[updated on 2/6/2016]
Companies report their business results in financial statements on a regular basis. Otherwise, how could they, the companies, attract serious investors?
Financial statements describe the use of money to sell products and grow a business. The statements are prepared by accountants who consolidate business transactions into standardized measurements of profitability, cash flow, and net worth. Those measurements represent stories of business success. The purpose of this article is to describe the framework and core stories of financial statements.
Companies use financial accounts to perform a large variety of business functions. The effective use of accounts generates a profit for the company and its investors.
There are accounts for banking, payroll, supplies, customers, investors, shipping, advisors, taxes, and many other essential functions. Non-cash and cash transactions are recorded in the appropriate accounts. For example, each sale to a customer is initially recorded as a non-cash transaction in the customer’s account based on the price in the shipping statement. Later, the customer’s payment is recorded as a cash transaction in the company’s bank statement. In another example, the company initially records its purchase of supplies as an non-cash transaction recorded on a receipt. Later, the company’s payment to the supplier is recorded as a cash transaction in the company’s bank statement.
Accrual accounting. Accrual accounting is the practice of recording non-cash transactions at the time of transaction. The data are collected from invoices, promissory notes, and other documents of unpaid transactions.
Non-accrual accounting. Non-accrual accounting is the practice of recording cash payments. Data for cash payments are collected from bank statements and other documents of paid transactions.
GAAP. U.S. stock companies are required to publish financial statements that conform to Generally Accepted Accounting Principles (GAAP). Foreign countries may allow companies to publish financial statements using non-GAAP methods.
Income statement. The unpaid transactions of business operations are organized into revenues, expenses, and net income (Eq. 1). The statement’s top line is called total revenues and represents all recorded sales during the fiscal period. Every sale is typically recorded at the time the product is shipped to a customer. Cash payment is expected at a different time and is not recorded in the income statement. The statement’s bottom line is called net income and represents the residual value of all sales after deduction of all the expenses incurred during the fiscal period.
net Income = Total revenues – Total expenses (Eq. 1)
Cash flow statement. The company’s payments are separated into categories of net operating cash flow (CFO or OCF), net investing (CFI), and net finance (CFF). The net value of each category is the balance between total cash inflow and outflow for the entire fiscal period. All cash surpluses and deficits are relegated to the category called net Cash Flow (Eq. 2). Companies that focus on growth attempt to maintain their net Cash Flow close to a zero balance. Investments in growth are paid through the CFI with funds obtained from the CFO or the CFF.
net Cash Flow = net CFO + net CFI + net CFF (Eq. 2)
Balance sheet. The total book value is the net value of all corporate assets and liabilities at the end of the fiscal period (Eq. 3). The total book value is sometimes called the shareholders’ equity, net worth, or net asset value.
Total book value = Total assets – Total liabilities (Eq. 3)
Financial statements are designed to measure profitability and cash flow during the fiscal period and net worth at the end of the fiscal period. A simple analysis of measurements can reveal the company’s business performance.
Profitability. The income statement describes how the company used sales and expenses to earn a profit during the fiscal period. The income statement might reveal that expensive business operations forced the company to sell a large number of products in order to be profitable.
Cash flow. The cash flow statement describes how the company used its money during the fiscal period. If the company paid for growth, the basic scheme was to use its cash from customers or investors to grow by purchasing more assets for the business or investing in other companies.
Net worth. Net worth is measured by the total book value at the end of the reporting period and provides a momentary valuation of the company. A company with considerable net worth has much greater value in total assets than in obligations to pay future expenses. The investor would judge that company to be financially strong.
Companies distribute their financial statements to the U.S. Securities and Exchange Commission (SEC), investors, financial services companies, and brokerage firms. Free copies can be obtained from the SEC.gov website, corporate websites, financial websites, and brokerage firms.
Domestic companies listed in U.S. stock markets file forms 10-K and 10-Q with the SEC. Form 10-K is an annual filing that contains financial statements for the fiscal year. 10-K is useful for performing a fundamental analysis of the company. Form 10-Q is a quarterly filing that also contains financial statements. 10-Q is useful for making quarterly reviews of the company.
Financial statements measure a company’s profitability, cash flow, and net worth. These measurements reveal the company’s business performance as a factor for making investment decisions. Free copies of financial statements are available in the internet.
Copyright © 2015 Douglas R. Knight