Learn to Read Financial Statements

Professionally prepared financial statements generally contain an Accountant's Report, a Balance Sheet, an Income Statement, a Statement of Cash Flows and Notes to the Financial Statements.

Accountant's Report

Notes to the Financial Statements

Statement of Cash Flows

Income Statement

Balance Sheet

Accountant's Report

When reading a financial statement, the first thing you should read is the Accountant's Report. The accountant's report will tell you if the financial statements were compiled, reviewed or audited. It will also tell you if any financial information is missing (omitted from the statements) and what opinion the CPA firm has about the financial statements.

If the statements have been compiled then the CPA firm is not making an opinion one way or the other. All information presented is what the Management of the Company wants to present and in the way they want it presented. Compiled financial statements do NOT have to be in accordance with Generally Accepted Accounting Principals (GAAP) and usually are not. The accountant has simply put management's information in the form of financial statements. If any statements, such as the Statement of Cash Flows, or disclosures (notes to the financial statements) are missing the accountant's report will state that the information is missing.
If the statements have been reviewed, then the CPA firm is not making an opinion one way or the other, but they will tell you if they are aware of any changes that should be made in the statements for them to be properly stated (according to Generally Accepted Accounting Principles - GAAP). Most statements that have been reviewed have been prepared in accordance with GAAP. If the accountant believes changes should be made to the statements they will state what the changes are and how they would affect the statements in the final paragraph of this report.
If the statements have been audited, then the CPA firm will make an opinion on the statements.
- If their opinion is unqualified, then the statements are said to have received a "clean opinion". A clean opinion means that the auditors believe the company is using "acceptable" accounting methods and disclosures and any misstatements or missing information is "not material". In other words, just because the financial statements have been audited and given an unqualified or clean opinion it does not mean that intentional errors, fraud, unintentional errors, misstatements or lack of disclosures have not been made. The auditors may have hoped the company would have used other accounting methods and disclosures, but the financial statements are not those of the auditor, they are management's. So, if management uses "acceptable" methods and disclosures within "materiality", then the auditor will say that the financial statements, taken as a whole, are not misleading and issue a clean or unqualified opinion.
- If their opinion is qualified, then the auditors disapprove of management's accounting method(s) and/or disclosure(s). The auditors still believe that the financial statements, taken as a whole, are not misleading, but they are alerting the readers that management has not followed all the rules (GAAP).
- If their opinion is adverse, then the auditors not only disapprove of management's accounting method(s) and/or disclosure(s), but they also believe the departures are so great that the financial statements are misleading.

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Notes to the Financial Statements

The second thing you should read is the Notes to the Financial Statements. There are two kinds of notes:

Notes identifying and explaining the accounting policies the company is using
- If GAAP (General Accepted Accounting Principles) allows more than one accounting principle, then the company must inform it's readers in their Notes to the Financial Statements, which method of accounting they have decided to use. The following are simple examples of different "acceptable" methods of accounting:
- Other accounting premises and methods that they used to prepare the statements including:
Notes providing additional information not contained in the statements, examples include:

Reading the notes may be boring and hard to understand, but it gives you a very good picture of how management is running their business. If you are comparing two different companies to invest in and one uses LIFO and the other uses FIFO and you never read the notes to the financial statements then one company may look like they have a better profit margin or a better inventory turnover, when in fact they could be nearly identical had they been using the same accounting method.

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Statement of Cash Flows

Now that you've read the Accountant's Report and the Notes to the Financial Statements it's time to read the Statement of Cash Flows. The Statement of Cash Flows show us the cash that flowed into the company and the cash that flowed out of the company during the period being reported. Cash is what keeps a business going, so we need to pay close attention to how management is acquiring it and using it. This is exactly what the The Statement of Cash Flows show us. The Statement of Cash Flows is divided into three sections:

Cash Flows from Operating Activities - this portion will tell you if the company generate cash or lost cash from their operating activities
Cash Flows from Investing Activities - this portion will tell you if the company generate cash from their investments (selling equipment, buildings, stocks, etc.) or lost cash from their investing activities (purchased equipment, buildings, etc.)
Cash Flows from Financing Activities - this portion will tell you if the company generate cash by borrowing it or selling company stock or if they decreased cash by paying off debts or buying back their stock or paying a dividend to stockholders

Although the Cash Flow Statement is an extremely important statement, as it shows where all the cash came from and where it went during the period being report on, it does NOT show us the following:

How the Net Income of the company was determined
What financial condition the company was in at the end of the reporting period

And without the answers to these very important question we do not have a good understanding of the overall financial health of the company.

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Income Statement

The Income Statement is a summary report that shows the profit of the company for a period of time. It usually has categories as outlined and explained below:

*Typical Income Statement Line Items*	*General Explanation*
Sales Less: Sales returns and allowances	When a sale is made the amount of the sale is recorded to various sales accounts (book sales, paper sales, etc.) and they are all totaled into one line item for the income statement. Any sales returns or allowance for possible future returns or bad debts (failure to pay, bounced checks, etc.) are recorded to Sales returns and allowances.
Net Sales	Net Sales = Sales - Sales Returns and Allowances

Cost of Goods Sold	Cost of Goods Sold is the cost of buying or making the product that the company sells. If the company you are looking at is in a service industry (medical professionals, attorneys, consultants, etc.), where the company is selling a service and not a product, they will not have a Cost of Goods Sold section.
Gross Profit	Gross Profit = Net Sales - Cost of Goods Sold

Selling, General and Administrative Expenses Salaries Payroll taxes & Other fringe benefits Advertising expenses Rent (of land and buildings) Property Taxes Insurance Utilities Depreciation and amortization expense Bad debts expense Other selling, general and administrative expenses	Selling, General and Administrative Expense are all expenses that are incurred to operate the business.
Operating Income (Loss)	Non-service Industries: Operating Income = Gross Profit - Selling, General & Administrative Expenses Service Industries: Net Sales - Selling, General & administrative Expenses

Other Revenues and Gains Interest income Gain on sale of investment Other Expenses and Losses Interest expense Loss on sale of equipment	Interest income is the revenue the company received from their available cash. Interest expense is the price a company pays to borrow money. Gain or Loss on the sale of equipment is the profit or loss incurred when they disposed of assets they no longer needed.
Income (Loss) from Operations before Income Taxes	Income (Loss) from Operations before Income Taxes = Operating Income (Loss) + Other Revenues and Gains - Other Expenses and Losses
Income Taxes Expense	Many differences are permitted between the income reported for taxing purposes and the income reported on the financial statements. The differences would be discussed in the Notes to the Financial Statements. So Income Tax Expense is not just a percentage of Income (Loss) from Operations because many adjustments may have to be made to arrive at taxable income.
Net Income (Loss)	Net Income = Income (Loss) from Operations before Income Taxes - Income Tax Expense

As we have just seen from the Statement of Cash Flows, if a company has a lot of profit, but no cash, we have to wonder how healthy the company is, which is why we still need to review the Balance Sheet.
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Balance Sheet

The Balance Sheet is a summary report that shows the financial position(which is why it is also called the Statement of Financial Position) of a business as of the end of business on one day in past, the end of the income statement period. The best use of a Balance Sheet is to compare it to something. Typically, when analyzing a company, you compare a Balance Sheet to the following:

Their own past Performance: Has their Inventory or Accounts Receivable gotten bigger or smaller? Are their debts growing out of control?
Other companies in their industry (line of business): Do their competitors maintain the same percentage of cash, accounts receivables, inventory, and debt? Please remember to read the Notes to the Financial Statements of these other companies when making these comparison, because if they are using a different accounting method, then they are not directly comparable.

*Typical Income Statement Line Items*	*General Explanation*
Assets Current Assets Cash Accounts Receivable Inventory Prepaid Expenses Property Plant & Equipment Land, Building, Machines, Equipment & Furniture Accumulated Depreciation	The Assets of a company are usually divided between Current Assets (assets that are either cash or expected to be cash within one year) and Property, Plant & Equipment (assets that are expected to be retained and used in the business).
Total Assets	Total Assets = Sum of all the current and long-term assets or Total Assets = Total Liabilities and Stockholders' Equity

Liabilities & Stockholders' Equity
Liabilities Current Liabilities Accounts Payable Accrued Expenses Income Tax Payable Short-Term Notes Payable Long-Term Notes Payable	The Liabilities of a company are usually divided between Current Liabilities (liabilities that are expected to be paid within one year) and Long-Term Liabilities (liabilities that are expected to be paid in more than one year).
Total Liabilities	Total Liabilities = Sum of all the current and long term obligations of the company

Stockholders' Equity Capital Stock Retained Earnings	Stockholders' Equity is usually divided between the Capital Stock and Retained Earnings. Capital Stock is the stock authorized, issued and outstanding. Retained Earnings is the sum of all the profits and losses since inception of the business.
Total Stockholders' Equity	Total Stockholders' Equity = Capital Stock + Retained Earnings or Total Stockholders' Equity = Total Assets - Total Liabilities

Total Liabilities and Stockholders' Equity	Total Liabilities and Stockholders' Equity = Total Liabilities + Stockholders' Equity or Total Liabilities and Stockholders' Equity = Total Assets