is spending cash.
• They are only beneficial when the company’s stock is purchased at a good price.
• To determine how much a company’s management paid per share to repurchase shares, investors can reference the company’s annual report.

Cash dividends paid

• Self-explanatory.

Net cash by financing activities

• The sum of the above.
• More likely to be positive for high-growth companies than for mature ones.