Understanding Financial Statements
Financial statements are written records that convey the business activities and the financial performance of a company. Financial statements are often audited by government agencies, accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes. Financial statements include the
Investors and financial analysts rely on financial data to analyze the performance of a company and make predictions about the future direction of the company’s stock price. One of the most important resources of reliable and audited financial data is the annual report, which contains the firm’s financial statements.
The financial statements are used by investors, market analysts, and creditors to evaluate a company’s financial health and earnings potential. The three major financial statement reports are the balance sheet, income statement, and statement of cash flows.
The balance sheet provides an overview of a company’s assets, liabilities, and stockholders’ equity as a snapshot in time. The date at the top of the balance sheet tells you when the snapshot was taken, which is generally the end of the reporting period. Below is a breakdown of the items in a balance sheet.
- Cash and cash equivalents are liquid assets, which may include Treasury bills and certificates of deposit.
- Accounts receivables are the amount of money owed to the company by its customers for the sale of its product and service.
- Shareholders’ equity is a company’s total assets minus its total liabilities. Shareholders’ equity represents the amount of money that would be returned to shareholders if all of the assets were liquidated and all of the company’s debt was paid off.
- Retained earnings are part of shareholders’ equity and are the amount of net earnings that were not paid to shareholders as dividends.
Example of a Balance Sheet
Below is a portion of ExxonMobil Corporation’s (XOM) balance sheet for fiscal-year 2021, reported as of Dec. 31, 2021.
- Total assets were $338.9 billion.
- Total liabilities were $163.2 billion.
- Total equity was $175.7 billion.
- Total liabilities and equity were $338.9 billion, which equals the total assets for the period.1
Unlike the balance sheet, the income statement covers a range of time, which is a year for annual financial statements and a quarter for quarterly financial statements. The income statement provides an overview of revenues, expenses, net income, and earnings per share.
Operating revenue is the revenue earned by selling a company’s products or services. The operating revenue for an auto manufacturer would be realized through the production and sale of autos. Operating revenue is generated from the core business activities of a company.
Non-operating revenue is the income earned from non-core business activities. These revenues fall outside the primary function of the business. Some non-operating revenue examples include:
- Interest earned on cash in the bank
- Rental income from a property
- Income from strategic partnerships like royalty payment receipts
- Income from an advertisement display located on the company’s property
Other income is the revenue earned from other activities. Other income could include gains from the sale of long-term assets such as land, vehicles, or a subsidiary.
Primary expenses are incurred during the process of earning revenue from the primary activity of the business. Expenses include the cost of goods sold (COGS), selling, general and administrative expenses (SG&A), depreciation or amortization, and research and development (R&D).
Typical expenses include employee wages, sales commissions, and utilities such as electricity and transportation.
Expenses that are linked to secondary activities include interest paid on loans or debt. Losses from the sale of an asset are also recorded as expenses.
The main purpose of the income statement is to convey details of profitability and the financial results of business activities; however, it can be very effective in showing whether sales or revenue is increasing when compared over multiple periods.
Investors can also see how well a company’s management is controlling expenses to determine whether a company’s efforts in reducing the cost of sales might boost profits over time.
Example of an Income Statement
Below is a portion of ExxonMobil Corporation’s income statement for fiscal-year 2021, reported as of Dec. 31, 2021.
- Total revenue was $276.7 billion.
- Total costs were $254.4 billion.
- Net income or profit was $23 billion.2
Cash Flow Statement
The cash flow statement (CFS) measures how well a company generates cash to pay its debt obligations, fund its operating expenses, and fund investments. The cash flow statement complements the balance sheet and income statement.
The CFS allows investors to understand how a company’s operations are running, where its money is coming from, and how money is being spent. The CFS also provides insight as to whether a company is on a solid financial footing.
There is no formula, per se, for calculating a cash flow statement. Instead, it contains three sections that report cash flow for the various activities for which a company uses its cash. Those three components of the CFS are listed below.
The operating activities on the CFS include any sources and uses of cash from running the business and selling its products or services. Cash from operations includes any changes made in cash, accounts receivable, depreciation, inventory, and accounts payable. These transactions also include wages, income tax payments, interest payments, rent, and cash receipts from the sale of a product or service.
Investing activities include any sources and uses of cash from a company’s investments into the long-term future of the company. A purchase or sale of an asset, loans made to vendors or received from customers, or any payments related to a merger or acquisition is included in this category.
Also, purchases of fixed assets such as property, plant, and equipment (PPE) are included in this section. In short, changes in equipment, assets, or investments relate to cash from investing.
Cash from financing activities includes the sources of cash from investors or banks, as well as the uses of cash paid to shareholders. Financing activities include debt issuance, equity issuance, stock repurchases, loans, dividends paid, and repayments of debt.
The cash flow statement reconciles the income statement with the balance sheet in three major business activities.
Example of a Cash Flow Statement
Below is a portion of ExxonMobil Corporation’s cash flow statement for fiscal-year 2021, reported as of Dec. 31, 2021. We can see the three areas of the cash flow statement and their results.
- Operating activities generated a positive cash flow of $48 billion.
- Investing activities generated negative cash flow or cash outflows of -$10.2 billion for the period. Additions to property, plant, and equipment made up the majority of cash outflows, which means the company invested in new fixed assets.
- Financing activities generated negative cash flow or cash outflows of -$35.4 billion for the period. Reductions in short-term debt and dividends paid out made up the majority of the cash outflows.3
Limitations of Financial Statements
Although financial statements provide a wealth of information on a company, they do have limitations. The statements are open to interpretation, and as a result, investors often draw vastly different conclusions about a company’s financial performance.
For example, some investors might want stock repurchases while other investors might prefer to see that money invested in long-term assets. A company’s debt level might be fine for one investor while another might have concerns about the level of debt for the company.
When analyzing financial statements, it’s important to compare multiple periods to determine if there are any trends as well as compare the company’s results to its peers in the same industry.
What Are the 3 Most Important Financial Statements?
The three most important financial statements are the balance sheet, the income statement, and the cash flow statement. These three statements together show the assets and liabilities of a business, its revenues and costs, as well as its cash flows from operating, investing, and financing activities.
What Are the Main Items Shown in Financial Statements?
Depending on the corporation, the line items in a financial statement will differ; however, the most common line items are revenues, costs of goods sold, taxes, cash, marketable securities, inventory, short-term debt, long-term debt, accounts receivable, accounts payable, and cash flows from investing, operating, and financing activities.
What Are the Benefits of Financial Statements?
Financial statements show how a business operates. It provides insight into how much and how a business generates revenues, what the cost of doing business is, how efficiently it manages its cash, and what its assets and liabilities are. Financial statements provide all the detail on how well or poorly a company manages itself.