Guide to financial statements

What's in them?

Annual reports include at least three financial statements:

Statement of earnings: Summarizes results of the company's business operations (revenue and expenses)

Statement of financial position: Lists the company's assets and the claims against them (liabilities and stockholders' equity)

Statement of cash flows: Measures the flow of cash into and out of the company

The statements contain the financial information for a publicly held company. If a company is composed of many subsidiaries, divisions, and other companies, it presents the financial information of all its holdings as one "consolidated" company. IBM, for example, publishes a "consolidated statement of cash flows" and other "consolidated" financial statements, representing all the parts of its large organization.

To learn more about other components of an annual report, visit guide to Annual Reports.

Who prepares the financial statements?

The people who prepare the statements may differ from company to company. Usually, the accounting staff prepares them, but others, such as investor relations staff , review the statements and related notes.

Regardless of who the preparers are, federal securities laws require publicly-owned companies to follow a set of rules and financial reporting guidelines. Associations - such as the Financial Accounting Standards Board (FASB) , a private organization of accounting professionals, and the Securities and Exchange Commission (SEC) , a U.S. government agency - develop the rules and guidelines. These generally accepted accounting principles (GAAP) help ensure that the financial information reported is reliable and consistent in form with the reports all other companies prepare. GAAP also helps safeguard against investor fraud.

Although all companies follow common standards and requirements, they report on their financial performance in varied ways. Many decisions - from the statements' names to the accounts within them and the ways management calculates the numbers - are left to companies' discretion.


What is the auditors' report?

The auditors' report is a summary of the results of an audit, or examination of the financial statements by an independent firm of certified public accountants. The audit is an attempt to determine whether a company's financial statements report the company's financial status accurately and reliably. During an audit, for example, the auditors investigate a company's internal accounting controls, confirm the existence of many assets, and gather supporting information from external sources. The auditors make sure the financial statements are complete, reasonable, and prepared consistent with GAAP at a set time. If the auditors consider the statements are fair events of the company's financial position in relation to GAAP, they issue an "unqualified" opinion.


The Notes

The notes are required reading to understand the financial statements. Companies use notes to explain how they arrived at the numbers in the financial statements and to describe any significant events or changes in procedures that may affect the numbers. Notes also explain items in the statements and report details of the company's financial performance not shown in the statements.

A note might explain, for example, that a company's accounting methods have changed from the previous year or differ significantly from methods other companies in the same industry use (assuming they follow GAAP ). Analysts might examine why the company changed accounting methods, probing, for example, to learn whether the change distorts the company's financial results.

Another note might disclose an acquisition that may have a material effect on the company's financial condition, both short and long term. For example, with its acquisition of Lotus in 1995, IBM incurred costs and assumed liabilities associated with this significant event.

Finally, a note might provide additional detail on an item in a financial statement. For example, a note on "Investments and sundry assets" on the statement of financial position lists the assets IBM includes in this category (one listing is the intangible asset called goodwill).

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Purpose
The statement of financial position reports a company's financial status at a set date noted on the statement. The statement is like a snapshot because it shows what the company is worth at that set date. The statement shows:

• What the company owns
• What the company owes
  
• What belongs to the owners
  

Analysts often call the statement of financial position a balance sheet because of the way one part - assets - is in balance with the sum of the other two parts - liabilities and stockholders' equity.

In an annual report, the statement of financial position includes information for at least the last two years to allow comparison of changes between years.


Key numbers
The statement of financial position shows three main categories of information for each year covered. To interpret this information, analysts look at three key numbers related to these categories:

Assets (what the company owns)

Liabilities (what the company owes)

Stockholders' equity (what belongs to the owners)

Assets

Companies own things, called assets. These things might be physical assets such as buildings, trucks, inventories of products, equipment, and cash. Or things might be intangible assets such as goodwill, trademarks, and patents.

Assets are either current or noncurrent. Current assets are things a company expects to convert to cash within one year. Examples are accounts receivable or inventories of products to sell. Finally, current assets include cash and securities such as treasury bills and certificates of deposit the company expects to convert to cash within the year.

Non-current assets are things a company does not intend to convert to cash or that would take longer than a year to convert. Non-current assets include fixed assets, often listed as "property, plant, and equipment" because that is what they usually are. Companies use fixed assets to manufacture, display, store, and transport products.

The amounts of fixed assets vary by company and industry. For example, manufacturing companies generally have a large investment in fixed assets because making things requires property, plant, and equipment. Service companies usually have fewer fixed assets.

Liabilities

On the statement of financial position, debts are called liabilities. All companies have liabilities. Examples of liabilities include:

• Money owed to banks and other lenders
• Money owed to suppliers of goods and services (accounts payable)
• Taxes owed to government authorities
• Rents owed to owners of land and buildings

Liabilities are either current (short term) or long term. Current liabilities are due within one year. Long term liabilities are due after one year.

Although liabilities are a necessary part of doing business, companies must manage their liabilities carefully. If a company cannot make interest payments on time and repay the principal when due, the company can be forced to declare bankruptcy and either reorganize or disband.

Stockholders' equity

Stockholders' equity is the amount owners invested in new stock plus the earnings the company retained since it started (retained earnings is the amount of profit kept after dividends are paid). On the statement of financial position the amount of stockholders' equity always equals the value of all the assets minus all the liabilities. For example, if a company's assets are valued at $10,000 and liabilities total $6,000, the equity is $4,000.

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Overview
When financial analysts evaluate a company for possible investment, they look both at the information in the financial statements and at other information that puts these numbers into a larger context.

Analysts can make more reliable investment decisions by taking the basic information in the financial statements and extending it to identify:

• A company's internal strengths and weaknesses
  
• Company and industry trends
  
• Performance in the larger business environment

Brokerage firms offer the results of their analysts' research to individual investors as part of their service. Additionally, many professional analysts sell their evaluations and recommendations. Examples of sources of financial analysis are Moody's, Standard and Poor's, and Value Line.

Interpreting the numbers
Analysts usually begin evaluating a company by studying its financial statements. These sources present recent financial history in a concise format, making it easy to see short term changes in key numbers. Financial statements are also fairly standard within an industry, making it easy to compare the performance of a company to that of its competitors.

Analysts interpret the numbers on each financial statement using a variety of ratios and other comparative measures. Analysis covers:

• Statement of earnings
• Statement of financial position
• Statement of cash flows

Analysis: Statement of earnings

Analysts use the statement of earnings to examine a company's profitability. For example, analysts look at trends in revenue, operating income, and gross profit rates (or margins). Other measures include calculation of return on assets and return on equity. To view IBM's performance over recent years, see the historical charts.

Analysis: Statement of financial position

Analysts use the statement of financial position to examine a company's liquidity and to gain insight into the state of the company's debt and inventory. One measure analysts use is the current ratio, a comparison of current assets with current liabilities. Analysts also look at the relationship of this statement with the statement of earnings. For example, they may explore the relationships of accounts receivable with sales, and of inventory with the costs of sales. Collection of accounts receivable is a task financial analysts also watch closely. If customers take long to pay for goods and services, accounts receivable may become large, forcing the company to borrow money (and pay interest) to finance these receivables. The longer it takes to collect accounts receivable the less valuable they are.

Analysis: Statement of cash flows

Analysts use the statement of cash flows to determine how effectively a company generates and manages cash. Analysts look most closely at the cash from operating activities in evaluating a company's potential for long-term success because this figure shows how efficiently the company can produce and sell its primary product or service.

Analysts also evaluate cash flows in relation to earnings figures (from the statement of earnings). For example, in some cases, a company can report positive earnings on the statement of earnings and still report a negative net cash flow on the statement of cash flows. This situation may occur when a company is unable to meet the current demand for its products and consequently invests its profits, or even borrows additional money, to expand its manufacturing capability (for example, by purchasing equipment or new facilities). When such a situation occurs, analysts look for the implications. They try to determine if the prospective demand for the company's product is great enough to justify the expenditures and new debt.

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Purpose

The statement of earnings indicates how much revenue a company brings into the business by providing goods or services, or both, to its customers for a set time (usually one year). It also shows the costs and expenses associated with earning that revenue during that time.

In an annual report, the statement of earnings shows sales revenue and expenses for at least the last three years. The net earnings (or loss), often literally the "bottom line" on the statement, shows how much the company earned (or lost).

Key numbers

The statement of earnings shows two main categories of information for each year covered:

1. Revenue from products and services sold
2. Expenses, or costs, of doing business

To interpret this information, analysts look at several key numbers:

• Revenue
• Gross profit
• Operating income (operating profit)
• Net earnings (net income, net profit)

Revenue

Companies earn revenue in one or more of the following ways:

• By selling products or services, or both
  
• By leasing and renting equipment or property to others
  
• By receiving interest from loans to other companies or individuals
  

Some companies have only one source of revenue; others have several. For example, IBM reports revenue from its products, such as computer hardware and software. It also reports revenue from its services, which include maintenance, rentals, and financing.

Gross profit

A rule of business is, "it takes money to make money". Typically, producing goods for sale is the greatest cost of generating revenue. For example, a computer manufacturing company must buy wiring and other raw materials to make computers; pay wages to workers and managers; and spend money on overhead - power, facilities, and maintenance.

A company deducts these costs (cost of sales, cost of goods sold) from revenue, showing gross profit (or loss).

Operating income

In addition to the expenses directly related to producing goods and services, companies incur operating expenses. These include advertising, salaries, rent, research and development, office supplies, and any other administrative amounts spent. A company deducts these operating expenses from gross profit, resulting in operating income (or loss).

Operating income represents a company's revenue minus all expenses required to obtain that revenue. From this key number, companies deduct costs relating to debt financing and tax expenses. The remainder is called net earnings .

Net earnings

Net earnings are the "bottom line" (often literally the last line on the statement). After a company deducts all costs and expenses from revenue , the statement of earnings shows the net earnings (or loss). When revenue exceeds costs and expenses, the bottom line shows a profit. When costs and expenses exceed revenue, the bottom line shows a loss.

Growth in net earnings usually signals that a company is doing well.

Earnings per share

Earnings per share (EPS) shows how much money stockholders would receive for each share of stock if the company distributed all net earnings to its stockholders. For example, if the net earnings are $1 million and 500,000 shares are outstanding, the earnings per share are $2 ($1 million ÷ 500,000 shares = $2).

Although all net earnings really belong to the stockholders, a company almost never distributes the full amount to them directly. A company needs money to grow, so it takes part of the net earnings and reinvests that money in itself. The total amount of a company's net earnings since its inception, minus any payments made to stockholders, is called retained earnings.

Although the term may suggest a large pool of cash, that image is misleading. Retained earnings is actually part of stockholders' equity and represents the portion of a company's assets that is financed from profitable operations rather than from selling stock to investors or borrowing from external sources. If the company reinvests those earnings profitably, the stockholders benefit from that reinvestment over the long term.

A second way stockholders benefit from retained earnings is through dividends. A company's board of directors, with the advice of management, decides on the amount of dividends per share to pay. Companies usually pay dividends quarterly; however, many companies do not pay dividends at all, and a few pay dividends irregularly.

Using the information

Now that you have reviewed a brief introduction to the statement of earnings, you can learn about ways to interpret this information.

To see how analysts use this statement and related information, read analyzing the statements.

To get tips from three experienced investors on using this statement, visit the investors' tips section to review tips from a business school dean, a business executive, and a high school economics teacher.

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Purpose
The statement of cash flows reports the flow of cash into and out of a company in a given year.

Cash is a company's lifeblood. Cash includes currency, checks on hand, and deposits in banks. Cash equivalents are short term, temporary investments - such as treasury bills, certificates of deposit, or commercial paper - that can be quickly and easily converted to cash.

A company uses cash to pay bills, repay loans, and make investments, allowing it to provide goods and services to customers. If all goes well, a company uses cash to generate even more cash as a result of higher profits.

Key numbers
The statement of cash flows reports the company's sources and uses of cash and the beginning and ending values for cash and cash equivalents each year. It also includes (near the bottom of the statement) the combined total change in cash and cash equivalents from all sources and uses of cash.

Key numbers in this statement show results of transactions in three categories that are sources and uses of cash:

• Net cash provided (or used) by operating activities
• Net cash provided (or used) by investing activities
• Net cash provided (or used) by finance activities

Net cash provided (or used) by operating activities

A company generates cash just from operating its business. Therefore, the first key number is net cash provided from operating activities. This total includes some items from the statement of earnings; for example:

• Net earnings, showing the company's profit (or loss)
  
• Depreciation expense
  

This key number also includes changes in some items from the statement of financial position:

• Inventory changes (increases in inventories use cash and reductions provide cash)
• Changes in accounts receivable, the sales the company has not yet been paid for (again, increases use cash and decreases provide cash)
• Changes in accounts payable, the cash a company owes its vendors and suppliers (in this area, increases provide cash and decreases use cash)

The statement of cash flows adds the net cash from each type of operating activity and reports the company's total net cash provided (or used) by all operating activities.

Net cash provided (or used) by investing activities

The second key number might include investments in property (land), plant (factories and assembly plants), and equipment (machines, trucks, computer systems, telephone systems). Investing in such assets is a use of cash, selling them is a source of cash.

Examples of investing activities are overhauling trucks to extend their years of use or renovating factories and assembly plants to be more productive.

The statement of cash flows adds the net cash from each type of investing activity and reports the company's total net cash provided (or used) by all investing activities.

Net cash provided (or used) by financing activities

The third key number includes the sources and uses of cash for financing activities. Sources of cash include what a company raises by selling stocks and bonds and by borrowing from banks.

Uses of cash include buying back stock from stockholders , paying dividends to share profits with stockholders and repaying borrowed cash.

The statement of cash flows adds the net cash from each type of financing activity and reports the company's total net cash provided (or used) by all financing activities.

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Most analysts agree that the financial statements, financial ratios, and other comparative measures offer the best starting points for evaluating a company. However, they look at these items to provide only a portion of the information required to adequately evaluate a company for investment.

Analysts begin to put the key numbers into a larger context by looking at two other critical parts of the annual report itself:

The notes to the financial statements offer further explanation of the numbers on the statements. For example, for the statement of earnings, notes might describe changes in a company's investment in research and development (R & D). For the statement of financial position, notes might describe significant liabilities and contingencies.

The management discussion section provides management's perspective on the company's financial operation and performance. Reading this section in consecutive annual reports also allows analysts to gather more subjective information about a company, such as its ability to articulate and consistently pursue long term goals.

For company financial information not contained in the annual report, such as that in copies of form 10-K or form 10-Q filed with the Securities and Exchange Commission, analysts and investors frequently contact the company's investor relations department for copies of those forms.

Finally, analysts extend the scope of their financial information comparisons beyond the two to three year figures in a single set of financial statements. Instead, they look at the same ratios and performance measures over five to ten year periods. To see changes in IBM's financial record over time, visit the historical charts.

Analysts also compare these figures with several other numbers from other sources of business and economic information. For example, they:

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