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Feb. 5, 2007

If you can read a nutrition label or a baseball box score, you can learn to

read basic financial statements. If you can follow a recipe or apply for a

loan, you can learn basic accounting. The basics aren’t difficult and they

aren’t rocket science.

This brochure is designed to help you gain a basic understanding of how

to read financial statements. Just as a CPR class teaches you how to

perform the basics of cardiac pulmonary resuscitation, this brochure will

explain how to read the basic parts of a financial statement. It will not

train you to be an accountant (just as a CPR course will not make you a

cardiac doctor), but it should give you the confidence to be able to look

at a set of financial statements and make sense of them.

Let’s begin by looking at what financial statements do.

We all remember Cuba Gooding Jr.’s immortal line from the movie Jerry

Maguire, “Show me the money!” Well, that’s what financial statements

do. They show you the money. They show you where a company’s

money came from, where it went, and where it is now.

There are four main financial statements. They are: (1) balance sheets;

(2) income statements; (3) cash flow statements; and (4) statements of

shareholders’ equity. Balance sheets show what a company owns and

what it owes at a fixed point in time. Income statements show how much

money a company made and spent over a period of time. Cash flow

statements show the exchange of money between a company and the

outside world also over a period of time. The fourth financial statement,

called a “statement of shareholders’ equity,” shows changes in the

interests of the company’s shareholders over time.

Let’s look at each of the first three financial statements in more detail.

A balance sheet provides detailed information about a company’s

assets, liabilities and shareholders’ equity.

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Assets are things that a company owns that have value. This typically

means they can either be sold or used by the company to make products

or provide services that can be sold. Assets include physical property,

such as plants, trucks, equipment and inventory. It also includes things

that can’t be touched but nevertheless exist and have value, such as

trademarks and patents. And cash itself is an asset. So are investments

a company makes.

Liabilities are amounts of money that a company owes to others. This

can include all kinds of obligations, like money borrowed from a bank to

launch a new product, rent for use of a building, money owed to

suppliers for materials, payroll a company owes to its employees,

environmental cleanup costs, or taxes owed to the government.

Liabilities also include obligations to provide goods or services to

customers in the future.

Shareholders’ equity is sometimes called capital or net worth. It’s the

money that would be left if a company sold all of its assets and paid off

all of its liabilities. This leftover money belongs to the shareholders, or

the owners, of the company.

The following formula summarizes what a balance sheet shows:

ASSETS = LIABILITIES + SHAREHOLDERS' EQUITY

A company's assets have to equal, or "balance," the sum of its

liabilities and shareholders' equity.

A company’s balance sheet is set up like the basic accounting equation

shown above. On the left side of the balance sheet, companies list their

assets. On the right side, they list their liabilities and shareholders’

equity. Sometimes balance sheets show assets at the top, followed by

liabilities, with shareholders’ equity at the bottom.

Assets are generally listed based on how quickly they will be converted

into cash. Current assets are things a company expects to convert to

cash within one year. A good example is inventory. Most companies

expect to sell their inventory for cash within one year. Noncurrent assets

are things a company does not expect to convert to cash within one year

or that would take longer than one year to sell. Noncurrent assets

include fixed assets. Fixed assets are those assets used to operate the

business but that are not available for sale, such as trucks, office

furniture and other property.

Liabilities are generally listed based on their due dates. Liabilities are

said to be either current or long-term. Current liabilities are obligations a

company expects to pay off within the year. Long-term liabilities are

obligations due more than one year away.

Shareholders’ equity is the amount owners invested in the company’s

stock plus or minus the company’s earnings or losses since inception.

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Sometimes companies distribute earnings, instead of retaining them.

These distributions are called dividends.

A balance sheet shows a snapshot of a company’s assets, liabilities and

shareholders’ equity at the end of the reporting period. It does not show

the flows into and out of the accounts during the period.

An income statement is a report that shows how much revenue a

company earned over a specific time period (usually for a year or some

portion of a year). An income statement also shows the costs and

expenses associated with earning that revenue. The literal “bottom line”

of the statement usually shows the company’s net earnings or losses.

This tells you how much the company earned or lost over the period.

Income statements also report earnings per share (or “EPS”). This

calculation tells you how much money shareholders would receive if the

company decided to distribute all of the net earnings for the period.

(Companies almost never distribute all of their earnings. Usually they

reinvest them in the business.)

To understand how income statements are set up, think of them as a set

of stairs. You start at the top with the total amount of sales made during

the accounting period. Then you go down, one step at a time. At each

step, you make a deduction for certain costs or other operating expenses

associated with earning the revenue. At the bottom of the stairs, after

deducting all of the expenses, you learn how much the company actually

earned or lost during the accounting period. People often call this “the

bottom line.”

At the top of the income statement is the total amount of money brought

in from sales of products or services. This top line is often referred to as

gross revenues or sales. It’s called “gross” because expenses have not

been deducted from it yet. So the number is “gross” or unrefined.

The next line is money the company doesn’t expect to collect on certain

sales. This could be due, for example, to sales discounts or merchandise

returns.

When you subtract the returns and allowances from the gross revenues,

you arrive at the company’s net revenues. It’s called “net” because, if you

can imagine a net, these revenues are left in the net after the deductions

for returns and allowances have come out.

Moving down the stairs from the net revenue line, there are several lines

that represent various kinds of operating expenses. Although these lines

can be reported in various orders, the next line after net revenues

typically shows the costs of the sales. This number tells you the amount

of money the company spent to produce the goods or services it sold

during the accounting period.

The next line subtracts the costs of sales from the net revenues to arrive

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at a subtotal called “gross profit” or sometimes “gross margin.” It’s

considered “gross” because there are certain expenses that haven’t

been deducted from it yet.

The next section deals with operating expenses. These are expenses

that go toward supporting a company’s operations for a given period –

for example, salaries of administrative personnel and costs of

researching new products. Marketing expenses are another example.

Operating expenses are different from “costs of sales,” which were

deducted above, because operating expenses cannot be linked directly

to the production of the products or services being sold.

Depreciation is also deducted from gross profit. Depreciation takes into

account the wear and tear on some assets, such as machinery, tools and

furniture, which are used over the long term. Companies spread the cost

of these assets over the periods they are used. This process of

spreading these costs is called depreciation or amortization. The

“charge” for using these assets during the period is a fraction of the

original cost of the assets.

After all operating expenses are deducted from gross profit, you arrive at

operating profit before interest and income tax expenses. This is often

called “income from operations.”

Next companies must account for interest income and interest expense.

Interest income is the money companies make from keeping their cash

in interest-bearing savings accounts, money market funds and the like.

On the other hand, interest expense is the money companies paid in

interest for money they borrow. Some income statements show interest

income and interest expense separately. Some income statements

combine the two numbers. The interest income and expense are then

added or subtracted from the operating profits to arrive at operating profit

before income tax.

Finally, income tax is deducted and you arrive at the bottom line: net

profit or net losses. (Net profit is also called net income or net earnings.)

This tells you how much the company actually earned or lost during the

accounting period. Did the company make a profit or did it lose money?

Most income statements include a calculation of earnings per share or

EPS. This calculation tells you how much money shareholders would

receive for each share of stock they own if the company distributed all of

its net income for the period.

To calculate EPS, you take the total net income and divide it by the

number of outstanding shares of the company.

Cash flow statements report a company’s inflows and outflows of cash.

This is important because a company needs to have enough cash on

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hand to pay its expenses and purchase assets. While an income

statement can tell you whether a company made a profit, a cash flow

statement can tell you whether the company generated cash.

A cash flow statement shows changes over time rather than absolute

dollar amounts at a point in time. It uses and reorders the information

from a company’s balance sheet and income statement.

The bottom line of the cash flow statement shows the net increase or

decrease in cash for the period. Generally, cash flow statements are

divided into three main parts. Each part reviews the cash flow from one

of three types of activities: (1) operating activities; (2) investing activities;

and (3) financing activities.

The first part of a cash flow statement analyzes a company’s cash flow

from net income or losses. For most companies, this section of the cash

flow statement reconciles the net income (as shown on the income

statement) to the actual cash the company received from or used in its

operating activities. To do this, it adjusts net income for any non-cash

items (such as adding back depreciation expenses) and adjusts for any

cash that was used or provided by other operating assets and liabilities.

The second part of a cash flow statement shows the cash flow from all

investing activities, which generally include purchases or sales of long-

term assets, such as property, plant and equipment, as well as

investment securities. If a company buys a piece of machinery, the cash

flow statement would reflect this activity as a cash outflow from investing

activities because it used cash. If the company decided to sell off some

investments from an investment portfolio, the proceeds from the sales

would show up as a cash inflow from investing activities because it

provided cash.

The third part of a cash flow statement shows the cash flow from all

financing activities. Typical sources of cash flow include cash raised by

selling stocks and bonds or borrowing from banks. Likewise, paying back

a bank loan would show up as a use of cash flow.

A horse called “Read The Footnotes” ran in the 2004 Kentucky Derby.

He finished seventh, but if he had won, it would have been a victory for

financial literacy proponents everywhere. It’s so important to read the

footnotes. The footnotes to financial statements are packed with

information. Here are some of the highlights:

Significant accounting policies and practices – Companies are

required to disclose the accounting policies that are most

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important to the portrayal of the company’s financial condition and

results. These often require management’s most difficult,

subjective or complex judgments.

Income taxes – The footnotes provide detailed information about

the company’s current and deferred income taxes. The

information is broken down by level – federal, state, local and/or

foreign, and the main items that affect the company’s effective tax

rate are described.

Pension plans and other retirement programs – The footnotes

discuss the company’s pension plans and other retirement or

post-employment benefit programs. The notes contain specific

information about the assets and costs of these programs, and

indicate whether and by how much the plans are over- or under-

funded.

Stock options – The notes also contain information about stock

options granted to officers and employees, including the method

of accounting for stock-based compensation and the effect of the

method on reported results.

You can find a narrative explanation of a company’s financial

performance in a section of the quarterly or annual report entitled,

“Management’s Discussion and Analysis of Financial Condition and

Results of Operations.” MD&A is management’s opportunity to provide

investors with its view of the financial performance and condition of the

company. It’s management’s opportunity to tell investors what the

financial statements show and do not show, as well as important trends

and risks that have shaped the past or are reasonably likely to shape the

company’s future.

The SEC’s rules governing MD&A require disclosure about trends,

events or uncertainties known to management that would have a

material impact on reported financial information. The purpose of MD&A

is to provide investors with information that the company’s management

believes to be necessary to an understanding of its financial condition,

changes in financial condition and results of operations. It is intended to

help investors to see the company through the eyes of management. It is

also intended to provide context for the financial statements and

information about the company’s earnings and cash flows.

You’ve probably heard people banter around phrases like “P/E ratio,”

“current ratio” and “operating margin.” But what do these terms mean

and why don’t they show up on financial statements? Listed below are

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just some of the many ratios that investors calculate from information on

financial statements and then use to evaluate a company. As a general

rule, desirable ratios vary by industry.

If a company has a debt-to-equity ratio of 2 to 1, it means that the

company has two dollars of debt to every one dollar shareholders invest

in the company. In other words, the company is taking on debt at twice

the rate that its owners are investing in the company.

Inventory Turnover Ratio = Cost of Sales / Average Inventory

for the Period

If a company has an inventory turnover ratio of 2 to 1, it means that the

company’s inventory turned over twice in the reporting period.

Operating Margin = Income from Operations / Net Revenues

Operating margin is usually expressed as a percentage. It shows, for

each dollar of sales, what percentage was profit.

P/E Ratio = Price per share / Earnings per share

If a company’s stock is selling at $20 per share and the company is

earning $2 per share, then the company’s P/E Ratio is 10 to 1. The

company’s stock is selling at 10 times its earnings.

Working Capital = Current Assets – Current Liabilities

Debt-to-equity ratio compares a company’s total debt to

shareholders’ equity. Both of these numbers can be found on a

company’s balance sheet. To calculate debt-to-equity ratio, you

divide a company’s total liabilities by its shareholder equity, or

Inventory turnover ratio compares a company’s cost of sales on

its income statement with its average inventory balance for the

period. To calculate the average inventory balance for the period,

look at the inventory numbers listed on the balance sheet. Take

the balance listed for the period of the report and add it to the

balance listed for the previous comparable period, and then divide

by two. (Remember that balance sheets are snapshots in time. So

the inventory balance for the previous period is the beginning

balance for the current period, and the inventory balance for the

current period is the ending balance.) To calculate the inventory

turnover ratio, you divide a company’s cost of sales (just below

the net revenues on the income statement) by the average

inventory for the period, or

Operating margin compares a company’s operating income to net

revenues. Both of these numbers can be found on a company’s

income statement. To calculate operating margin, you divide a

company’s income from operations (before interest and income

tax expenses) by its net revenues, or

P/E ratio compares a company’s common stock price with its

earnings per share. To calculate a company’s P/E ratio, you divide

a company’s stock price by its earnings per share, or

Working capital is the money leftover if a company paid its current

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Modified: Feb. 5, 2007

liabilities (that is, its debts due within one-year of the date of the

balance sheet) from its current assets.

Although this brochure discusses each financial statement separately,

keep in mind that they are all related. The changes in assets and

liabilities that you see on the balance sheet are also reflected in the

revenues and expenses that you see on the income statement, which

result in the company’s gains or losses. Cash flows provide more

information about cash assets listed on a balance sheet and are related,

but not equivalent, to net income shown on the income statement. And

so on. No one financial statement tells the complete story. But combined,

they provide very powerful information for investors. And information is

the investor’s best tool when it comes to investing wisely.

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