If you can read a nutrition label or a baseball box score, you can learn to read basic financial statements. If you can follow a recipe or apply for a loan, you can learn basic accounting. The basics aren’t difficult and they aren’t rocket science.
This brochure is designed to help you gain a basic understanding of how to read financial statements. Just as a CPR class teaches you how to perform the basics of cardiac pulmonary resuscitation, this brochure will explain how to read the basic parts of a financial statement. It will not train you to be an accountant (just as a CPR course will not make you a cardiac doctor), but it should give you the confidence to be able to look at a set of financial statements and make sense of them.
Let’s begin by looking at what financial statements do.
“Show me the money!”
We all remember Cuba Gooding Jr.’s immortal line from the movie Jerry Maguire, “Show me the money!” Well, that’s what financial statements do. They show you the money. They show you where a company’s money came from, where it went, and where it is now.
There are four main financial statements. They are: (1) balance sheets; (2) income statements; (3) cash flow statements; and (4) statements of shareholders’ equity. Balance sheets show what a company owns and what it owes at a fixed point in time. Income statements show how much money a company made and spent over a period of time. Cash flow statements show the exchange of money between a company and the outside world also over a period of time. The fourth financial statement, called a “statement of shareholders’ equity,” shows changes in the interests of the company’s shareholders over time.
Let’s look at each of the first three financial statements in more detail.
A balance sheet provides detailed information about a company’s assets, liabilities and shareholders’ equity.
Assets are things that a company owns that have value. This typically means they can either be sold or used by the company to make products or provide services that can be sold. Assets include physical property, such as plants, trucks, equipment and inventory. It also includes things that can’t be touched but nevertheless exist and have value, such as trademarks and patents. And cash itself is an asset. So are investments a company makes.
Liabilities are amounts of money that a company owes to others. This can include all kinds of obligations, like money borrowed from a bank to launch a new product, rent for use of a building, money owed to suppliers for materials, payroll a company owes to its employees, environmental cleanup costs, or taxes owed to the government. Liabilities also include obligations to provide goods or services to customers in the future.
Shareholders’ equity is sometimes called capital or net worth. It’s the money that would be left if a company sold all of its assets and paid off all of its liabilities. This leftover money belongs to the shareholders, or the owners, of the company.
A company's assets have to equal, or "balance," the sum of its liabilities and shareholders' equity.
A company’s balance sheet is set up like the basic accounting equation shown above. On the left side of the balance sheet, companies list their assets. On the right side, they list their liabilities and shareholders’ equity. Sometimes balance sheets show assets at the top, followed by liabilities, with shareholders’ equity at the bottom.
Assets are generally listed based on how quickly they will be converted into cash. Current assets are things a company expects to convert to cash within one year. A good example is inventory. Most companies expect to sell their inventory for cash within one year. Noncurrent assets are things a company does not expect to convert to cash within one year or that would take longer than one year to sell. Noncurrent assets include fixed assets. Fixed assets are those assets used to operate the business but that are not available for sale, such as trucks, office furniture and other property.
Liabilities are generally listed based on their due dates. Liabilities are said to be either current or long-term. Current liabilities are obligations a company expects to pay off within the year. Long-term liabilities are obligations due more than one year away.
Shareholders’ equity is the amount owners invested in the company’s stock plus or minus the company’s earnings or losses since inception. Sometimes companies distribute earnings, instead of retaining them. These distributions are called dividends.
A balance sheet shows a snapshot of a company’s assets, liabilities and shareholders’ equity at the end of the reporting period. It does not show the flows into and out of the accounts during the period.
An income statement is a report that shows how much revenue a company earned over a specific time period (usually for a year or some portion of a year). An income statement also shows the costs and expenses associated with earning that revenue. The literal “bottom line” of the statement usually shows the company’s net earnings or losses. This tells you how much the company earned or lost over the period.
Income statements also report earnings per share (or “EPS”). This calculation tells you how much money shareholders would receive if the company decided to distribute all of the net earnings for the period. (Companies almost never distribute all of their earnings. Usually they reinvest them in the business.)
To understand how income statements are set up, think of them as a set of stairs. You start at the top with the total amount of sales made during the accounting period. Then you go down, one step at a time. At each step, you make a deduction for certain costs or other operating expenses associated with earning the revenue. At the bottom of the stairs, after deducting all of the expenses, you learn how much the company actually earned or lost during the accounting period. People often call this “the bottom line.”
At the top of the income statement is the total amount of money brought in from sales of products or services. This top line is often referred to as gross revenues or sales. It’s called “gross” because expenses have not been deducted from it yet. So the number is “gross” or unrefined.
The next line is money the company doesn’t expect to collect on certain sales. This could be due, for example, to sales discounts or merchandise returns.
When you subtract the returns and allowances from the gross revenues, you arrive at the company’s net revenues. It’s called “net” because, if you can imagine a net, these revenues are left in the net after the deductions for returns and allowances have come out.
Moving down the stairs from the net revenue line, 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. This number tells you the amount of money the company spent to produce the goods or services it 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.” It’s considered “gross” because there are certain expenses that haven’t been deducted from it yet.
The next section deals with operating expenses. These are expenses that go toward supporting a company’s operations for a given period – for example, salaries of administrative personnel and costs of researching new products. 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. Companies spread the cost of these assets over the periods they are used. This process of spreading these costs is called depreciation or amortization. The “charge” for using these assets during the period is a fraction of the original cost of the assets.
After all operating expenses are deducted from gross profit, you arrive at operating profit before interest and income tax expenses. This is often called “income from operations.”
Next companies must account for interest income and interest expense. Interest income is the money companies make from keeping their cash in interest-bearing savings accounts, money market funds and the like. On the other hand, interest expense is the money companies paid in interest for money they borrow. Some income statements show interest income and interest expense separately. Some income statements combine the two numbers. The interest income and expense are then added or subtracted from the operating profits to arrive at operating profit before income tax.
Finally, income tax is deducted and you arrive at the bottom line: net profit or net losses. (Net profit is also called net income or net earnings.) This tells you how much the company actually earned or lost during the accounting period. Did the company make a profit or did it lose money?
Earnings Per Share or EPS
Most income statements include a calculation of earnings per share or EPS. This calculation tells you how much money shareholders would receive for each share of stock they own if the company distributed all of its net income for the period.
To calculate EPS, you take the total net income and divide it by the number of outstanding shares of the company.
Cash Flow Statements
Cash flow statements report a company’s inflows and outflows of cash. This is important because a company needs to have enough cash on hand to pay its expenses and purchase assets. While an income statement can tell you whether a company made a profit, a cash flow statement can tell you whether the company generated cash.
A cash flow statement shows changes over time rather than absolute dollar amounts at a point in time. It uses and reorders the information from a company’s balance sheet and income statement.
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: (1) operating activities; (2) investing activities; and (3) financing activities.
The first part of a cash flow statement analyzes a company’s cash flow from net income or losses. For most companies, this section of the cash flow statement reconciles the net income (as shown on the income statement) to the actual cash the company received from or used in its operating activities. To do this, it adjusts net income for any non-cash items (such as adding back depreciation expenses) and adjusts for any cash that was used or provided by other operating assets and liabilities.
The second part of a cash flow statement shows the cash flow from all investing activities, which generally include purchases or sales of long-term assets, such as property, plant and equipment, as well as investment securities. If a company buys a piece of machinery, the cash flow statement would reflect this activity as a cash outflow from investing activities because it used cash. If the company decided to sell off some investments from an investment portfolio, the proceeds from the sales would show up as a cash inflow from investing activities because it provided cash.
The third part of a cash flow statement shows the cash flow from all financing activities. Typical sources of cash flow include cash raised by selling stocks and bonds or borrowing from banks. Likewise, paying back a bank loan would show up as a use of cash flow.
Read the Footnotes
A horse called “Read The Footnotes” ran in the 2004 Kentucky Derby. He finished seventh, but if he had won, it would have been a victory for financial literacy proponents everywhere. It’s so important to read the footnotes. The footnotes to financial statements are packed with information. Here are some of the highlights:
- Significant accounting policies and practices – Companies are required to disclose the accounting policies that are most important to the portrayal of the company’s financial condition and results. These often require management’s most difficult, subjective or complex judgments.
- Income taxes – The footnotes provide detailed information about the company’s current and deferred income taxes. The information is broken down by level – federal, state, local and/or foreign, and the main items that affect the company’s effective tax rate are described.
- Pension plans and other retirement programs – The footnotes discuss the company’s pension plans and other retirement or post-employment benefit programs. The notes contain specific information about the assets and costs of these programs, and indicate whether and by how much the plans are over- or under-funded.
- Stock options – The notes also contain information about stock options granted to officers and employees, including the method of accounting for stock-based compensation and the effect of the method on reported results.
Read the MD&A
You can find a narrative explanation of a company’s financial performance in a section of the quarterly or annual report entitled, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” MD&A is management’s opportunity to provide investors with its view of the financial performance and condition of the company. It’s management’s opportunity to tell investors what the financial statements show and do not show, as well as important trends and risks that have shaped the past or are reasonably likely to shape the company’s future.
The SEC’s rules governing MD&A require disclosure about trends, events or uncertainties known to management that would have a material impact on reported financial information. The purpose of MD&A is to provide investors with information that the company’s management believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations. It is intended to help investors to see the company through the eyes of management. It is also intended to provide context for the financial statements and information about the company’s earnings and cash flows.
Financial Statement Ratios and Calculations
You’ve probably heard people banter around phrases like “P/E ratio,” “current ratio” and “operating margin.” But what do these terms mean and why don’t they show up on financial statements? Listed below are just some of the many ratios that investors calculate from information on financial statements and then use to evaluate a company. As a general rule, desirable ratios vary by industry.
If a company has a debt-to-equity ratio of 2 to 1, it means that the company has two dollars of debt to every one dollar shareholders invest in the company. In other words, the company is taking on debt at twice the rate that its owners are investing in the company.
Inventory Turnover Ratio = Cost of Sales / Average Inventory for the Period
If a company has an inventory turnover ratio of 2 to 1, it means that the company’s inventory turned over twice in the reporting period.
Operating Margin = Income from Operations / Net Revenues
Operating margin is usually expressed as a percentage. It shows, for each dollar of sales, what percentage was profit.
P/E Ratio = Price per share / Earnings per share
If a company’s stock is selling at $20 per share and the company is earning $2 per share, then the company’s P/E Ratio is 10 to 1. The company’s stock is selling at 10 times its earnings.
Working Capital = Current Assets – Current Liabilities
- Debt-to-equity ratio compares a company’s total debt to shareholders’ equity. Both of these numbers can be found on a company’s balance sheet. To calculate debt-to-equity ratio, you divide a company’s total liabilities by its shareholder equity, or
- Inventory turnover ratio compares a company’s cost of sales on its income statement with its average inventory balance for the period. To calculate the average inventory balance for the period, look at the inventory numbers listed on the balance sheet. Take the balance listed for the period of the report and add it to the balance listed for the previous comparable period, and then divide by two. (Remember that balance sheets are snapshots in time. So the inventory balance for the previous period is the beginning balance for the current period, and the inventory balance for the current period is the ending balance.) To calculate the inventory turnover ratio, you divide a company’s cost of sales (just below the net revenues on the income statement) by the average inventory for the period, or
- Operating margin compares a company’s operating income to net revenues. Both of these numbers can be found on a company’s income statement. To calculate operating margin, you divide a company’s income from operations (before interest and income tax expenses) by its net revenues, or
- P/E ratio compares a company’s common stock price with its earnings per share. To calculate a company’s P/E ratio, you divide a company’s stock price by its earnings per share, or
- Working capital is the money leftover if a company paid its current liabilities (that is, its debts due within one-year of the date of the balance sheet) from its current assets.
Bringing It All Together
Although this brochure discusses each financial statement separately, keep in mind that they are all related. The changes in assets and liabilities that you see on the balance sheet are also reflected in the revenues and expenses that you see on the income statement, which result in the company’s gains or losses. Cash flows provide more information about cash assets listed on a balance sheet and are related, but not equivalent, to net income shown on the income statement. And so on. No one financial statement tells the complete story. But combined, they provide very powerful information for investors. And information is the investor’s best tool when it comes to investing wisely.
It used to be called the balance sheet. Although the name of this report has changed in the nonprofit world to the “statement of financial position” (SOP), the concept and the equation are essentially the same as any business balance sheet or statement of personal net worth.
|Assets||(what you have or what you are owed)|
|minus||Liabilities||(what you owe to others)|
|equals||Net Assets||(what’s left over)|
The SOP reflects the overall financial position of your organization at a given moment in time. It is the report that shows the accumulated results of all the individual years of your organization’s operations put together. It is important to learn how to read and understand your organization’s SOP report. Following is a discussion of the components of the SOP and what they can mean.
Assets are what your organization has, what is owed to you, what you have invested in, and what you have deposited with others.
What you have:
- Cash in bank accounts, investment accounts, and petty cash
- Things your organization has bought for future use, such as merchandise inventories or supplies
- Fixed assets such as furniture, equipment, and improvements to your facility, listed at cost, that are non-liquid, as the cash has already been spent to acquire them
- Accumulated Depreciation, a “contra asset” (against asset) indicating the extent the fixed asset has decreased in value as it is used up (depreciated) over its useful life
- Collections of art, artifacts, other valuables related to your mission
- Payments your organization has made for goods or services that have not yet been received or used such as annual insurance premiums that could be refunded to you if cancelled, or expenses relating to future fiscal years paid in advance (prepaid expenses)
- Long-term investments of unrestricted or temporarily restricted funds
- Long-term investments of permanently restricted principal such as endowment funds that cannot be used for operations
What is owed to you:
- Grant awards promised to your organization but not yet received
- Revenue earned from services provided by your organization for which payment has not yet been received
- Loans your organization may have made to others
What you have deposited with others:
- Deposits your organization has paid to others and is held by them on your behalf such as advance rent, utilities security deposits, payroll bonds, etc.
Assets are usually listed in order of declining liquidity. Short-term assets are those available as cash or equivalent within one year, and long-term after one year. Assets are a natural “debit balance” meaning that, in an accounting entry, a debit to an asset account will increase it. A negative number (credit balance) in the assets section of a balance sheet is unusual, and should be questioned and explained. The exception is Accumulated Depreciation, which, as noted above, is a “contra asset” (against asset) account that tracks the depletion of the value of fixed assets as they are used.
What you might want to ask when looking at the asset balances:
- Do we have enough cash to pay our bills?
- Is there too much cash in non-interest bearing accounts?
- Are our investments diversified per our investment policy?
- Have we protected the restricted funds?
- Is our cash balance increasing or decreasing?
- Are we collecting what is owed to us in a timely way?
- Are there any we will never receive?
- Do we have an allowance for doubtful accounts?
- What are current vs. long-term portions?
- Are we preparing for future programming?
- Do we have too much on hand or is the inventory too old?
- Do we need to replenish?
Other (Deposits, etc.)
- How much of our assets are held by others and for what purpose?
Fixed Assets (property, plant, equipment, accumulated depreciation)
- Have we invested enough (too much) in property and equipment?
- Do we need to upgrade our equipment or technology?
- How much did we invest in capital assets during the year?
Liabilities are what your organization owes to others or holds on behalf of others.
What you owe:
- Vendor accounts payable (bills for goods and services)
- Amounts payable on company credit cards
- Payroll liabilities (withholdings, federal, state, and local payroll taxes owed; unemployment owed)
- Accrued expenses (usually estimated rather than based on actual bills, for instance: accrued vacation pay or accrued interest)
- The amount accessed from a bank line of credit
- Short-term or long-term loans
What you hold on behalf of others:
- Deferred revenue or refundable advances (funds paid to your organization in advance for services not yet delivered; your organization would be liable to return these funds if the service is not delivered, for example, play subscriptions or tuition for future classes)
- Conditional contributions (funds given to your organization that you are entitled to only if the condition is met, such as a matching grant)
Liabilities are presented in declining order of their maturity. Short-term liabilities are those due within a year. Long-term liabilities are multi-year loans such as mortgages or other funds borrowed by the organization and payable over more than one year. Liabilities are a natural “credit balance” meaning that, in an accounting entry, a credit to a liability account will increase it. A negative number (debit balance) in the liabilities section of a balance sheet is not normal and should be questioned and explained.
What you might want to ask when looking at the liabilities balances:
Accounts Payable/Accrued Expenses
- Are vendors being paid in a timely way?
- Do we have enough cash to pay our bills?
- Are we carrying balances on high-interest credit cards?
- How long have we had these liabilities on the books?
- Are we meeting our tax liabilities in a timely way?
Deferred Revenue/Refundable Advances
- Are we recognizing revenues as they are earned? (This balance will decrease and income increase as services for which the deferred revenue was given are performed.)
- Are we sure no restricted contributions are included as deferred revenue?
- Can we raise the matching funds; meet the condition that gives us the right to the funds?
Line of Credit
- Do we have the means to repay our line of credit?
- Are we strategically using our line of credit?
- Are we using the line of credit to meet our operating expenses?
- How much has the organization borrowed?
- Is the loan internal (from cash reserve) or external?
- Is there a plan for repayment of the loan/mortgage?
The net assets of a nonprofit organization are equivalent to the net worth of the organization. Net assets can be liquid (comprising cash and short-term receivables), or fixed (furniture, fixtures, equipment, inventories, and land & buildings net of long-term debt), or long-term. Generally accepted accounting principles (GAAP) call for an organization’s net assets to be classified as unrestricted (UR), temporarily restricted (TR), or permanently restricted (PR).
Small and midsize nonprofit organizations usually do not have PR net assets such as endowments, and it is usually not advisable, as having an endowment ties up a lot of cash that is not accessible to the organization for operations or program delivery. It is far more advisable for small and midsize nonprofits to build a working capital or operating cash reserve fund before attempting to create an endowment. If a small or midsize nonprofit does have PR net assets, such as an endowment, these net assets usually comprise long-term investments and are not considered liquid.
TR net assets comprise contributions received or promised to the organization that carry a donor imposed restriction as to when (time restriction) or for what purpose (purpose restriction) the funds can be used. Funds that are “carried over” to the subsequent fiscal year for either restriction are shown as TR net assets.
All net assets that are not PR or TR are Unrestricted (UR) and can be used by the organization as its board sees fit. It is useful, at least for internal financial management purposes, to separate liquid from non-liquid UR net assets in order to have a better idea of the organization’s liquidity, the financial resources it can use for day-to-day transactions. A single UR line item balance does not always tell the full story.
For instance, the total UR net asset balance in all three examples below is $100,000.
|NP Org A||NP Org B||NP Org C|
|Unrestricted Net Assets||$100,000|
|Property, Plant & Equipment||$25,000||$120,000|
|Total UR Net Assets||$100,000||$100,000||$100,000|
Nonprofit Org A shows total UR net assets as $100,000 without distinguishing between available vs. fixed (non liquid) net assets. It would be easy to assume the organization was in decent shape with a positive $100,000 in UR net assets. However, with a deeper look at more detailed information as to the composition of the UR net assets as in Examples B or C, different conclusions about those organizations’ financial health would be reached.
Nonprofit Org B shows $75,000 in undesignated net assets that one could assume comprises cash, receivables, and investments available for operations. In addition Org B shows net fixed assets of $25,000, totaling $100,000, a more accurate picture of the organization’s financial position. This organization’s board might want to consider designating some of the $75,000 into a cash reserve fund and an equipment maintenance and replacement fund.
Nonprofit Org C also shows a positive $100,000 in total net assets as well, but its financial picture is very different. In this scenario the organization has spent all its available cash on equipment or its facility and has an accumulated operating deficit of $20,000. Showing the net assets in this greater detail would help this organization’s board to understand why the organization has positive net assets but is still struggling to pay the bills on time.
The above distinctions could be reached by “doing the math” using other totals on the balance sheet, but the objective is to present clear and easily readable reports, and not to make the reader work so hard to figure it out. Accounting for and reporting net assets in these more detailed categories for internal reports is valuable and recommended and gives a clearer picture of the organization’s actual financial position.
Recommended SOP Internal Report Format
A well-formatted SOP report provides accurate and relevant information with enough context for the board to thoroughly understand what’s going on with your organization financially.
Below is a general format for a statement of financial position report recommended for internal reporting purposes. The report for your organization would include more detailed line items in each category, but the objective would be to not exceed one page in length.
The first column is the current year total-to-date for each line item. This report format calls for additional clarification of the line item totals, for instance, to show how much, if any, of the cash is restricted or designated by the board for a specific purpose. This is achieved by including columns to separate restricted funds and board designated funds, showing what is actually available for day-to-day operating.
Showing the financial data in these separate columns allows the board to verify restricted funds are present in the form of cash or receivables, and to see clearly the organization’s liquidity: what is available for day-to-day operations. Because fixed assets are not liquid, they are included in the board designated column, presuming the board approved purchases of equipment, etc.
No accounting software, particularly ones in the price range of most small and midsize nonprofits, can produce a “canned” report with as much context and analysis as the above. Therefore this report is formatted in a spreadsheet and raw data are taken from the accounting software and inserted or linked into the preformatted report for the year-to-date total. Separating the totals into the various columns is a management task done directly in the spreadsheet, unless the accounting software has that capability.
For a “how to” on exporting financial data from QuickBooks accounting software and linking the data into a preformatted Excel report, see the following link:
Custom Excel Reports from QuickBooks Data
For more about setting long-term financial position targets that relate to strategic goals, see the following link:
Net Assets of Nonprofits
FASB116 & 117 (Re: restricted contributions)
SOA (Statement of Activities) aka Profit & Loss, Income Statement
© 2008 Elizabeth Hamilton Foley