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Financial Statements Simplified

Gain the courage to dig a little deeper into your financial statements, and what they tell you.

Financial Statements Simplified

Removing complexities to reduce uncertainties when dealing with financials.

It can seem daunting to read through financial statements and truly understand what they’re saying - especially if you’re not well-versed or educated on the complexities and jargon of the world of finances. However, it doesn’t have to be so intimidating; financial statements such as the Income Statement, Balance Sheet, and Cash Flow Statement are revered with an unnerving and undeserved reputation thanks to countless decades of being overanalyzed and unnecessarily complicated. In reality, they can be deciphered and conquered quickly by just about anyone - much like David swiftly dismissing the exaggerated intimidation of the supposedly mighty Goliath.

This article aims to lay out the roadmap that anyone can use to familiarize themselves with these financial statements and then easily learn to understand them, dissolving the false state of intimidation along the way - no matter your financial proficiency, skills, education, or age. Each statement will be introduced briefly alongside some useful information they encompass and a short description of what they’re typically used for in finance. Once each sheet is understood at a high level, an explanation about how the three of them communicate and intertwine with one another will be examined and broken down to enhance understanding further.

Here is a simplistic explanation of financial statements:

Income Statement

The Income Statement - alternatively known as the Profit & Loss Statement - shows the viewer whether the company was profitable or not during a specific period. Typically plotted over a year, the Income Statement focuses on two things in particular to show the company’s profitability: revenue and expenses.

Revenue - or sales - is the amount of money a company generates each period by selling its products. However, these products usually have a cost associated with building them, known as the cost of revenue or cost of goods sold. This means that the cost of building the product must be subtracted from the revenue accumulated from the sale. This leads to the gross profit, which is the amount of money remaining from the original sale after taking away the cost of the product. It is considered healthy - depending on the industry - when a company has a gross profit margin (percentage of total sales remaining after subtracting the cost of revenue) of approximately 50-70% of revenue.

The other important part of the Income Statement is the operating expenses, which encompass all the necessary costs to operate the business - payroll, rent, equipment, and marketing, among others. Once the expenses are accounted for, they are subtracted from the gross profit, leading to the EBITDA (earnings before interest, taxes, depreciation, and amortization), which provides a snapshot of the company’s profitability. From there, the interest, taxes, depreciation, and amortization are subtracted to determine the Net Income - which shows if the company’s revenue outweighs its expenses, which makes it profitable. If a company’s expenses outweigh its revenue, it is spending more than it earns, meaning it is not profitable.

The Income Statement is valuable internally and externally as it shows the company’s profitability and how efficiently they manage expenses.

Balance Sheet

The Balance Sheet is intended to do what its name suggests - balance. This financial statement considers the company's assets, liabilities, and shareholder’s equity and is often used to determine what the company owns and owes. The Balance Sheet is the source of a company’s most valuable financial ratios, such as the liquidity and leverage ratios. As mentioned, the Balance Sheet must balance the assets with the liabilities and shareholder’s equity, meaning that when a company purchases an asset, the balance sheet should show the asset and how it was purchased through debt or other means.

The assets are the useful and valuable things that the company owns and can be categorized in multiple ways: financial (such as accounts receivable), current (useful for less than one year), fixed (expected to last long-term, such as land or equipment), and intangible.

Opposite the assets, the company’s liabilities indicate what the company owes. The company will typically have current (due within a year, such as accounts payable) and long-term liabilities on its balance sheet.

However, the liabilities often don’t completely match the total assets, hence why liabilities and shareholder’s equity are added together and then subtracted from the assets to balance the sheet. The Shareholder’s Equity represents the total money raised through equity financing between common shares, preferred shares, and retained earnings. This is the amount of capital that has been invested in the company.

The Balance Sheet provides an immediate window into what the company owns and owes now and into the future and how much it’s successfully raised through financing.

Cash Flow Statement

Finally, the last financial statement is the Cash Flow Statement. The Cash Flow Statement shows the movement of cash and cash equivalents throughout the company at specific periods. It shows changes in the company’s cash availability from the beginning to the end of the period. This is an essential statement as its shows the company’s ability to generate enough cash to pay its various obligations on time and in full. There are three pillars to the Cash Flow Statement: Operating activities, investing activities, and financing activities. This financial statement completes the Income Statement and the Balance Sheet as it flows through both and weaves the three together.

Operating activities are driven primarily by information on the Balance Sheet. However, the Net Income appears here as well. These activities are based on the cash coming through the company’s business operations, such as income from selling its products, accounts receivable, inventory, and accounts payables.

The cash from investing activities tracks the cash used to sell or purchase long-term fixed and intangible assets. Changes to these long-term investments are tracked in the investing activities. They could result in a profitable company having a negative cash flow if they own various long-term assets. However, as the purchases are paid, the company’s cash flow becomes positive, which is ideal in the long run.

Cash from financing activities is related to the company’s long-term liabilities and shareholder equity. Financing activities track the payment of a long-term debt or dividends over time (cash out) and influxes of cash from raising financing rounds (cash in).

The Cash Flow Statement shows a company’s ability to generate cash to pay its various debts and other obligations. It also shows periods when the company will be projected to have more cash in the bank if they want to make a long-term investment to enhance its long-term health. It should be noted that there is a difference between cash and profit, which often is forgotten. A profitable company with a positive net income does not mean they are cash positive. Cash is not automatically collected when a sale is made - hence accounts receivable. Cash is what’s currently in the bank; even though a company might have an account payable owing, it still has the cash in its bank. There are many complexities when it comes to Cash Flow, but a company should be healthy if it’s profitable and is cash positive in the long term.

Though initially difficult to understand, these financial statements are straightforward and can be effectively utilized if understood correctly. Knowing what each statement tells the reader is a fantastic first step to gaining financial intelligence to understand, create, and use these financial statements. With this knowledge, the statements don’t seem nearly as frightening, and you can sigh in relief. Much like the child bravely shining a flashlight under the bed to find the monster was never there, you need the courage to dig a little deeper and seek the truth to see that financial statements aren’t nearly as scary as they’re portrayed.

Brady Vandervelden

Fintech Business Lead