Introduction To Financial Statements (Part 2)
In Introduction To Financial Statements (Part 1), we talked about why it’s important to learn to read financial statements and discussed in detail the balance sheet.
Now, let’s look at the income and cash flow statements.
Income Statements
An income or profit loss statement is a report that shows how much you’ve earned over a specific time period. An income statement shows the costs and expenses associated with earning that money. The literal “bottom line” of the statement usually shows the company’s net earnings or losses.
Income statements also report earnings per share (or “EPS”) which calculates how much money shareholders would receive if you distributed all of the net earnings for the period.
At the top of the income statement is the total amount of revenue from sales of products or services. This top line is often referred to as gross revenues or sales, because expenses have not yet been deducted.
The next line is money the company doesn’t expect to collect on certain sales such as discounts or merchandise returns.
When you subtract the returns and allowances from the gross revenues, you get your net revenues.
Next 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, or cost of goods sold. This is the amount of money you spent to produce the goods or services sold during the accounting period.
The next line subtracts the costs of sales from the net revenues to arrive at a subtotal called “gross profit” or sometimes “gross margin.”
The next section is operating expenses. These are expenses that go toward supporting a company’s operations for a given period. 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. Accounting spreads the cost of these assets over the periods they are used. This process of spreading these costs is called depreciation or amortization. The cost for using these assets during a certain period is a fraction of the original cost of the assets.
Next you arrive at a total called income from operations. Operating expenses are deducted from gross profit to arrive at operating profit before interest and income tax expenses.
You must also account for interest income and interest expense. Interest income is the money you make from any investments.
Finally, income tax is deducted and you arrive at the bottom line: net profit or net losses. Now you know how much the company actually earned or lost during the period.
Cash Flow Statements
Cash flow statements report your company’s inflows and outflows of cash. While an income statement can tell you whether your company made a profit, a cash flow statement can tell you whether your company generated cash.
A cash flow statement shows changes over time rather than absolute dollar amounts at a point in time.
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:
- Operating activities
- Investing activities
- Financing activities
1. Operating Activities
The first part of a cash flow statement analyzes your company’s cash flow from net income or losses. This section of the cash flow statement usually reconciles the net income (as shown on the income statement) to the actual cash your company received from or spent in operating activities.
Net income is adjusted for any non-cash items (such as adding back depreciation expenses) and any cash that was used or provided by other operating assets and liabilities. When a cash flow statement is accurate, it can be a helpful tool in determining the value of your business.
2. Investing Activities
This is the cash flow from all investing activities, which generally include purchases or sales of long-term assets, such as property, plant and equipment. When you buy equipment, the cash flow statement would reflect this as a cash outflow from investing activities. If you sell an investment, the proceeds from the sales would show up as a cash inflow.
3. Financing Activities
The third part of a cash flow statement shows the cash flow from all financing activities.