How to Read Financial Statements Like a Pro (Part 1)

A Crash Course in Balance Sheets, Income Statements, and Statements of Cash Flows

Recently, it occurred to me that many readers may not be familiar with the basic financial statements. As a practicing accountant and someone who’s been fortunate enough to receive an education from the country’s top-tier business schools, I am admittedly a little too familiar with them. Although I won’t bore you with the details of actually preparing these statements, it’s imperative for any investor to understand how to read financial statements on a basic level prior to committing his or her funds to a stock purchase.

I’ll break my analysis into a 3-part miniseries. Part 1 will focus on analyzing a balance sheet, while parts 2 and 3 will cover the income statement and the statement of cash flows, respectively. Without any further ado, let’s hop into financial statement analysis.

Part 1: The Balance Sheet

The balance sheet is comprised of 3 different sections: Assets, Liabilities, and Equity. At its most basic level, assets are what you own. Think cash, investments, accounts receivable, inventory, buildings, equipment, and intellectual property. Liabilities are what you owe. These might include accounts payable, accrued expenses, and debt financing. And lastly, equity is what’s left in the “pot”, so to speak, if you were to liquidate the company and pay off what you owe.

And why is it called the balance sheet? Because, ta-da, it balances. All balance sheets follow the same format: Assets = Liabilities + Equity. If the balance sheet does not follow this formula, it’s out of balance and was not prepared properly. The various accounts shown on the balance sheet are also sorted based on the ease to which they can be converted to cash. This is concept is known as liquidity.

Another important point to note is the balance sheet depicts your financial position at a point in time, whereas both the income statement and the statement of cash flows show your financial activity over a period of time.

Let’s illustrate with a fictional example, shall we?

Say I quit my day job and decide to start an ice cream shop. I know – every girl’s dream! My hypothetical balance sheet might resemble the following:

ASSETS

Cash and Inventory

Let’s assume most customers pay by cash or credit card. Of course, under this situation, the company holds cash. Generally speaking, most businesses do! In addition to cash, inventory represents another asset. The ice cream being sold represents the company’s inventory. Any company that sells a tangible, physical product will most likely have inventory. There’s a variety of different costing methods for inventory, but I’ll save that discussion for a later date. Additionally, in the case of food sales, you might have spoilage costs. That is, food you don’t sell before it goes bad. For the sake of ease, let’s assume there’s no spoilage.

Fixed Assets

In addition, our ice cream shop owns land and a building. Land is not depreciated under U.S. Generally Accepted Accounting Principles (GAAP). However, the building is. Let’s say the building is depreciated over 40 years straight-line and costs $100,000 to purchase. This equates to depreciation expense on the building of $2,500 a year ($100,000 / 40 years = $2,500/year). Notice also that fixed assets are recorded at cost. In other words, we paid $100,000 to acquire the building and we recorded it on our balance sheet at that same amount. In reality, the building may be worth much more based on its fair market value. Under GAAP, a company is unable to “write up” the value of it’s fixed assets, but can – and should – write down the value of its assets if impaired.

Other fixed assets per our example includes equipment. For our ice cream shop, equipment may take the form of blenders and other essential kitchenware. We’ll depreciate equipment over 5 years. As such, year 1 depreciation expense on the equipment would be $800, calculated as $4,000 / 5 years. In year 2, the cost basis for the equipment jumped from $4,000 to $5,000; we’ll assume the company acquired a new asset for $1,000. Annual depreciation expense on the new equipment would be $200, assuming the new equipment was acquired January 1st and is depreciated using the straight-line method.

Depreciation expense for each period is rolled into the accumulated depreciation balance, a contra-asset account. Based on our calculations above, year 1 depreciation expense would be $2,500 on the building and $800 on the equipment. There is no accumulated depreciation to start, so after year 1 has eclipsed, accumulated depreciation totals $3,300 ($2,500 + $800). Depreciation expense for year 2 would total $3,500 and consists of $2,500 for the building, $800 for the original equipment, and $200 for the new equipment. This brings the accumulated depreciation balance up to $6,800 ($3,300 during year 1 + $3,500 during year 2) at the end of year 2.

LIABILITIES

Current and Long-Term Debt

Next, we have our liabilities. For my fictional ice cream shop, debt is its largest liability. Oftentimes, companies assume debt financing as a means for acquiring assets. In our case, the ice cream shop received a bank loan of $420,000 to use towards the purchase of the building and land. You can think of this similar to how you would a personal mortgage or a car loan. Debt is broken out into current and non-current. Current represents the portion of the debt that is due in a year or less.

Accounts Payable

Accounts payable is another liability account. Oftentimes, accounts payable consist of payments to company vendors. In the case of our ice cream shop we may decide to purchase our supply of toppings from outside vendors, or even the ice cream itself. We’re in the business of selling ice cream after all, not producing Oreos, chocolate sauce, and whipped cream!

Accrued Expenses and Unearned Revenues

Although our ice cream shop example only has debt and accounts payable, accrued expenses and unearned revenues are other common liability accounts. Accrued expenses may take the form of a subscription service you’re using, but haven’t yet paid for. Or, they could even be accrued payroll costs for work performed by employees, but not yet paid out by the company. Unearned revenue represents customer deposits for work the company hasn’t yet performed.

EQUITY

Rounding out our analysis of the balance sheet is the equity section. I won’t go into too much detail as equity accounting can become complicated pretty quickly. Equity accounts might consist of retained earnings, common stock, preferred stock, additional paid in capital, and treasury stock. Again, for sake of ease, I only include retained earnings in our example. Retained earnings represents the previous periods’ retained earnings plus the net income (or loss) for the period less dividends paid out to shareholders.

Next Steps

Now, it’s time for you to get started reading financial statements! Search for any publicly traded company’s financials using the SEC’s Edgar Search Tool and put your knowledge to the test.

And if you liked this post, check out Part 2 of the miniseries: The Income Statement.

Also, check out my latest stock analyses and share your thoughts!