The following is part of our Financial Basics series. If you landed on this post, you may find the following one useful as well:
You’ve probably heard people discuss “financial statements.” These are documents that companies use to report the financial health of their business. They consist of 1) balance sheet, 2) income statement, 3) cash flow statement and 4) change in equity.
Today we are going to focus on the balance sheet and income statement discussing:
- What they are
- Why they are important
- How to use them
- How they work together
If you want to see balance sheets and income statements in action, public companies release them every quarter. You can see Apple’s here under the “10-Q” form. You can actually see any public company’s financial statements on the SEC’s EDGAR system here.
The balance sheet gives a snapshot in time of a company’s assets and liabilities. As the name suggests the balance sheet needs to balance the following equation:
Assets = Liabilities + Shareholders’ Equity
Figure 1. Balance sheet.
Why the balance sheet is important
It gives an overview of what the company owns (assets), owes (liabilities) and the amount invested (shareholders’ equity). Since this is just a snapshot in time, the current balance sheet is often compared against previous balances sheets to see how the above equation has changed over time.
How to use a balance sheet
Assets are split into current (assets that can be turned into cash within a year) and noncurrent (assets that can be turned into cash over a longer period of time). They should be listed in the order that they can be converted to cash (most quickly at the top).
Current assets include:
- Marketable securities (investments the company has that can be converted on a liquid market; for example, the stock market)
- Accounts receivable (invoice payments the company is owed)
- Prepaid costs (e.g advertising)
Noncurrent assets include:
- Long terms investments that can’t be quickly converted to cash
- Fixed assets (e.g land, real estate, equipment)
- Intangible assets. These can include things like IP and goodwill (generally not applicable to smaller companies)
Liabilities, like assets, are also split into current and noncurrent. Current liabilities are owed in the next year; noncurrent are owed beyond that. They should be listed in the order they are owed.
Current liabilities can include:
- Accounts payable (invoices the company needs to pay)
- Interest payable (outstanding loans)
- Customer prepayments (if product has not yet been delivered)
- Wages payable (for work done but not yet paid)
Noncurrent liabilities can include:
- Long term debt
- Deferred tax payments
- Pension payments
Shareholders equity can include:
- Stock (investments into the company)
- Retained earnings (the net earnings the company has kept in the business over time)
Also known as the profit and loss statement (P&L), it shows where the company is generating and spending money over a period of time (usually a quarter or year). It follows the basic formula:
Net income = (Revenue + Gains) – (Expenses – Losses)
Figure 2. Income statement
Why the income statement is important
It shows how profitable a company is by highlighting where it is generating revenue (which sales verticals are performing well or otherwise) and gives insight into how the company’s expenses are evolving. In general terms, this can show how efficient the management team is.
How to use the income statement
By classifying the revenue and expenses into their different sources you can calculate the net and gross income of the business.
Revenue can be split out into two categories:
- Operating revenue: revenue generated from core business activities
- Non-operating revenue: recurring revenue generated from non core business activities. This is different for every business but may include things like interest or royalty payments.
Gains are revenue generated from one time events like the sale of a property.
Expenses can also be split into different categories:
- Cost of revenue (or cost of goods sold): direct expenses associated with creating the product the company is selling, e.g materials and manufacturing.
- Operating expenses: the costs associated with operating the business. These can include:
- Selling, general and administrative (SG&A)
Losses are one off costs, such as lawsuits.
By subtracting cost of revenue from revenue, you are given gross profit. By subtracting all expenses and losses from revenue and gains, you can calculate net profit. You can get more details about this in our previous post: Gross vs Net profit – understanding the differences.
How the balance sheet and income statement work together
Once you have calculated the net income (also known as net profit) from the income statement you can take this and add it to the retained earnings of the balance sheet.
This updated retained earnings figure is needed to ensure the balance sheet equation (assets = liabilities + shareholders’ equity) actually balances.
Figure 3. How Net income from the income statement feeds into the balance sheet.
Now you have a basic structure on how to create an income statement and balance sheet you can ensure your financial reports are accurate and even get under the hood of competitors finances.
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