5 Things You Must Understand About Financial Statements

Savvy investors know how to read and analyze financial statements with a keen eye. We present the five most important things you should know about these often complicated documents:

1. The fundamental theorem of accounting: assets = liabilities + equity.

In order to understand the basics about financial statements, an investor has to understand how a financial statement is put together. The most basic rule of accounting, sometimes called the “fundamental theorem of accounting,” is that assets must equal liabilities plus equity. This basic theorem governs the balance sheet, and also underlies how the income sheet and cash flow statement are put together.

Therefore, it is crucial that investors understand what this rule means. Simply put, the fundamental theorem of accounting means that any increase in assets, liabilities, or equity must be offset by a change in one of the other categories. This is why the balance sheet “balances”—equity plus liabilities must always balance with assets.

This idea is at the heart of double-entry accounting; anytime a change is made to an account, a corresponding balancing change must be made to another account so that the balance sheet will still balance.

For example, if inventory is bought with cash, the cash account, which is an asset, will decrease, and inventory, another asset account, will increase by the same amount. No net change to assets occurs in this example. In another example, if a company borrows $100 from a bank and deposits the money in its own checking account, the company increases liabilities by $100 and also increases assets by $100. The harmonious balance is maintained.

2. The differences between the balance sheet, income statement, and cash flow statement.

Another thing investors must understand about financial statements are the differences between the three parts of the financial statements. Every publicly held company produces audited financial statements, which include a balance sheet, an income statement and a cash flow statement. All three parts contain crucial information for investors. In general, an investor will need to understand all three statements to get a picture of the financial condition and performance of the company.

The balance sheet is the part of the financial statement that gives a picture into a company’s overall financial health. The balance sheet tells investors how much the company has in assets, how much liabilities it has, and how much equity shareholders have. The fundamental theorem of accounting governs the balance sheet and ensures that it balances.

From the balance sheet, an investor can tell how leveraged, or indebted, a company is, and whether it is solvent. The investor can also often tell what types of assets a company has, such as how much cash the company has on hand, how much inventory, how much intangible assets, and how much physical plant (buildings, equipment).

The income statement tells an investor about how much profit the company made in the past period. It provides information on a company’s profit margins, cost of inputs, and other selling costs. It is important to understand that income earned is not at all the same as cash going into the company’s bank account.

The third part of the balance sheet, the cash flow statement, tells an investor more about the cash flowing in and out of the company’s coffers during the period in question. The cash flow statement not only tells an investor what the net change in cash was during the accounting period, but can also give the investor other important information, like how much the company invested in capital equipment and how much debt the company raised or retired during the period.

3. Most assets are carried at historical cost.

Investors must also understand that most assets are carried on a company’s books at historical cost. That means that the company books the cost the company paid for the asset. As a result, the company’s books do not reflect a market value for its assets. Only a few kinds of assets are carried at market value. In general, these are the kinds of assets that can very readily be turned into cash. For a detailed explanation, an investor would do well to consult an accounting text.

Therefore, an investor must understand that net equity per share, sometimes called book value per share, is at best a very rough approximation of a company’s worth. If a company has many assets that have likely appreciated in value, a company may be worth many times its book value per share. For instance, real estate purchased by the Coca-Cola corporation in Atlanta in 1890 is still carried on Coca-Cola’s balance sheet at the 1890 purchase price.

4. Accrual accounting: revenue is booked when earned, liabilities booked when incurred.

Investors must also understand accrual accounting to understand financial statements. Accrual accounting means that revenue is booked when earned, not when the cash for the revenue is actually received. Likewise, it means that liabilities are booked when incurred, regardless of the cash flow.

Therefore, under accrual accounting, a company that sells widgets will usually recognize revenue when the customers receive the widgets. As a result, the income statement will show the company selling widgets. The actual cash for the sales, however, may not be received by the company in the same period—it may have been received earlier or later than the period in which the sale was booked. This is one reason why the cash flow statement is important.

5. Financial statement analysis is only one part of investment analysis.

Finally, investors must know that financial statements are only part of understanding a company’s business position. Investment analysis involves understanding a company’s business, and the financial statements only tell part of the story. Missing from the financial statements are all the important qualitative information an investor must know to make an informed investment decision. For example, the financial statements do not tell an investor if the company makes cars or buggy whips, or if the company’s management is keen on selling the company, or a host of other crucial information an investor must know to be fully informed.

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