EBITDA and Other Scary Words: Scary Word No. 2 – Financial Statements
"This article originally appeared on Financial Poise and is reprinted here with permission."
How do companies share their financial information with owners, potential investors, banks and others? Pictures are nice but it is kind of difficult to draw a liability. You can put a lot of information in a song but recording an album is too time-consuming. The most accepted method is to use financial statements.
Financial statements are a formal record of the financial activities (revenues and expenses) and financial position (assets, liabilities and equity) of a person, business or other entity.
Let’s start with personal financial statements. If you have ever applied for a loan, you’ll remember how the bank gathered some basic financial information – assets you own and outstanding liabilities as of a specific date, annual income and annual expenses. This is the same information that goes on a personal financial statement. The balance sheet has your assets like cash, investments, and your home along with liabilities like credit card balances and mortgages. The net of your assets and liabilities is your net worth or equity. The income statement lists your income and expenses to calculate your net income.
Under Generally Accepted Accounting Principles or GAAP (we talked about this in our last article) financial statements consist of the following:
- Accountant’s report or auditor’s opinion letter
- Balance sheet
- Income statement or statement of operations (typical wording used if there was a net loss)
- Statement of changes in owner’s equity
- Statement of cash flows
- Supplemental information (if applicable)
If you have an external accountant provide assurance on your financial statements there are three levels of assurance a CPA can provide. A compilation provides no assurance from the accountant. A review provides limited assurance that the financial statements are free of material misstatements and in conformity with GAAP. The highest level of assurance is from an audit. The audit opinion can be unqualified, qualified, adverse or a disclaimer of opinion. Unqualified is actually a good thing. It means that the financial statements are in accordance with GAAP or another basis of accounting and there are no material issues. Qualified opinions are given when the financial statements have a particular account balance or other item that may be materially misstated or GAAP is not being followed. An adverse report is issued when there are material misstatements throughout the financial statements. A disclaimer of opinion is used when the accountant is not independent or the audit can not be completed.
The balance sheet is a snapshot of the assets, liabilities and owners’ equity at a specific date. Just as the title states, the balance sheet balances. The formula is assets = liabilities + equity. One of the limitations of a balance sheet is that the amounts are generally historical values and not fair market values.
The income statement presents revenues, expenses, and net income or loss. If the company has a net loss, it is called a statement of operations instead of an income statement. This sounds better than a loss statement.
The statement of changes in owners’ equity provides details about the increase or decrease in equity for the period. Capital contributions and net income are increases to equity. Distributions, dividends and net losses are decreases to equity.
The statement of cash flows shows the changes in the balance sheet for the period. The changes are broken down into operating, investing and financing activities. Operating activities are the primary activities of the business. This includes the changes in the accounts receivable, inventory and accounts payable; as well as adjustments for non-cash operating activities such as depreciation, amortization, bad debts, and gains from sale of investments or property and equipment. Investing activities represent cash flows from the purchase and sale of assets other than inventories. Financing activities are for cash flows related to equity and debt activity, such as proceeds from bank loans or distributions to shareholders.
Footnotes provide additional information that support the financial statements. Common disclosures include a note about the nature of the entity’s operations, significant accounting policies, details of significant assets and liabilities, related party transactions, and commitments and contingencies.
Keep in mind that the financial statements are interrelated and there are certain amounts that agree with each other. Cash on the balance sheet agrees with cash on the cash flow statement. Equity on the balance sheet agrees with the equity on the statement of changes in equity. Net income on the income statement agrees with net income on the statement of changes in owners’ equity and on the statement of cash flows.
The components of the financial statements and the accounting method are usually determined by the user or reader. For example, a line of credit with a bank might require a company to submit quarterly internal financial statements and a year-end audited financial statement. Each quarter the company’s CFO would prepare an internal financial statement that would consist of just a balance sheet and income statement. For the annual audit, a CPA will issue an audited financial statement with all of the items listed above and possibly additional supporting schedules.
Now that you know more about financial statements, you can get past the scary part and use the information to make decisions about your business.