If you were to travel from Canada to Germany, what do you think is the most useful skill you could acquire before departure?
I think most of us would agree that it's a foundation in the German language.
The world of business and investing is no different. Being able to communicate effectively is key. The difference is instead of communicating through language, we communicate through financial statements.
This post will serve as a brief introduction to each of the three financial statements used in the business world.
The Language of Business
Financial statements are generally used by five main parties:
- Shareholders and potential investors use financial statements to assess the attractiveness of a business as an investment opportunity.
- Governments use financial statements to ensure the accuracy of tax returns
- Management uses financial statements to make capital allocation decisions - ideally, they want to maximize the growth of their highest-profiting departments
- Employees use financial statements - in fact, employees are responsible for creating the financial statements for the use of everyone else
- Suppliers use financial statements to asses whether to provide goods on credit, or require cash up front.
Some financial statements, like the balance sheet, provide a snapshot of a business' position at a particular point in time. This point is often the end of a financial quarter or year. Others provide a description of changes over time, where again the time period is typically a financial quarter or year.
Accrual Accounting vs. Cash Accounting
One important concept that should be understood before diving into the three financial statements is the difference between accrual accounting and cash accounting.
The difference lies in the timing of when revenue and expenses are recorded. The cash method of accounting records revenues and expenses only when payment is made. The accrual accounting method records revenues and expenses when they are incurred.
For example, let's say you own a lawncare company and in month 1, you mow $2000 worth of lawns but only receive payments for $1200. The rest of the lawns you mowed on credit, expecting to be paid later.
With the cash method of accounting, you would record $1200 worth of revenue. With the accrual method of accounting, you would record $2000 worth of revenue.
Most large businesses use accrual accounting, while small businesses and individuals sometimes make use of cash accounting.
The Balance Sheet
The balance sheet is a financial statement that summarizes a company's assets, liabilities, and shareholder's equity at a particular points in time (at the end of a fiscal quarter or year). This financial statement is called the balance sheet because assets must balance with the sum of liabilities and shareholder's equity. Mathematically:
Assets = Liabilities + Shareholder's Equity
Obviously, this makes sense, because there are only two methods that a company can use to raise cash for operations (i.e. to pay for their assets). They can issue debt (which increases liabilities) or they can issue stock (which increases shareholder's equity). Doing either would increase your assets by a proportionate amount.
On the balance sheet, you can find the follow line items:
- Cash and cash equivalents
- Marketable securities
- Accounts receivable
- Prepaid expenses
- Long-term assets
- Current Liabilities
- Long-term liabilities
- Shareholder's equity
You can read more about these particular line items in a detailed follow up post about the balance sheet. Stay tuned!
The Income Statement
The income statement is the financial statement concerned with the generation of revenue and expense over a particular accounting period. Unlike the balance sheet, which covers a moment in time, the income statement covers a period of time.
The income statement's main purpose is to show the profitability of a company over a period of time. The financial statement begins with revenue (called the "top line") and finishes with earnings per share (called the "bottom line").
Line items that can be found in the income statement vary much more than on the balance sheet. Depending on the size, industry, and business model of a company, there are a broad array of line items that could appear. The simplest type of income statement would look like this:
Just like the balance sheet is separated into two sections (assets vs liabilities & shareholder's equity), the income statement is separated into revenue and expenses.
The income statement is called the profit and loss account in the UK. In some other parts of the world, it is also called the statement of revenue and expense.
Just like with the balance sheet, I plan to write a detailed follow up post that covers the income statement in detail. So stay tuned for that post!
The Statement of Cash Flows
The third and last financial statement that I will cover in this website is the statement of cash flows. It breakdowns the movement of cash and cash equivalent over a particular time period, both into and out of a company's accounts. Just like the income statement, it covers a period of time, not a moment in time like the balance sheet.
The statement of cash flows is generated under the accrual method of accounting. The statement of cash flow is generally divided into three main sections:
- Cash From Operating Activities
- Cash From Investing Activities
- Cash From Financing Activities
The main purpose of the statement of cash flow is to determine how effectively a company is translating earnings into cash flow. Since earnings are based upon the accrual method of accounting, and cash flow is based upon the cash method of accounting, it is a direct method of how effectively a company is able to act on their accounts receivable.
Just like with the other two financial statements covered in this post, I will be providing a more detailed post doing a deep dive on the statement of cash flows. Stay tuned for that.
The Importance of Understanding Financial Statements
I wanted this post to serve as an introduction, not an in-depth course. So that's all the technical content I'm going to write about.
I want to finish off by touching on the importance of understanding financial statements for the serious investor. As covered in my post The Importance of Having Your Own Investment Strategy, I am a value investor from the school of Benjamin Graham and Warren Buffett. This means that I seek to purchase companies that are trading below my perception of their true value (often called "intrinsic value" by value investors).
The study of financial statements (often called "fundamental analysis") is the only real way to asses the fair value of a company. We do this using valuation metrics such as the Price-to-Earnings Ratio, Price-to-Book Ratio, or Earnings Yield.
Readers, how did you learn how to read and interpret financial statements? What kind of analysis do you perform financially before investing in a company? In your opinion, what is the most useful financial statement for an investor? Let me know in the comments section!