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Understanding the Three Financial Statements

A robust understanding the three financial statements is important for banking and asset management interviews. This post is meant to be a quick review for an interview, or a complement to your introduction to financial accounting course, which covers this material in much greater detail.

The three financial statements that all public companies must file are:

  • Balance Sheet
  • Income Statement
  • Cash Flow Statement

They must adhere to a set of accounting rules, known as the GAAP or the IFRS. The purpose of these statements is to provide financials to shareholders and debt holders so that the company can lower its cost of capital.

Balance Sheet

The balance sheet describes the financial position of a company at a point in time, usually at the end of a reporting period. The balance sheet is comprised, on a high level, of assets, liabilities, and equity. Balance sheets must always satisfy the Basic Accounting Equation, where:

assets = liabilities + equity

This means that every change in assets must be accompanied by an equal change in liabilities/equity or an equal but opposite change in another asset. For example, a purchase of groceries on your credit card would show as the following on your balance sheet:

  • credit card payable increase by $100.00
  • retained earnings decrease by $100.00

Under IFRS (in North America), the items on the balance sheet are typically ordered by decreasing liquidity (most liquid like cash comes first).

Balance sheets are used to understand the financial condition of the company, useful for both lenders and investors. Ratios such as current ratio, quick ratio, and debt to equity Ratio are used to compare liquidity and solvency between related companies.

Assets

Assets are anything controlled by the company that will generate future economic benefit to the company. Assets are split into current assets and non-current assets, which are classified by their liquidity characteristics. Current assets include cash, accounts receivable, marketable securities, and inventory. Non-current assets include long-term financial investments, PP&E, land, and intangible assets (like patents, trademarks, goodwill etc.).

Depending on the asset, they can be recorded at their historical cost or fair value. For example, inventory and equipment are usually recorded at their historical cost, and may be depreciated over time. Marketable securities can be recorded at its fair value. The trade-off between the two methods is reliability vs. relevance.

Liabilities

Liabilities are anything that will generate future economic sacrifice to the company. Liabilities are also split into current and non-current ones, which are classified similarly. Current liabilities include accounts payable, accrued liabilities and unearned revenues. Non-current liabilities include long-term debt and tax liabilities.

Equity

Equity represents capital from the owners of the company, or residual claims on the company. In event of bankruptcy, debt holders get higher claim on the company’s assets, and equity holders get what is leftover. Equity can be divided into contributed and earned capital, where contributed represents money from the owners and earned represents money the company through its operations. Retained earnings is a part of earned capital, it covers accumulated earnings minus any distributed to shareholders.

Income Statement

The income statement describes the operating results of a company over the past reporting period. On a high level, the income statement has three items, revenue (top line), expenses, and profit (bottom line). The expenses are usually broken down into operating and non-operating expenses, with operating expenses above non-operating expenses.

Revenue
Operating Expense
EBIT
Non-Operating Expense
Profit (Net Income)

The income statement interacts with the balance sheet through profit, or net income. At the end of the period, the net income will flow into retained earnings to be distributed or reinvested.

Operating Expense

Operating expense are anything  related to the operations of the company. This includes direct costs like labor and materials (called Cost of Goods Sold) and indirect costs like SG&A, R&D, and depreciation. Operating costs are associated with two important ratios: gross margin and operating margin. These ratios offer a way to compare profitability between similar companies.

Non-Operating Expense

Non-operating expenses are anything that is unrelated to the operations of the company. This includes interest and tax expense. Non-operating expenses are associated with interest coverage ratio, a measure of solvency.

Cash Flow Statement

The cash flow statement describes all changes in cash over the past reporting period. It can be broken down into operating, investing, and financing cash flow. Operating accounts for buying and selling products and services, investing accounts for asset purchases and financing accounts for borrowing or raising cash. Operating cash flow is associated with free cash flow (FCF) and unlevered free cash flow (UFCF), both of which important in valuations.

The cash flow statement differs from the income statement mainly due to accrual accounting. The income statement records revenue when the services are rendered, or the goods are delivered to the customer, irrespective of whether or not the company receives any cash. The expenses associated with the services or goods are then matched to the revenue.

Finance 101Statistical Inference and Hypothesis Testing · Understanding Porter’s Five Forces · Modern Portfolio Theory and the Capital Allocation Line · Accounting Estimates: Managing Earnings · M&A Deal Case Study · Introduction to Enterprise Value and Valuation · Accounting Estimates: Recognizing Assets · Accounting Estimates: Recognizing Expenses · Accounting Estimates: Recognizing Revenue · Understanding Market Structure — Perfect Competition, Monopoly and Monopolistic Competition · Marginal Costs and Marginal Revenue · Analyzing Financial Statements and Ratios · Understanding the Three Financial Statements · Fama French and Multi Factor Models · Understanding the Yield Curve · Bond Valuation and Arbitrage · Central Banks and Monetary Policy: The Federal Reserve · CAPM – Capital Asset Pricing Model · Inflation and Interest · Annuities and Perpetuities · Net Present Value · Understanding Supply and Demand ·

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