WISDOM IN A NUTSHELL

How to Use Financial

Statements

A Guide to Understanding the Numbers

By James Bandler
McGraw-Hill, 1994
ISBN 078630197X
147 pages

BusinessSummaries.com is a business book summaries service. Every week, it

sends out to subscribers a 9- to 12-page summary of a best-selling business
book chosen from among the hundreds of books printed out in the United States.
For more information, please go to http://www.bizsum.com.
The Big Idea
Reading and understanding Financial Statements has always been considered a
difficult task to most. These days, financial statements are not solely for
accountants, economists and businessmen. Knowing how to read and
understand financial statements can help you know your company better, can
help you plan investments, spot industry trends and can help you find a better
job.

You do not need to be an accountant to use the information on a basic

statement. All you need are a few basic concepts. This book gives you a clear
and simple way of reading and understanding financial statements. It puts
complex ideas into plain and easy to understand language.

What Are Financial Statements and What Do They Tell Us

Financial statements are necessary sources of information about a company. It is
used to analyze a company’s past, present and future performance.

Financial statements consist of three separate but interrelated topics:

1. Statement of financial position or balance sheet

ƒ Gives a snapshot of the company’s financial position at any given time.
ƒ Lists down the company’s assets against liabilities and owner equity.
Assets should always equal liabilities plus owner equity.

2. Profit or loss or the income statement

ƒ Shows how profitable a company is at any given time.
ƒ Shows revenues minus expenses to come up with net profit.

3. Statement of cash flow

ƒ Tells how much cash a company made, and where it went.

Who Uses Financial Statements and What Do They Look For

Primary users of financial statements are:
ƒ Owners/investors - places more emphasis on the profit side of the
business; will focus most likely on the income statement
ƒ Lenders - tends to give more importance to balance sheets and cash
flow.
ƒ Managers - uses financial statements to gauge the performance of the
company or business.
ƒ Suppliers - concerned with the ability of the company to make
payments. They are inclined to look at cash flow and how “liquid” a
company is.
 ƒ Customers - looks into a company’s financial strength.
ƒ Attorneys and litigants - interested in the client’s ability to pay. Financial
statements are also used to determine who will be named in a law suit
and how much to demand.
ƒ Employees and jobseekers - employees need to know if the company
can provide the job and employment security he needs.

An Introduction to Accrual Concept

Financial statements are based on the concept of Accrual Accounting. It is
important to understand this concept of recognizing revenue and expense when
you read and analyze financial statements.

Accrual accounting records revenue as it is earned and expenses as it is

incurred, even if no money has changed hands. It matches revenues with
expenses of a particular period regardless of cash involvement.

Revenue is recognized upon completion of a sale or service which requires a

client to make payment. Revenues may be earned before or after cash is
received.

Expenses are recorded at the time it is incurred or when a company receives

supplies or services - regardless of whether cash payment had been made.
Expenses are recognized when the company has an obligation to make
payments.

Accrual Accounting and Depreciation

Matching of revenues and expenses can be found in the purchase of income
generating assets such as property, plant and equipment. Instead of charging
these assets at the time of purchase, resulting in a misrepresentation of company
income, the cost of these assets is expensed over its useful life. The cost is
matched against the revenue that will be generated over a particular period.

The Statement of Financial Position or Balance Sheet

The balance sheet lists and totals the company’s assets, liabilities and the
owner’s equity at the end of each operating period. An operating period can be 1
month, 3 months, 3 months or a year.

It has three board categories and can be summarized as:

Assets = Liabilities + Owner’s Equity

A balance sheet, therefore, should always have equal assets to liabilities and
owner’s equity. To get owner’s equity, you have to reorganize the equation as:
 Owner’s Equity = Assets – Liabilities

Items found in the balance sheet are as follows:

ƒ Assets
o Current Assets. Includes cash, things easily converted to cash, and
things that enable a company to make products or render services that
generate cash. It lists in order of liquidity (how it is easily converted to
cash within a period of 1 year), beginning with cash itself. It may include
accounts receivable, marketable securities, insurance or taxes.
o Non-current Assets. This includes properties, plants, and equipment
used in the production of products and services.
ƒ Liabilities
o Current Liabilities. Discloses amounts owed by the company, such as
debt, unpaid bills, expenses not yet paid or yet to be paid within a period
of one year. This typically includes payment for wages and salaries, rent
and expenses, interest expense on debt and other account payables
within one year.
o Long-term debt. These are obligations not due for payment within the
following year.
ƒ Owner’s equity. This consists of both the funds contributed to the company
for the purchase of ownership and the accumulation of profit not yet paid to the
owners in the form of dividends or other capital distribution.

The balance sheet can tell you the amount the company has in debt in relation to
its owner’s equity. This is known as Leverage. A company is said to be highly
leveraged if total liabilities are large in relation to owner’s equity. A company
which has high owner’s equity in relation to its liabilities is low leveraged and is
less risky than the former.

The Profit and Loss or Income Statement

The income statement shows if the company is making profit or incurring
losses. It subtracts the cost of doing business (i.e. the cost of production,
operating expenses) from the revenue gained from the sales of products or
services.

An example of an income statement:

Net sales $10,000,000

Cost of goods sold 7,000,000
Gross Profit 3,000,000
Operating expenses:
Selling, general & administrative 1,600,000

Depreciation 200,000

Total Operating expense (1,800,000)

Profit from operations 1,200,000

Interest expense (200,000)
Income before taxes 1,000,000
Provision for income taxes (400,000)
Net Profit $600,000

Revenues (net sales). These are products sold or various sales and services
rendered regardless if cash was received. It can also come from rentals, interest
earned, commissions, etc.

Cost of goods sold. These are all cost allocated to inventory that was sold
during the period. It includes labor, materials and overhead.

Gross Profit. It is the difference between revenues and the cost of goods sold.

Operating expenses. These are expenses incurred to keep the business

running day to day. General and administrative cost includes salaries and wages,
payment for utilities, insurance, rental and other expenses. Selling expenses
includes all forms of advertising, cost of supporting sales function, salaries and
commissions of sales personnel.

Provision for income tax. This is the income tax expense and is based on the
company’s income tax rate.

Net income. This is also called the “bottom-line”. It is what is left after all cost of
doing business is deducted from revenues earned.

The income statement directly affects the balance sheet. Sales can lead to an
increase in accounts receivable. Cost of goods sold can lead to a decrease in
inventory. Operating expenses can affect a rise in accrual expenses or accounts
payable. It can also decrease cash and prepaid expenses. Net profit leads to an
increase of retained earnings or owner’s equity.

The Statement of Cash Flow

The statement of cash flow essentially converts income statement into sources
and uses of cash.

Conceptual basis for determining cash flow

Cash flow statement begins with net income and assumes that all transactions
(revenues and expenses) are made in cash during the operating period. It then
makes necessary change to show that it is not so.
An example of a cash flow statement: (based on the above income statement)
Cash flow from operations
Net profit 600,000
Depreciation 200,000
800,000

Changes to operating assets and liabilities

Accounts receivable (500,000)
Inventory (300,000)
Accounts payable 200,000
Accrued expenses (100,000)
Net cash provided by operations 100,000
Cash flow from investing activities
Additions to property, plant and equipment (1,000,000)
Net cash from financing activities
Repayment of long-term debt (200,000)
Net cash provided (used) $(1,100,000)

Calculating cash flow

Depreciation is not considered a cash outlay, so it is added back to net income.
Accounts receivable and Inventory are deducted from cash flow as it is not yet
cash during that period (no income made). Accounts payable are considered
sources of cash since no payment was made during that operating period.

Also deducted from cash are investment activities such as additions to

property, plant and equipment.

Cash from financial activities can increase or decrease cash flow. Payment of
long-term debt reflects a decrease of cash flow while an increase of long term
debt provides cash and is added to income.

Alternative format for statement of cash flows

This aims to show how much cash was made from sales, how much was utilized
for production and how much was spent for operating expenses. It adjusts
revenues earned or expenses incurred into cash received or cash paid.

It is computed as:
Cash revenue = accrual revenue + beginning accounts receivable - ending
accounts receivable
Cost of goods sold / production cost = beginning accounts payable +
purchases - ending accounts payable
Operating expense = total beginning accrual expenses - total ending accrual
expenses.
Resulting cash flow statement looks like this:

Cash received from revenues $9,500,000

Cash paid for production cost (7,100,000)

Cash paid for operating expenses (2,300,000)

Cash derived from operations 100,000

Cash paid for property, plant & equipment (1,000,000)

Cash paid for debt reduction (200,000)

Net cash flow $(1,100,000)

Using the statement of cash flow

For a meaningful analysis of cash flow, you should also focus on the individual
components and not just the change in cash or net cash flow.

The primary purpose of cash flow statement analysis is that a company should
not tie up its funds in assets that are not able to generate cash for the company
to meet its obligations. Analyzing cash flow of a company should be done over
an operating period of several years and in detail.

Following a Transaction through the Financial Statements

Important accounting issues and rules give additional meaning. Company
transactions such as inventory purchase, payment or sale of inventory and
collection of accounts receivable influence financial statements over an operating
period.

A growth or decline in a company’s business, its ability to create cash or meet its
obligations, its efficiency and profitability can affect the balance sheet, income
statement and cash flow.

Special Inventory Valuation and Depreciation Reporting Issues

To effectively compare and analyze financial statements, it is imperative to take
note of the specific methods used by the company. Two items that regularly
appear are inventory valuation and depreciation of property, plant and
equipment. Methods of valuation and depreciation are usually stated in the
footnotes of financial statements.

Inventory valuation alternatives

First in - First out (FIFO). Reports as cost of sale the earliest acquisition cost of
inventory.
Last in - First out (LIFO). Reports as cost of sale the latest acquisition cost of
inventory.
Average cost method. Reports as cost of sale the average cost of its inventory.
Depreciation methods
Straight line method. Applies a consistent rate of asset cost to each period

Accelerated method. Applies a greater rate of depreciation in the earlier years

of an asset’s life, and less in the later years.

In computing depreciation, the following information is required:

1. Cost of asset. This should include the asset’s purchase price and all cost
incurred to get the asset in the position and condition for operation / use.
2. Useful life. This estimates the serviceable or productive years of the
asset. Normal wear and tear, obsolescence, and change in requirements
should be taken into consideration.
3. Residual or salvage value. This approximates the amount the company
can get from the sale of the asset at the end of its useful life.

Intangible Assets and Amortization

These are assets lumped together in the category “other assets” seen on the
balance sheets:
1. Intangible assets. These are assets that can not be seen nor felt but
generate revenues. Patents, trademarks, copyrights and franchises are
considered intangible assets.
2. Good will. This is the excess amount a company has paid over the book
value assets of a company (subsidiary or affiliate) it has acquired.
3. Amortization. It is the cost of intangibles which are charged over the
period they are expected to generate income.

Service Companies
Service companies such as banks, public utilities, hotels, hospitals, data
providers, travel agents differ from product or merchandise oriented companies
in the way they report their financial statements.

Service companies differ on how they generate revenues and other financial
characteristics. They can be grouped into:
1. Financial Service Companies. These normally show large amount of
loans and investment against owner’s equity.
a. Banks. Loans are considered assets while deposits are liabilities.
Income comes from interest earned from loans while interest paid is
considered expenses.
b. Insurance companies. Assets are in the form of marketable
securities, common or preferred stocks and other investments.
Liabilities are in the form of payment of claims. Revenues come
from policy premiums and investments. Expenses are projected
and actual policy claims.
 c. Securities brokerage. Revenue comes from commissions from
security traders and other agency fees. Commissions paid by the
company to brokers are considered expenses.
2. Capital Intensive Companies. Revenues mainly come from property,
plants and equipment. These companies invest heavily on property, plants
and equipment to provide services and thus are capital intensive.
Hospitals, hotels, airlines and other transportation companies, TV and
cable companies, phone companies are some examples of these type of
companies.
3. People Intensive Companies. These companies provide professional
services. Law firms, accounting firms, consultancy agencies and
employment agencies are under this category. People (or employees) are
considered assets since they generate income.

What are the Rules that Preparers of Financial Statement Must

Play By?
To present the reader with an accurate and fair presentation of financial
information, financial statements are prepared in accordance with the Generally
Accepted Accounting Principles or GAAP. The GAAP standardizes how
financial statements are prepared so that you can effectively compare a company
with another in the industry.

Most GAAPs are defined and served as guides for reporting and reading a
financial statement. All information or disclosures needed by the reader to
understand the financial statements, the company’s accounting practices as well
as the auditor’s opinion can be found in the footnotes of a financial statement.

Some of the disclosures commonly found are:

ƒ General. This reports the nature of a company’s business and its operating

and accounting principles.

ƒ Summary of significant accounting policies
o Principles of consolidation. States if the financial information of a
company’s subsidiary are consolidated or mixed in with the parent
company instead of showing it as a separate asset.
o Revenue recognition. Tells how a company recognizes revenue for a
better understanding of the statement.
o Treatment of “excess of purchase price over net assets of business
acquired”. This is also known as goodwill. It states how it is recognized
(i.e. is it amortized? For how long?).
o Property and equipment. Reports useful life of an asset and method of
depreciation as well as net asset value of each.
o Inventory. Tells what method (FIFO, LIFO, Average cost) of inventory
valuation is used. Breakdown of inventory components are also included.
 o Research and development. Shows if R&D expenses are reported as
assets (which benefits future periods) or as expenses for the current
period.
o Definition of cash equivalents. Most companies invest in short-term debt
instruments instead of putting cash in banks.
o Warranties of any other unusual terms of sale. States if there are unusual
obligations or expenses arising from the sale of a company’s products or
services.
ƒ Description of credit facilities. States a company’s lending agreements with
its creditors
ƒ Description of terms and funding of employee’s benefits and retirement
plans. Tells estimated cost for providing benefits and who are eligible for
these benefits.
ƒ Reconciliation of income tax expenses. Also known as provision for income
tax. This tells what tax rate was used, the company’s tax credit, actual amount
paid or due for taxes.
ƒ Long term debt maturities. This is useful in determining future cash flow and
financing needs as it reports how much debt must be paid and other future
long-term obligations.
ƒ Property and casualty insurance. Discloses if the company is insured
against risk and losses and if it is within industry standard.
ƒ Transactions with insiders or related entities. Reveals how the company
conducts business with management or directors of company owned or
controlled corporations.
ƒ Major customers and suppliers. States the percentage of sales or
purchases from parties and if the company is highly vulnerable to a loss of the
major supplier or customer.
ƒ Industry segment information. Discloses sales information by product line
and geography.
ƒ Current cost or replacement value of non-monetary assets.
ƒ Contingent liabilities. States current development that might become future
liability to the company (i.e. pending law suits).
ƒ Events subsequent to the date of the financial statements. Discloses
events that might affect the financial statement after it has been made.
ƒ Opinion letters. An outside auditor’s opinion on the financial statement. It
should state that the financial statement has been prepared in accordance
with GAAP or that the statements fairly represent the financial conditions of
the company. Opinion letters offer the highest level of assurance as they are
made by independent auditors or accountants.

Some Basic Tools of Financial Analysis

To be able to analyze a company’s success or failure, its strength and weakness
as well as its future outlook, you need to understand the relationships of the data
presented in the financial statements. These relationships are analyzed by
means of ratios.

Some useful ratios and what they tell us

1. Leverage ratio. Tells if the company’s assets are adequate to cover
claims of creditors and still present ample equity to owners.
Leverage ratio = Total liabilities ÷ owner’s equity

2. Current ratio and quick ratio. Measures how liquid a company is.
Quick ratio = total cash, short term marketable securities and accounts
receivable ÷ current liabilities

Current ratio = total current assets ÷ total current liabilities

3. Debt coverage ratio. Tells if a company’s cash flow before payment of

debts is adequate to cover debt requirements.
Debt coverage ratio = total of net income + non cash charge ÷ current
maturities of long term debt

4. Accounts Receivable collection period. Discloses if the company is

able to collect its account receivable on time (A/R) and long it collects A/R.
Accounts Receivable collection period = Accounts receivable ÷ sales for
the period x number of days for the period

5. Days inventory supply. Tells if the company is carrying enough in its

inventory to meet demands of the market.
Days inventory supply = inventory ÷ cost of goods sold for the period x
number of days for the period.

6. Return on assets. A measure of profitability of assets. Tells if assets are

producing sufficient income.
ROA = net income ÷ total assets

7. Return on equity. Measures the return of investment of an owner or

stock holder. Tells the profitability of owner’s investment
ROE = Net income ÷ owner’s equity

The Limitations of Financial Statements

Financial statements are merely historical measures of a company’s
performance. Though it represents a fair representation of a company’s current
condition, most data (except cash and other liabilities) are based on estimates,
forecast and assumptions. Different methods (depreciation method, inventory,
etc) used can distort a financial statement.