How to read financial statements

Balance Sheets

conveys the book value of the company.
It shows its assets, liabilities, and owners’ equity (essentially, what it owes, owns, and the amount invested by shareholders)
Balance sheet equation: Assets = Liabilities + Owners’ Equity

Assets are anything a company owns with quantifiable value. There are 2 types
- Current assets typically include anything a company expects it will convert into cash within a year
- Non-current assets typically include long-term investments that aren’t expected to be converted into cash in the short term, such as land and patents
Liabilities refer to money a company owes to a debtor, such as outstanding payroll expenses, debt payments, rent and utility, bonds payable, and taxes. There are 2 types
- Current liabilities typically refer to any liability due to the debtor within one year such as rent and payroll
- Non-current liabilities typically refer to any long-term obligations or debts which will not be due within one year such as loans
Owners’ equity refers to the net worth of a company. It’s the amount of money that would be left if all assets were sold and all liabilities paid. Typically includes 2 key elements, money which is contributed to the business in the form of an investment, and earnings that the company generates

Also known as a profit and loss (P&L) statement, summarizes the cumulative impact of revenue, gain, expense, and loss transactions for a given period
Key components are

Difference between income statement and balance sheet: income statement tallies income and expenses; a balance sheet, on the other hand, records assets, liabilities, and equity

Vertical analysis refers to the method of financial analysis where each line item is listed as a percentage of a base figure within the statement. This means line items on income statements are stated in percentages of gross sales, instead of in exact amounts of money, such as dollars.
- This isn’t always as immediately useful as horizontal analysis, but it can help you determine what questions should be asked, such as: Where did costs rise or fall? What line items are contributing most to profit margins? How are they affected over time?
Horizontal analysis reviews and compares changes in the dollar amounts in a company’s financial statements over multiple reporting periods. It’s frequently used in absolute comparisons. Ultimately, horizontal analysis is used to identify trends over time

Detailed picture of what happened to the company's cash flow during the accounting period
Ideally, a company’s cash from operating income should routinely exceed its net income, because a positive cash flow speaks to a company’s ability to remain solvent and grow its operations
Broken into 3 sections, CF from:
- Operating activities: CF that’s generated once the company delivers its regular goods or services
- Investing activities: CF from purchasing or selling assets
- Financing activities: CF from debt and equity financing
There are 2 methods to calculate CF
- Direct method: take all cash collections from operating activities, and subtract all of the cash disbursements from the operating activities.
- Indirect method: accrual accounting method in which the accountant records revenues and expenses at times other than when cash was paid or received—meaning that these accrual entries and adjustments cause the cash flow from operating activities to differ from net income.
  - Essentially, the accountant will convert net income to actual cash flow by de-accruing it through a process of identifying any non-cash expenses for the period from the income statement. The most common and consistent of these are depreciation, the reduction in the value of an asset over time, and amortization, the spreading of payments over multiple periods.

CF statements can reveal what phase a business is in: whether it’s a rapidly growing startup or a mature and profitable company. It can also reveal whether a company is going through transition or in a state of decline.
CF is typically depicted as being positive (the business is taking in more cash than it’s expending) or negative (the business is spending more cash than it’s receiving).
Positive CF indicates that a company has more money flowing into the business than out of it over a specified period.
- This does not necessarily translate to profit, however. Your business can be profitable without being CF-positive, and you can have positive CF without actually making a profit
Having negative CF means your cash outflow is higher than your cash inflow during a period, but it doesn’t necessarily mean profit is lost.
- It may also be caused by a company’s decision to expand the business and invest in future growth

Author: Tim Stobierski