What Are Financial Statements?

Financial statements are reports businesses compile to record financial performance and health. They offer a clear, standardized picture to parties such as investors, creditors, and management, allowing them to assess operations and whether the business is headed in the right direction.

Key Takeaways

Financial statements provide an overview of a company's financial health to stakeholders.

The four primary types of financial statements are: balance sheet, income statement, cash flow statement, and statement of shareholders' equity.

Understanding how to read financial statements allows you to make informed investment decisions about a company's performance, stability, and future potential. 

Financial statements organize important financial data so stakeholders, including board members, investors, shareholders, creditors, employees, customers, and analysts, can analyze the health of a company's finances. These statements must present complex data in a clear and accessible way for everyone, from CEOs to average consumers.

Accountants prepare financial statements following specific accounting rules, like the Generally Accepted Accounting Principles (GAAP) for U.S. companies or the International Financial Reporting Standards (IFRS) for many international companies. These accounting standards ensure that financial statements are clear, consistent, and comparable, so financial data presentation is as similar as possible. 

There are four primary types of financial statements that provide valuable insights into a company's financial position and performance.

A company's balance sheet provides stakeholders with a snapshot of its assets, liabilities, and shareholder equity at a specific point in time—typically the last day of the reporting period. Rather than predicting future success or trends, the balance sheet reflects the company's current financial position.

The balance sheets follow the standard equation: Assets = Liabilities + Equity.

You must understand a few basic financial terms to read a balance sheet effectively. 

Assets represent what a company owns and are categorized as either current or non-current assets.

Current Assets
Current assets, often considered short-term assets, can be converted into cash within the firm's fiscal year.

Cash and Cash Equivalents:Any highly liquid asset, like cash, checking accounts, or money market funds.

Accounts Receivable: Money owed by customers.

Inventory: Products or raw materials used for products.

Prepaid Expenses: Payments made in advance for expenses like rent or insurance.

Non-Current Assets
These assets, also called long-term assets, are critical for a company's success but cannot be converted into cash within the firm's fiscal year.

Property, Plant, and Equipment (PP&E):Buildings, machinery, vehicles, or other equipment.

Intangible Assets: Non-physical assets like patents and trademarks.

Long-term Investments:Stocks, bonds, or notes held more than one year.

Deferred Tax Assets:Taxes due back for overpayment or advance payment.

Current Liabilities
The liabilities due within a year.

Accounts Payable: Money owed to suppliers and vendors.

Short-term Debt: Loans or credit lines due within the year.

Accrued Expenses: Incurred, but unpaid costs like wages or taxes.

Unearned Revenue:Money received for goods or services not yet delivered.

Non-Current Liabilities
Often called long-term liabilities, these are the company's financial obligations not due within a year.

Long-term Debt:Debt payable in more than one year, such as bonds or long-term loans.

Deferred Tax Liabilities: Future tax payments.

Pension Liabilities:Employee retirement benefits obligations.

Lease Liabilities: Long-term lease commitments for buildings or equipment. 

Equity, also called net assets, represents the company's assets minus its liabilities. Net assets are payable to shareholders.

Common Stock/Preferred Stock: Value of issued shares.

Retained Earnings: Profits not distributed as dividends.

Treasury Stock:The company's repurchased stock.

An income statement overviews a company’s revenues, expenses, net income, and earnings per share over a specified period, such as a quarter or a year. It answers the question: Did the company make money?

Income statements help stakeholders assess financial health and management success by comparing income statements across multiple periods.

Key Components of Income Statements:

Revenue: Total income from sales or services rendered.

Cost of Goods Sold (COGS): Cost of producing goods.

Gross Profit:All revenue minus the cost of goods sold. 

Operating Expenses:Costs to run the company, such as rent, salaries, and utilities. 

Net Income:The final profit after paying all expenses and taxes.

Important

This statement has a few key components, but the formula for calculating shareholder equity varies from company to company.

Comprehensive income expands equity exploration by including items not typically seen on a traditional income statement. It accounts for adjustments in securities held for sale by the firm, unrealized gains or losses on investments, hedging activities, foreign currency exchange rate changes, and adjustments to future pensions.

Some companies produce a separate statement for comprehensive income, while others include it as a footnote on the income statement. While it is easy to overlook, comprehensive income gives a much fuller picture of the company's financial position.

A company's cash flow statement (CFS) tracks the movement of cash into and out of the business over time. The primary purpose of the CFS is to show stakeholders where a company's money is coming from and how management is spending it. Cash flow statements are divided into three categories:

Operating activities: Cash from day-to-day business operations

Investing activities: Cash spent on or earned from investments

Financing activities: Cash made from borrowing, debt repayment, or issuing stock

The cash flow statement shows where money went and if there is enough left or incoming to sustain future operations.

The Statement of Shareholders' Equity shows how a company's equity changes over a reporting period. It complements the balance sheet and helps assess whether the company's stock is profitable.

Another way to use the Statement of Shareholders' Equity is to assess how much money is left for shareholders after the company pays all liabilities and accounts for all assets. The leftover equity should accurately reflect the cost per share. A positive number signals stability, while a negative result may indicate looming financial trouble, possibly even bankruptcy.

Until the Securities and Exchange Commission (SEC), through the Securities Act of 1933 and the Securities Exchange Act of 1934, mandated that public companies have audits, financial statements were merely something some companies used to attract investors. However, after the 1929 stock market crash and the Great Depression, mistrust grew due to manipulated financial data. 

As the stock market and regulations evolved, independent auditors established standard reporting procedures to keep financial statements transparent and uniform. Today, several international and national standards boards regulate reporting structures to ensure that companies report accurate and transparent information. 

While financial statements are informative, they have limitations:

Historical Data: Financial statements report past performance and rely on interpretation to predict future success.

Non-Financial Information: Important factors, such as brand reputation, employee morale, and market position, are not captured.

Inflation: Financial statements do not account for inflation, and assets and liabilities are often recorded at historical costs.

Reporting Periods: Differences in reporting periods and estimates or assumptions used by management make cross-company comparisons challenging.

How Do You Read Financial Statements?

To read financial statements, you must understand key terms and the purpose of the four main reports: balance sheet, income statement, cash flow statement, and statement of shareholder equity.
Balance sheets reveal what the company owns versus owes. Income statements show profitability over time. Cash flow statements track the flow of money in and out of the company. The statement of shareholder equity shows what profits or losses shareholders would have if the company liquidated today.

Are Financial Statements the Same Worldwide?

The core structure of financial statements is the same worldwide, but the accounting rules differ depending on which standard the company follows based on its locality or trading location. U.S. companies are required to use Generally Accepted Accounting Principles (GAAP), while foreign companies may use International Financial Reporting Standards (IFRS).

Why Are Financial Statements Important?

Financial statements give a company's stakeholders, such as investors, board members, creditors, employees, and analysts, a picture of a company's financial performance and stability. They help stakeholders assess profitability and overall economic health to make decisions about investing in, lending to, or working with the company. 

Financial statements are important tools for evaluating a company's financial health and future projections. There are four main types of financial statements: balance statements, income statements, cash flow statements, and statements of shareholders' equity, each with a specific purpose in detailing the company's financials. 

Whether you're an investor looking for new opportunities, a CEO seeking a quick snapshot of a company's finances, or someone curious about the inner financial workings of a company, knowing how to read and interpret these statements is a measure of financial literacy that will pay future dividends.