How to Read and Understand Financial Statements & Introduction to the Income Statement and Balance Sheet - ABA YLD 101 Practice Series

By Erica Galpern Waxman

The objective of this article is to give attorneys and non-accounting professionals a basic overview of financial statements including the Income Statement and Balance Sheet.  Although you may encounter financial statements that are very complex, each financial statement will always come back to the basic equations set forth below.  If you understand these basic equations you will be able to read and understand all Income Statements and Balance Sheets.   

Income Statement:
The Income Statement reports a company's financial performance over certain periods of time, usually quarterly (10-Q) or annually (10-K).  It summarizes and displays the revenue for the sale of good or services less the costs to make and sell those goods or services.  Further, all business activities that generate income or result in a loss for a company are recorded on the Income Statement.   

Income Statement Basic Equation:

                Net Sales
-               Cost of Goods Sold                
=              Gross Profit
-               Operating Expenses              
=              Net Income before Taxes
-               Taxes                                     
=              Net Income after Taxes

Net Sales:

  • Net Sales = Total Sales – (Deductions of returns and allowances for damaged or missing goods + any discounts)
  • Sales are recorded on the Income Statement when the company realized the sale, which is often when the company actually ships products to customers. 

Cost of Goods Sold ("COGS"):

  • Cost of Goods Sold include the direct costs attributable to the production of the goods sold by a company.  This can include the material costs used in creating the goods and the direct labor costs used to produce the goods.
    • Cost of Goods Sold does not include the indirect expenses such as distribution costs and sales force costs.
  • When a product is shipped and a sale is recorded, the company records the total cost of manufacturing the product as Cost of Goods Sold on the Income Statement.
  • The cost to manufacture products are accumulated in inventory until the products are sold.  Then these costs are expensed through the Income Statement as Cost of Goods Sold. 

Gross Profit:

  • Gross Profit = Net sales – Cost of Goods Sold
  • The remaining amount from sales after direct product costs or costs of goods sold are deducted.

Operating Expenses:

  • Expenditures that a company needs to operate.
  • Include Sales and Marketing Expenses, Research and Development Expenses, and General and Administrative Expenses. 

Although you may encounter income statements that are much more complex, each income statement will always come back to the basic equation stated above.  If you understand the basic equation, you will be able to read and understand the Income Statement.  For an example of an Income Statement please refer to the 10-K of the Boston Beer Company, Inc.: http://idea.sec.gov/Archives/edgar/data/949870/000095013509001646/b73467bbe10vk.htm#113.

Balance Sheet:
The Balance Sheet presents a company's financial position at a given point of time (i.e.: end of quarter, company's year end).  It includes Assets, Liabilities, and Equity.  Remember, the balance sheet must always balance. 

Balance Sheet Basic Equation:

Assets = Liabilities + Equity
 
Assets:

  • What the company has today:
    • i.e.: Cash in the bank, inventory, machines, buildings, and property.
  • Assets are displayed on the balance sheet in descending order of liquidity or the ease of convertibility into cash.  There are 3 types of Assets that are summed together to equal total assets:
    • Current Assets
      • Current Assets are expected to be converted into cash in less than 1 year or the company's operating cycle.
      • Examples include cash, short term investments, accounts receivable, inventory, and prepaid expenses.
    • Net Fixed Assets
      • Net Fixed Assets = Fixed Assets at Cost – Accumulated Depreciation
      • Fixed Assets are productive assets not intended for sale and are commonly referred to as Property, Plant, and Equipment or "PP&E."
      • Accumulated Depreciation is the sum of all the depreciation charges taken since the asset was first acquired.
      • Examples of fixed assets commonly include land, buildings, machinery, equipment, furniture, automobiles, trucks, etc.
    • Other Assets
      • Assets of the company that cannot be properly classified into current assets or fixed assets are referred to as other assets. 
      • Intangible assets lack physical substance and usually have a high degree to uncertainty concerning their future benefits.
      • Examples include patents, copyright, franchise, goodwill, trademarks, and trade names.

Liabilities:

  • Economic obligations of the company or how much the company owes today.
  • There are two types of liabilities:
    • Current Liabilities:
      • Obligations that are expected to be paid within 1 year.
    • Long Term Liabilities:
      • Obligations that are not expected to be paid within 1 year.

Equity:

  • Equity represents the value of the company to its owner or what the company is worth today.
  • There are generally two components:
    • Capital Stock
      • The original amount of money the owners contributed as their investment in the stock of the company.
    • Retained Earnings
      • All the earning of the company that have not been paid out as dividends to owners.

Although you may encounter  balance sheets that are much more complex, each balance sheet will always come back to the basic equation of Assets = Liabilities + Equity.  If you understand the basic equation, you will be able to read and understand all Balance Sheets.  For an example of a Balance Sheet please refer to the 10-K of the Boston Beer Company, Inc.: http://idea.sec.gov/Archives/edgar/data/949870/000095013509001646/b73467bbe10vk.htm#113.

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About the Author

Erica Galpern Waxman is an attorney in South Florida.  She practices in the areas of litigation, fraud, and anti-money laundering.

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