Financial statements provide the most important details about the financial health of a company. In aggregate, they indicate how a whole sector is doing. How do you read them? What do they contain? What useful information should be in financial statements, but is not? How can management manipulate financial statements to deceive outsiders? Learn it all here!
By Mark D. Harris
Introduction
The US Securities and Exchange Commission (SEC) requires annual statements (10K) and quarterly statements (10Q) from all publicly traded companies. These reports inform stakeholders about the company’s earnings and other key factors that influence the behavior of lenders, investors, employees, analysts, ratings agencies, governments, and others. These stakeholders rely on company management to report accurately.
Stock price, at least in theory, encapsulates all the pertinent factors of a company, such as management, product, demand, and other internal and external factors, and summarizes everything stakeholders need to know about a company. In the real world, however, stock price can be affected by firm characteristics and can be manipulated by managers seeking their own interests over the interests of shareholders.
Financial Statement Summary
The four types of financial statements include the Balance Sheet, Income Statement, Statement of Cash Flows, and Statement of Changes in Equity. The balance sheet encapsulates assets (short and long term), liabilities (short and long term), and shareholder’s equity at a moment in time (Murphy, 2022). The income statement summarizes sales revenue, cost of goods sold (COGS), administrative and other costs, interest on debt, and taxation to calculate the net income. The statement of cash flows reveals how much cash the firm receives from operations, from investments, and from financing activities. Cash generated is used to pay current and long-term obligations and fund future investments. Finally, the statement of changes in equity shows what the company is doing with its profits, whether reinvesting them in profitable ventures or returning cash to shareholders in the form of dividends of stock buy backs (Murphy, 2022). These financial statements are all part of the annual report for every publicly traded US company.
Balance Sheet
The first section of the balance sheet details assets, starting with current assets, in descending order of liquidity. Cash and cash equivalents include money market accounts, treasury bills, certificates of deposit, and commercial paper (short term corporate debt). Accounts receivable consists of money owed to a company by customers for its goods and services. Inventory is a mix of finished goods, work in progress, and raw materials needed to manufacture goods for sale (Brealey et al., 2020). Inventory value is estimated by the cost of goods sold (COGS) using first-in-first-out (FIFO) or last-in-first-out (LIFO). Mathematically, Ending Inventory (EI) = Beginning Inventory (BI) – Net Purchases – COGS. Other current assets include prepaid expenses.
Long term assets come next. Property, plant, and equipment are typical examples, and are reported after subtracting accumulated depreciation. Intangible assets include patents, and goodwill, which is the price premium paid for an acquisition. Current and long-term assets comprise the left side of the balance sheet (Brealey et al., 2020).
The second section of the balance sheet details liabilities, beginning with current liabilities. Debt due for repayment is the money that must be paid on debt this year. If a firm owed $1 million to a bank for a previous loan at 10%, the debt due for repayment this year would be $100,000. Accounts payable include money owed to vendors and other creditors, including employees. Long term debt, payable later than one year, consists of loans, bonds issued, and other agreements.
The third section of the balance sheet is shareholder’s equity. Common stock and paid in capital reflects how much shareholders have contributed to the company (par value + additional investment) over time. Retained earnings communicates how much of money generated by the firm over time (cumulative) has been reinvested in the firm, as opposed to being paid out in dividends. Mathematically, RE = beginning period RE + Net Income/Loss – cash dividends – stock dividends. Treasury stock shows the worth of the shares that have been bought back by the company from the shareholders. Total assets must equal Total Liabilities plus Shareholder’s Equity.
The book value of a company equals total assets minus total liabilities. It is the amount of money shareholders would get if they liquidated the company. Market value is the share price times the number of shares, and is usually higher than the book value (Brealey et al., 2020).
Balance sheets report the most accurate estimates of value possible. The market value of current assets, for example, is relatively easy to determine. A money market account with a balance of $10,000 on 31 December 20X1 will be reported as worth $10,000 on the annual balance sheet. The value of accounts receivable is precise, except for credit losses (markdowns for uncollectable debts) and returns and allowances. Combined, these can reduce accounts receivable by 3-5%. Inventory values are less precise, as it is impossible to say how much of current inventory will be sold and at what price, but can be reasonably estimated.
Historical costs however, such as property, plant, and equipment, are typically reported as purchase cost since the market value may not be known. A common sized balance sheet shows each item as a percentage of total assets. This allows comparison between small and large companies.
Table 1 – Balance Sheet Example (in millions, cash and common sized versions)
| Current Assets (CA) | $ | % | Current Liabilities (CL) | $ | % |
| Cash and Securities | 3595 | 8.1 | Debt due for repayment (short term) | 2761 | 6.2 |
| Accounts Receivable | 1952 | 4.4 | Accounts Payable | 7244 | 16.3 |
| Inventories | 12748 | 28.6 | |||
| Other Current Assets | 638 | 1.4 | Other Current Liabilities | 6189 | 13.9 |
| Total Current Assets | 18933 | 42.5 | Total Current Liabilities | 16194 | 36.4 |
| Fixed Assets | Long Term Liabilities | ||||
| Tangible Assets | Deferred Income Taxes | ||||
| Property, Plant, and Equipment | 41414 | 93.0 | Total Long-Term Debt (>12 mo) | 24267 | 54.5 |
| Less Accumulated Depreciation | 19339 | 43.4 | Other Long-Term Liabilities | 2614 | 5.9 |
| Net Tangible Fixed Assets | 22075 | 49.6 | Total Liabilities | 43075 | 96.7 |
| Intangible Assets – no physical existence, (patents) | Shareholder’s Equity (SE) (TA-TL) | ||||
| Goodwill – price paid for acquisition minus book value | 2275 | 5.1 | Common Stock and Paid-In Capital | 9715 | 21.8 |
| Long Term Investments | Retained Earnings | 39935 | 89.7 | ||
| Other Assets | 1246 | 2.8 | Treasury Stock | -48196 | -108.2 |
| Total Shareholder’s Equity | 1454 | 3.3 | |||
| Total Assets (TA) | 44529 | 100 | Total Liabilities (TL) + SE | 44529 | 100 |
As this is a balance sheet, total assets must equal total liabilities plus shareholder’s equity. Total liabilities can be thought of as everything that has been put into a business, and total assets as everything that management has been able to do with the assets provided.
Income Statement
The income statement begins with the top line, sales revenue, subtracts COGS, subtracts selling, general, and administrative (SGA) expenses (including wages, commissions, and R&D), and subtracts depreciation to provide the earnings before interest and income taxes (EBIT). EBIT minus interest expense equals taxable income, from which taxes are subtracted to provide net income. Net income is split into dividends and additions to retained earnings. Additions to retained earnings (RE) is the net income minus the dividend payouts for a given year. A common sized income statement reveals percentages relative to total revenue (Brealey et al., 2020).
Operating revenue is generated by the core business of the firm. Non-operating revenue comes from interest earned from cash deposits, rents on a property, income from partnerships, non-core services provided to other entities, and the sale of assets. Losses on a sale of assets is recorded as an expense.
Table 2 – Income Statement Example (in millions)
| Amount | % sales | |
| Net Sales (revenue) | 100904 | 100 |
| Cost of Goods Sold | 66548 | 66 |
| Selling, General and Admin Expenses | 17864 | 17.7 |
| Depreciation | 1811 | 1.8 |
| Earnings before Interest and Income Taxes (EBIT) | 14681 | 14.5 |
| Interest Expense | 983 | 1.0 |
| Taxable Income | 13698 | 13.6 |
| Taxes (corporate rate 21% after 2017) | 5068 | 5.0 |
| Net Income | 8630 | 8.6 |
| Allocation of Net Income | ||
| Dividends | 4212 | 4.2 |
| Addition to retained earnings (ie. Capital expenditures) | 4418 | 4.4 |
Statement of Cash Flows
Cash flow from operations begins with Net Income, the “bottom line” on the income statement. It then adds depreciation back since while depreciation is a cost under accrual accounting, it does not require a cash outflow (Brealey et al., 2020). Working capital (or “net working capital”) is defined as the cash required for day-to-day operations of a business, and is quantified as current assets minus current liabilities (NWC = CA – CL). Net income (as adjusted by depreciation and amortization) is modified by changes in current assets (accounts receivable, inventories, etc.) and current liabilities (accounts payable, etc.) to derive the total cash from operations. Companies that give shares to employees as part of their compensation package will incur a “stock-based compensation expense” which will diminish cash flow from operations.
Cash flows from investments include capital expenditures, sales or acquisitions of long-term assets, and cash from other investment activities (Brealey et al., 2020). This measure can often be negative. Cash flows from financing activities reflect increases or decreases in short- or long-term debt, dividends, and stock repurchases.
Table 3 – Cash Flow Statement Example (in millions)
| Cash Provided by Operations | $ |
| Net Income | 8630 |
| Depreciation + Amortization | 2062 |
| Changes in Working Capital Items | |
| Dec/Inc in Accounts Receivable | 139 |
| Dec/Inc in Inventory | -84 |
| Dec/Inc in other current assets | -10 |
| Inc/Dec in Accounts Payable | 352 |
| Inc/Dec in other current liabilities | 669 |
| Total Dec/Inc in working capital | 1066 |
| Stock Based Compensation Expense | 273 |
| Cash provided by operations | 12031 |
| Cash Flows from Investments | |
| Capital Expenditure | -1897 |
| Sales (acquisitions) of long-term assets | 47 |
| Other investing activities | -378 |
| Cash provided by (used for) investments | -2228 |
| Cash Provided By (Used For) Financing Activities | |
| Inc/Dec in short term debt | 850 |
| Inc/Dec in long term debt | 2448 |
| Dividends | -4212 |
| Repurchases of stock | -7745 |
| Other | -211 |
| Cash provided by (used for) financing activities | -8870 |
| Net Inc/Dec in cash or cash equivalents | 933 |
Table 4 – Comparison of the Balance Sheet, Income Statement, and Cash Flow Statement
| Balance Sheet | Income Statement | Cash Flow Statement | |
| Time Interval | One point in time, a cross-section of the company | A time duration, typically one year | A time duration, typically one year |
| Purpose | Overall financial position | Net Income | Cash flows in and out |
| Parts | Assets, liabilities, equity of shareholders (SE) | Revenue, expenses, depreciation, taxes | Operations, financing, Investments |
| Start | Balance (Assets, Liabilities, and SE) | Revenue | Net Income |
| End | Retained Earnings | Net Income | Cash Balance |
Statements of Changes in Equity
This statement begins with final equity from the preceding period (beginning equity) and adds net income (from the income statement. Reporters then subtract dividend payments and add or subtract comprehensive income, which is a variation in net assets from non-owner sources.
Some companies provide a Statement of Comprehensive Income, which includes any unrealized gains or losses not reported on the income statement.
Financial Statements for Non-Profits
- Statement of Financial Position – similar to a balance sheet, but without equity positions.
- Statement of Activities – similar to the income statement, including donations, grants, and event revenue.
- Statement of Functional Expenses – unique to non-profits.
- Statement of Cash Flows – similar to for-profit entities.
Changing the Accuracy of Financial Reports and Consequent Stock Prices
Ali (2017) describes how inherent characteristics of firms can impact stock prices. Clear and honest reporting minimizes information asymmetry between insiders and outsiders. Financial disclosure quality improves with greater board independence, higher profitability, and larger firm size. The quality worsens with larger board size, stock price volatility, higher degree of leverage, and when one person holds both the CEO and Chairman roles.
Ertugrul and colleagues (2017) identifies internal factors in firms’ annual financial reports (SEC 10K) that suggest transparency, or a lack thereof. Longer reports and reports with unclear language are associated with a loan spread up to 2% higher than shorter than more concise reports. Duplicity and obfuscation have real financial penalties.
Market disruptions arise from asset bubbles to wars and a thousand other reasons. Mutual funds are major actors in US investing, holding vast portfolios of stocks, bonds, and other investment vehicles. If they suddenly need cash they may sell off assets at “fire sale” prices. If Mutual Fund A held the stock of Company X, valued at $20/share, and sold it at $16/share, the sudden flood of Company X’s shares on the secondary market would depress its value. Jiang and colleagues studied management response, in the form of voluntary disclosure and financial reporting, to market disruptions (such as mutual fund fire sales). They found that during market disruptions, well-performing firms provided earnings guidance more frequently while poorly performing firms used earnings management techniques (such as income smoothing) to improve their image.
Environmental, social, and governmental disclosures (ESG) are big topics in the business world as companies compete to be seen as sustainable and socially responsible. Murata and Hamori (2021) note the following strategies for ESG investment:
- Negative/Exclusionary – refusal to invest in a company, sector, or country, such as financiers refusing to loan to fossil fuels industries or businesses pulling out of Russia since they invaded Ukraine.
- Positive – preferentially investing in a company, sector, or country, like investing in the private company Ben and Jerry’s Ice Cream since they have boycotted Israel.
- Impact Investing – trying to solve a social problem while making money, such as the Gates Foundation attempted when it invested in the Abraaj Group under Arif Naqvi and were swindled out of $100 million.
- Norms-based – investing only in companies that meet certain standards.
The authors assumed that ESG investing was an indicator of corporate ethical behavior and that more ethical companies would have a lower risk of stock price crash. Murata and Hamori conclude that ESG disclosure can decrease stock price crash risk in Europe and Japan but did not find that ESG disclosure decreased incidence of a stock price crash risk in the United States.
CEO pay is highly visible, at least in the West, and highly controversial. Xu and Zou (2019) investigate how publicly revealing CEO pay would impact the risk of stock price crash in a company. CEOs are vital to companies. Their political connections can help a firm decrease its cost of debt and their social networks can confer higher risk-adjusted stock returns. Such networks give CEOs more information that can benefit the company. CEO pay is directly related to CEO power. Against this backdrop, Xu and Zou found no evidence that CEO pay is related to stock price crash risk.
Earnings management techniques, covered in another article, are significant ways that managers can change their reports and influence stock prices.
Future Study
Discovering which firm characteristics, and which CEO characteristics, falsely maximize company performance and stock price is the Holy Grail of management. Ertugrul’s (2017) admonition is to mine more useful information out of firm financial reports, and to make that information available to less sophisticated investors. Jiang (2021) notes that more complex firms might automatically have larger 10Ks and use more ambiguous words, thereby frustrating analysts and confusing potential investors. Finally, Xu suggests study on how the type of investment vehicle impacts CEO pay and the impact on stock price crash risk.
Conclusion
Financial statements are the key documents informing actors in the financial system in every nation in the world. They provide critical information on businesses, sectors, markets, and non-profits. Anyone dealing in business finance should know how to read financial statements. However, organizations can shade their reports to make themselves look better than they actually are. Stakeholders need to be on the lookout for characteristics of companies with reliable and unreliable reporting.
References
Ali, A., & Abdelfettah, B. (2017). Financial Disclosure Information, Board of Directors, and Firm Characteristics among French CAC 40 Listed Firms. Journal of the Knowledge Economy. https://doi.org/10.1007/s13132-017-0503-z
Brealey, R. A., Myers, S. C., & Marcus, A. J. (2020). Fundamentals of Corporate Finance (10th ed.). McGraw-Hill.
Ertugrul, M., Lei, J., Qiu, J., & Wan, C. (2017). Annual Report Readability, Tone Ambiguity, and the Cost of Borrowing. Journal of Financial and Quantitative Analysis, 52(2), 811–836. https://doi.org/10.1017/s0022109017000187
Hunter, B. M., & Murray, S. F. (2019). Deconstructing the Financialization of Healthcare. Development and Change, 50(5), 1263–1287. https://doi.org/10.1111/dech.12517
Jiang, J., Nanda, V., & Xiao, S. C. (2021). Stock-market disruptions and corporate disclosure policies. Journal of Corporate Finance, 66, 101762. https://doi.org/10.1016/j.jcorpfin.2020.101762
Murata, R., & Hamori, S. (2021). ESG Disclosures and Stock Price Crash Risk. Journal of Risk and Financial Management, 14(2), 70. https://doi.org/10.3390/jrfm14020070
Murphy, C. (2022, August 15). How to Interpret Financial Statements. Investopedia. https://www.investopedia.com/terms/f/financial-statements.asp
Xu, J., & Zou, L. (2019). The impact of CEO pay and its disclosure on stock price crash risk: evidence from China. China Finance Review International, ahead-of-print(ahead-of-print). https://doi.org/10.1108/cfri-10-2018-0138
