An introduction to financial statements
Today’s episode of “Saving and Investing” features three short videos, each of which is an introduction to a particular financial statement. Learning to read financial statements can help you evaluate the companies in which you would like to invest. (These statements are mandatory parts of corporate financial reports.)
First, Michael Fischer explains balance sheets:
This video has some difficult-to-read subtitles. They are, in order:
- “The left side and right side of a balance sheet are shown at book value (value according to accounting convention).”
- “This ownership interest would also be shown at book value.”
- “Balance sheets for accounting purposes show assets, equity, and debt at book value. And they balance.”
- “Assets (left side), equity, and debt (right side) could also be at market value, and the balance sheet would balance.”
- “For accounting purposes everything is shown at book value, but it is important to understand the principle.”
- “That assets = sources of funding (equity and debt). That is what a balance sheet shows.”
The difference between book value and market value can be confusing. Here’s a definition of book value:
An accounting term that states the equity value of an outstanding share of stock. A stock’s book value is determined by dividing the amount of stockholders’ equity by the number of common shares outstanding. A company’s book value may be of no relevance to its to market value.
The book value is what the company is worth on paper. It’s how much has already been paid into it. Market value, on the other hand, reflects how much the company is actually worth. My understanding is that book value represents the past, while market value represents the future (or present).
Visit the following for more information about balance sheets:
- The wikipedia article on balance sheets.
- The Investopedia’s guide to reading a balance sheet.
- This nice summary of what goes into a balance sheet.
The second video in this set is about income statements:
Once again, YouTube doesn’t do a good job of displaying Michael’s exhibit. Here’s a reconstruction:
| REVENUE/SALES | $100,000 |
| Less expenses | |
| Cost of Goods | 20,000 |
| Salaries | 50,000 |
| Rent | 6,000 |
| Insurance | 1,650 |
| Interest Expense | 3,500 |
| Other Expenses | 6,850 |
| Total Expenses | 88,000 |
| Pretax Profit | 12,000 |
| Taxes | 4,000 |
| NET INCOME | $8,000 |
For more information about income statements, check out:
- The wikipedia article on income statements.
- The Investopedia’s has an article on understanding the income statement.
- AccountingCoach.com has an explanation of income statements.
The last financial statement with which investors should be familiar is the cash flow statement:
Here’s my transcription of the cash flow statement exhibit:
| Operations | |
| Net Income | 25,000 |
| Depreciation | 4,000 |
| Decrease in Inventories | 500 |
| Cash Flow from Operations | 29,500 |
| Investing | |
| Van bought | -20,000 |
| Cash Flow from Investing | -20,000 |
| Financing | |
| Bank Loan | 10,000 |
| Proceeds: Outside Investor | 10,000 |
| Cash Flow from Financing | 20,000 |
| CHANGE IN CASH | $29,500 |
Visit the following for more information about cash flow statements:
- The wikipedia article on cash flow statements.
- The Investopedia’s answer to what is a cash flow statement?.
- AccountingCoach.com has an extensive overview of cash flow statements.
Finally, the U.S. Securities and Exchange Commission offers a Beginners’ Guide to Financial Statements.
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There are 10 comments to "An introduction to financial statements".
I believe it’s very important to understand these concepts. That’s why it was one of the first things that I wrote about here.
Not only do these concepts apply to publicly traded companies, but they can also be applied to one’s personal finances.
-limeade
I think people need to understand the relative differences of the numbers from the financial statement with its peers (competitors) rather than the absolute number. Companies that has great profit does not necessarily mean their stock price is going to go up faster than a company with a lot of debt.
The concepts of financial statements should not be viewed only as a tool of corporate america. I encourage people to develop a personal financial statement (Personal Balance Sheet) and list all thier assets and all thier liabilites and do this on a set schedule. There are a couple good free statements out there.
I work in banking, let me tell you net income does not always equal net worth…
Another great post- I’ve never realized their was a difference between a cashflow statement and an income statement. Its really interesting to see that lump sum purchases aren’t accounted in their entirety when they are bought.
There is one technical problem with this post though- the two first two videos are both the Income Statement one. Might want to get that fixed… 😀
Thanks for the great posts, I am really learning alot from this blog and enjoying it as well!
The first and second videos are both “What is an income statement?” The balance sheet one is MIA.
Just letting you know. 🙂
Oops. Sorry about that. Midstream yesterday, I changed the order of the videos. Apparently I outsmarted myself. How embarrassing!
Excellent post. I don’t remember the name of it, but somewhere in my library I have an entire book that is basically devoted to explaining these three financial statements, and I don’t think it does it as well as this post does.
Book value is the amount of money I paid for a stock. The same as the amount of money paid to a company in agrregate by all stock holders. Market value is the amount of money I could get if I sold my stock minus commissions for sale. When market value of my investments go above book value by enough to cover both buying and selling commissions and then 10% profit( I try not to be greedy) then I sell.
Call me crazy, but I was very excited when I learned how to read a balance sheet and income statement in an accounting course in school. Understanding financial statements made me look at investing in companies in a whole new, more informed, light.
May I suggest;
How to Read a Financial Report by John Tracy. Easy to read, and he ties the three major reports/statements all together. The three majors are “articulated”.