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Understanding Financial Statements

Companies prepare financial statements for a number of purposes. Often, they are critical tools that a company’s management, investors and analysts use to evaluate performance. Management may also prepare new financial statements or adjust its periodic financial statements for specific purposes, such as requesting a loan, seeking an investor or buying or selling a business. The purpose of the financial statements will determine the depth and scope of review, both by attorneys and financial professionals.

Although there are many different financial statements, the three most common are (1) the Balance Sheet, (2) the Income Statement and (3) the Cash Flow Statement.

In the United States, publicly-held companies must file their financial statements periodically with the U.S. Securities and Exchange Commission on Form 10-K. Many companies also publish their annual report on their corporate website.

Auditors must review and sign-off on certain financial statements of public companies and some non-public companies, such as those obtaining a loan or investment. After conducting an audit, the auditor will issue an Auditor’s Report opining on the accuracy of the company’s financial statements. With the passage of the Sarbanes-Oxley Act of 2002, auditors must also opine on the effectiveness of internal controls over financial reporting for most public companies. Ideally, an Auditor’s Report is unqualified, meaning the auditor believes the financial statements are generally accurate and consistent with GAAP. If a report is qualified, it should be thoroughly reviewed to understand the reason for the auditor’s qualification(s). When a company produces management reports – those used for the internal decision-making of the company – they are often unaudited.

Balance Sheet

The Balance Sheet is a key financial statement that provides a “snapshot” of a company at a specific point in time, along with comparisons to prior periods. A balance sheet is always structured in three main parts: (1) assets, (2) liabilities and (3) stockholders’ equity. It is a fundamental principle of accounting that a balance sheet must “balance,” meaning that a company’s assets must equal its liabilities plus its stockholders’ equity. Essentially, the liabilities and stockholders’ equity show how a company funds its assets. Although a typical balance sheet has standard line items, accounting rules specify the level of detail required.

The assets section is typically subdivided into two main parts: (1) current assets and (2) non-current or long-term assets. Current assets are those assets that can either be converted quickly into cash or used in one operating cycle (typically one year, but longer in certain industries). Typical line items in this section are cash and cash equivalents, inventory and accounts receivable. Non-current or long-term assets are those assets that cannot be quickly converted into cash or used in one operating cycle. Typical line items in this section include property, plant and equipment and intangible assets (e.g., copyrights).

The liabilities section is typically divided into two main parts: (1) current liabilities and (2) non-current or long-term liabilities. Current liabilities are those liabilities that can be collected within one year or one operating cycle. Typical line items in this section are short-term debt, current portion of long-term debt and accounts payable. Non-current or long-term liabilities are those liabilities that have a life span longer than one year or one operating cycle. Typical line items in this section are long-term debt and deferred income taxes.

The stockholders’ equity section details a company’s funding of its assets through methods other than liabilities. Typical line items in this section are par value, additional paid-in capital and retained earnings. Par value and additional paid-in capital represent a company’s common stock at book value (rather than market value), while retained earnings represent income invested back into the company (as opposed to being paid out in dividends).

Income Statement

The Income Statement is a key financial statement that details a company’s earnings during a specific period. Typically, companies prepare income statements with monthly, quarterly and yearly views, along with comparisons to prior periods. An income statement is often structured into three main parts: (1) Gross Profit; (2) Operating Profit; and (3) Other Expenses. The income statement operates like a tiered waterfall with revenues at the top and net income at the bottom with various slices of “profit” presented in between (e.g., operating profit, earnings before interest and taxes (“EBIT”), net income). Although the three main tiers identified here are in most income statements, many companies choose to break down the income statements into subsections. As a result, unlike the balance sheet and cash flow statement, not all income statements are formatted the same, and cross-company comparison may require additional calculations.

The gross profit section presents a company’s revenue or “top line” and its cost of goods sold, with the first line item typically reporting the company’s earned proceeds, or revenue, during the relevant period. Because revenue is recognized when it is earned under GAAP, and not when payment is received, the revenue line item is not an accurate representation of how much “cash” a company received during a given period. In the gross profit section, a company also reports its cost of goods sold, which represents its cost of raw materials or inventory. A company often completes this section by calculating “gross profit,” which is revenue minus cost of goods sold. Typically, the less revenue used up by the cost of goods sold the better; however, some “volume” businesses have low gross profit margins and rely on high volume to drive profit.

The operating profit section typically presents a company’s operating expenses and may also present depreciation and amortization. Operating expenses, often described as selling, general and administrative expenses, typically include salaries, rent, insurance and other expenses required to operate the business. Depending on several factors, the operating profit section may also include depreciation and amortization, which are accounting methodologies used to allocate the cost of a non-current asset across its useful life. It is important to note that there are multiple methods of depreciation (e.g., straight-line, double-declining balance, etc.) and interested parties should review a company’s notes to the financial statements to understand the method applied. A company often ends this section by calculating “operating profit,” or EBIT (earnings before interest and taxes), which is normally calculated as gross profit minus operating expenses, depreciation and amortization. However, some companies choose to separate out depreciation and amortization and present a separate interim income calculation called earnings before interest, taxes, depreciation and amortization (“EBITDA”).

The other expenses section details the reminder of a company’s expenses that appear on an income statement, including interest expenses, taxes and other miscellaneous expenses. If depreciation and amortization are not included in operating profit, they will be included in this section. A company ends this section by calculating its “bottom line” or net profit. Some companies may choose to show multiple income calculations in this section, making it easier on investors and analysts reviewing the income statement (e.g., calculating income after interest expense, but before taxes are removed).

Cash Flow Statement

The Cash Flow Statement is a key financial statement that details the nature of a company’s cash flow, whether generated or expended, during a specific period. Typically, companies prepare cash flow statements with quarterly and yearly views along with comparisons to prior periods. A cash flow statement is structured into four main parts: (1) operating cash flows, (2) investing cash flows, (3) financing cash flows and (4) end of period cash flow. As with a balance sheet, the sections in a cash flow statement are consistent across companies and, although specific line items vary, the overall structure is the same.

The cash flow from operations section presents a company’s cash flows generated or expended in operations. Companies utilize two methods when preparing cash flow from operations, either the indirect or direct method. The most popular method is the indirect method, by which a company begins with net income (from the income statement) and then conducts a series of adjustments to arrive at cash flow from operations. One set of adjustments would include accounting for non-cash transactions included in income, such as depreciation and deferred income tax recognition. In contrast, the direct method simply accounts for all of the company’s operating cash transactions during the relevant period to arrive at operating cash flow. Regardless of the method used, the ultimate cash flow from operations will be the same. A company’s cash flow from operations is often considered the most important metric because it is an indicator of financial health. If a company has poor (or negative) cash flow from operations, questions may arise about its ability to pay short-term expenses.

Cash flow from investing activities presents a company’s cash flows generated from, or expended on, non-current assets. This section typically includes any cash earned or expended on property, equipment or other investments. For many companies, this section may show a negative cash flow, especially if a company has made recent investments in property and equipment. Because negative cash flow in this section is a common occurrence, its presence is not a cause for alarm so long as the purchase of property or equipment does not otherwise hinder the company’s financial stability.

The cash flow from financing activities presents a company’s cash flows generated or expended in transactions with creditors or debtors. This section typically includes any debt financing received, or payments made, and any dividends paid or cash infusion from an equity issuance.

The end-of-period cash flow presents a reconciliation of cash from the previous period’s cash flow through the current period. The cash flow amount, calculated at the end of the current period, must equal the balance sheet’s cash and cash equivalents line item. In addition, some companies include line items outside of the end-of-period cash flow calculation (e.g., cash from income taxes and interest) either at the end of the cash flow statement or in the notes to the financial statements.

This blog post is not intended to consist of legal advice and you should always consult with a lawyer before acting on anything you find on the Internet.  If you have questions or comments about this post, about the topic, or if you need legal assistance, you should feel free to give us a call or send us an email.  Let us know how a New York City corporations lawyer can assist you.

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