Reading Financial Statements 101: Part I

Revenue. Expenses. Assets. Equity. Liabilities. Profit.  Many of you may be thinking, ‘Hey, I know some of those words’. Sometimes financial jargon can feel intimidating and overwhelming, but there are four primary financial statements that everyone can (and should!) understand and be familiar with. Just remember – they’re more afraid of you than you are of them.

The financial statements are comprised of four basic reports:

1. Income Statement (aka Profit and Loss Statement) – What revenue has been earned and what expenses have been incurred during a period of time?
2. Balance Sheet – What do all company accounts look like at a particular moment in time?
3. Cash Flow Statement – How have changes in the balance sheet and income accounts affected cash and cash equivalents?
4. Statement of Retained Earnings (aka Statement of Changes in Equity) – How have the cumulative net earnings (profit) of the firm changed over the period?

In general, the Income Statement (IS) and the Balance Sheet (BS) are seen as the primary reports. There is one simple, but very important distinction between them that is essential to your understanding of these statements.   While the IS provides information about a period of time (this year, this month, etc.), the BS is a ‘snapshot’ of the company at a point in time (usually the end of a reporting period).

Now you’re thinking ‘But why do we need them all?’ And ‘How do I read these things?’

The Income Statement

Let’s start with the key items on the income statement: revenue, expenses, gains and losses. The Income Statement starts with the details of sales, and works its way down to calculate Net Income. Essentially, the IS demonstrates how revenue is transformed into earnings.

Revenue and Gains

1. Operating Revenue – This is revenue realized through the primary activities of the business. For example, for a company that manufactures a product, their revenue from primary activities is achieved from sale of the product. For a company that offers services, revenue from primary activities refers to the fees earned in exchange for offering those services.
2. Non-Operating Revenue – This is revenue realized through non-core business activities – i.e. secondary activities. Some examples of non-core revenue include interest earned on investments and royalty payments.
3. Gains – Also known as ‘other income’, this is money earned from one-time, non-business activities, such as the sale of long-term assets. For example, a company sells its old equipment that is no longer being used.

Expenses and Loses

1. Operating Expenses – All expenses incurred in normal operations that are linked to primary business activities. This can be further broken down into sub-categories such as:
   • Cost of Goods Sold (COGS)
   • General and Administrative (G&A)
   • Depreciation/Amortization
   • Research and Development (R&D)
2. Non-Operating Expenses – This includes all expenses linked to non-core business activities. For example, interest paid on a loan from the bank.
3. Losses – Losses include all expenses that go towards a loss-making sale of long-term assets and other non-recurring/unusual costs (ex. consumer lawsuit expense).

Income Statement Structure

The basic formula used to calculate net income is:

Net Income = (Revenue + Gains) – (Expenses + Losses)

To understand this formula, it’s best to view a sample statement:

Every Income Statement should start with the company name, title of the document (Income Statement) as well as the period covered by the statement.  This sets the stage for the reader.  From there, Revenues are always listed first.  Revenue can be earned on the sale of goods (‘Product Sales’) or on the provision of Services.  Once total earnings are summed, any costs that were directly associated with producing that good or service (ex. the cost of fabric to make a sweater) are deducted. These expenses are referred to as ‘Cost of Goods Sold’ or ‘COGS’.  This leaves you with your ‘Gross Profit’. Operating Expenses, such as rent, and Non-Operating Expenses, such as interest payments, are then totaled and subtracted from Gross Profit.  Lastly, Gains and Losses (i.e. Other Income) are added or deducted as necessary.  You are left with your ‘Net Income’ for the period. A positive Net Income is also known as a ‘profit’, while a negative Net Income is referred to as a ‘loss’.

The above is a relatively simple example of how Net Income is calculated.  This format is known as a ‘Single Step Income Statement’.  Real-world companies often have a wide array of operations, expenses, business activities, etc. and therefore, tend to use a ‘Multiple-Step Income Statement’, which segregates operating revenues, expenses and gains, from non-operating revenues, expenses and losses.

Uses of the Income Statements

The primary purpose of the Income Statement is to convey details of profitability and business activities to stakeholders.  Stakeholders include directors, employees, government agencies, shareholders and suppliers. Other users of the financial statements include competitors hoping to gain insights into company parameters and focus-areas.  Creditors, such as banks, may also request to view the income statements as part of their credit assessment.

Internally, financial analysis of the Income Statement – in combination with other reports – reveals the inner workings of an organization.  It is through this analysis, that management can make important strategic decisions, such as where to expand sales, what products to discontinue, where to invest, and ultimately, infer how company efforts improve or reduce profitability over time.