Three financial statements are critical to financial statement analysis: the balance sheet, the income statement, and the statement of cash flows. We provide a brief overview of each statement and describe what information it contains.
The balance sheet provides the details of the accounting identity.
Assets = Liabilities + Owners’ equity
Investments=Investments paid for with debt + Investments paid for with equity
The balance sheet is a financial snapshot of the firm, usually prepared at the end of the fiscal year. That is, it provides information about the condition of the firm at one particular point in time. By reviewing a series of balance sheets from different years, the analyst can identify changes in the firm over time. Table 1 shows an example of balance sheet, and the video discusses its content.
Table 1 Balance Sheet Example
|Assets||Liabilities and Equity|
|Current Assets||Current Liabilities|
|Marketable securities||Accrued expenses|
|Accounts receivable||Short-term notes|
|Total current assets||Total current liabilities|
|Fixed Assets||Long-Term Liabilities|
|Machinery and equipment||Long-term notes|
|Total fixed assets||Total long-term liabilities|
|Par value||Retained earnings|
|Paid in capital|
|Total other assets||Total equity|
|Total Assets||Total Liabilities and Equity|
1. Assets generate income (the left-hand side)
The left-hand side of the balance sheet lists the firm’s assets. The only reason for a firm to hold an asset is if it produces income. There is no reason for a firm to hold an asset if it is not going to produce income.
2. Financing the assets (the right-hand side)
For every dollar in assets the firm has, there will either be a dollar of liability or a dollar of equity on the right-hand side of the balance sheet. The right-hand side of the balance sheet shows how the firm is financing its assets. By adjusting the mix of debt and equity, the lowest cost of financing can be achieved.
In summary, the left-hand side of the balance sheet reports the assets that earn income and the right-hand side reports how these assets are financed.
Unlike the balance sheet, which tells us the state of the firm at one point in time, the income statement tells us how the firm has performed over a period of time.
Income statements usually have two sections. The first section reports the results of operating activities or operating income. This includes sales minus operating expenses. Financing activities are reported in the second section, where interest expense, taxes, and preferred dividends are subtracted to arrive at net income. Table 2 provides an example of income statement, and the video discusses the content of the income statement.
Table 2 Income Statement Example
— Cost of goods sold
— Selling expense
— Administrative expense
— Depreciation expense
Earnings Before Interest and Taxes (EBIT)
| — Interest expense|
Earnings Before Taxes
Net Income Before Preferred Dividends
— Preferred stock dividends
|Net Income Available to Common Stockholders|
Statement of Cash Flows
Many students are not as comfortable with the statement of cash flows as they are with the income statement and balance sheet. It does, however, provide insight not readily available from the other statements. In finance, we are particularly concerned with cash flows rather than accounting earnings. Table 3 shows an example of statement of cash flows. The video above explains the content of the statement of cash flows.
Table 3 Sample Statement of Cash Flows
|Cash Flow from Operations|
Net profit after taxes
+ Decrease in accounts receivable
+ Decrease in inventories
+ Increase in accounts payable
+ Decrease in accruals
Cash provided by Operations
|Cash Flow from Investments|
Increase in fixed assets
Change in business ownership
Cash provided by Investment Activities
|Cash Flow from Financing|
+ Decrease in notes payable
+ Increase in long-term debt
+ Changes in stockholders’ equity
— Dividends paid
Cash provided by Financing Activities
|Net increase/decrease in Cash and Marketable Securities|
Provides a financial summary of the firm’s operating results during a specified period.
Statement of Cash Flows
Provides a summary of the firm’s operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period of concern.
A snapshot of a firm at a particular point in time that shows its assets and liabilities.