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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Learn how to read, understand, analyze, and interpret different types of financial reports
In the newly revised and updated 10th Edition of How to Read a Financial Report, seasoned accounting, financial, and business consultant Tage C. Tracy guides readers through reading, understanding, analyzing, and interpreting various types of financial reports, including cash flow, financial condition, and profit performance reports. This book also reveals the various connections between different financial metrics, reports, and statements, discusses changes in accounting and finance reporting rules, current practices, and recent trends, and explains how financial information can be manipulated, such as through inclusion or omission of certain KPIs.
This bestselling guide uses jargon-simplified and easy-to-understand language to make the information accessible to all, regardless of finance or accounting background. Updates to the 10th Edition include:
- Relevant terminology and issues critical to understand in today's economic environment.
- New material on loans, debt, and using financial reports and statements to understand performance.
- The connection of capital including debt and equity to the income statements and cash flow statements.
- Expanded financial analysis tools and ratios that provide a deeper understanding of a company's financial performance and strength.
- A more in-depth overview of how company's may engineer financial results and how understanding cash flows can help root out fraud.
An essential all-in-one guide on the art of reading a financial report and avoiding common pitfalls and misconceptions, How to Read a Financial Report earns a well deserved spot on the bookshelves of all business leaders and investors who want to be able to read and understand financial reports and statements like a professional.
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Seitenzahl: 381
Veröffentlichungsjahr: 2024
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Table of Contents
Cover
Table of Contents
Title Page
Copyright
LIST OF EXHIBITS
PREFACE TO THE TENTH EDITION
Part One: FUNDAMENTALS
1 ARMING YOU WITH ESSENTIAL KNOWLEDGE
What Is a Financial Report?
Financial Information and the Big Three Financial Statements
Let’s Speak the Proper Language
A Final Word before You Dive into the Rest of the Book
2 STARTING WITH CASH FLOWS
Summary of Cash Flows for a Business
What Does the Cash Flows Summary
Not
Tell You?
Profit Is Not Measured by Cash Flows
Cash Flows Do Not Reveal Financial Condition
A Few Additional Thoughts to Keep in Mind
3 BEDROCK FINANCIAL STATEMENT #1: THE INCOME STATEMENT
The Income Statement: A Closer Look
Reporting Profit Performance: The Income Statement
4 BEDROCK FINANCIAL STATEMENT #2: THE BALANCE SHEET
Reporting Financial Condition: The Balance Sheet
5 REPORTING CASH FLOWS
The Statement of Cash Flows
Cash versus Accrual Accounting
Financial Tasks of Business Managers
Part Two: CONNECTIONS
6 FITTING TOGETHER FINANCIAL STATEMENTS
One Problem in Financial Reporting
Connecting the Dots
7 SALES REVENUE AND ACCOUNTS RECEIVABLE
Exploring One Link at a Time
How Sales Revenue Drives Accounts Receivable
Accounting Issues
8 COSTS OF SALES REVENUE, INVENTORY, AND ACCOUNTS PAYABLE
Acquiring Inventory on the Cuff
Accounting Issues: Accounts Payable
Holding Products in Inventory Until They Are Sold
Inventory Control
Accounting Issues
9 OPERATING EXPENSES AND PREPAID EXPENSES
Paying Certain Operating Costs before They Are Recorded as Expenses
Accounting Issues: Using Prepaid Expenses to Massage the Numbers
10 DEPRECIATION AND AMORTIZATION EXPENSE, AND FIXED AND OTHER LONG-TERM ASSETS
Overview of Expense Accounting
Up First, Depreciation Expense
Accumulated Depreciation and Book Value of Fixed Assets
Book Values and Current Replacement Costs
Intangible Assets
11 OPERATING EXPENSES AND ACCOUNTS PAYABLE
Recording Expenses before They Are Paid
12 ACCRUING LIABILITY FOR UNPAID EXPENSES
Recording Accrued Liability for Operating Expenses
Accounting Issues
13 INCOME TAX EXPENSE AND ITS LIABILITY
Taxation of Business Profit
Accounting Issues
14 INTEREST EXPENSE, ACCRUED LIABILITIES, AND LOANS PAYABLE
Bringing Interest Expense Up to Snuff
Type, Purpose, and Source of Loans
Accounting Issues
15 NET INCOME, RETAINED EARNINGS, AND EARNINGS PER SHARE (EPS)
Net Income into Retained Earnings
Earnings per Share (EPS)
Accounting Issues
16 CONNECTING THE CASH FLOW DOTS
Profit versus Cash Flow from Profit
Changes in Assets and Liabilities That Impact Cash Flow from Operating Activities
Profit before the Bottom Line
Completing the Statement of Cash Flows
Seeing the Big Picture of Cash Flows
Accounting Issues
Part Three: USING AND ANALYZING FINANCIAL STATEMENTS
17 FOOTNOTES AND MANAGEMENT DISCUSSIONS
Financial Report Content in Addition to Financial Statements
Financial Statements: A Brief Review
Why Footnotes?
Two Types of Footnotes
Management Discretion in Writing Footnotes
Analysis Issues
18 FINANCIAL STATEMENT RATIOS AND ANALYSIS: STRENGTH
Financial Reporting Ground Rules
Financial Statement Preliminaries
Benchmark Financial Ratios—Strength
Final Comments
19 FINANCIAL STATEMENT RATIOS AND ANALYSIS: PERFORMANCE
Financial Performance versus Financial Strength
Two Cash Flow Ratios to Chew On
20 FINANCIAL ENGINEERING
What Financial Engineering Is Not
What Financial Engineering Is
Common Types of Financial Engineering
Financial Engineering and QW Example Tech, Inc.
A Final Word
21 FINANCIAL FRAUD, AKA COOKING THE BOOKS
Non-Number Fraud Flags
Financial Fraud Flags
Critical Thoughts on Fraud
The Moral of the Story
22 CPAs AND FINANCIAL REPORTS
Certified Public Accountant (CPA)
From Preparation to Audit of Financial Reports by CPAs
Why Audits?
Do Auditors Discover Financial Reporting Fraud?
23 BASIC QUESTIONS, BASIC ANSWERS
When You Buy Stock Does the Company Get Your Money?
Are Financial Reports Reliable?
Are Some Financial Statements Misleading and Fraudulent?
Should You Take the Time to Compute Financial Statement Ratios?
Why Read Financial Statements, Then, If You Won’t Find Information That Has Been Overlooked by Others?
The Financial Statements and Footnotes of Large Public Companies Would Take Several Hours to Read Carefully: What’s the Alternative?
Is There a Basic Test to Gauge a Company’s Financial Performance?
Do Financial Statements Report the Truth, the Whole Truth, and Nothing but the Truth?
Does Its Financial Report Explain the Basic Profit-Making Strategy or Profit Model of a Business?
Does the Market Price of a Public Company’s Stock Shares Depend Directly and Only on the Information Reported in Its Financial Statements?
Does the Balance Sheet of a Private Business Tell the Market Value of the Business?
Do Books on Investing and Personal Finance Refer to Financial Statements?
A Very Short Summary
ABOUT THE AUTHOR
INDEX
End User License Agreement
List of Tables
Chapter 2
EXHIBIT 2.1 UNAUDITED SUMMARY OF CASH FLOWS, SIMPLE FORMAT
Chapter 3
EXHIBIT 3.2 UNAUDITED SINGLE-STEP INCOME STATEMENT
Chapter 5
EXHIBIT 5.2 UNAUDITED—REVENUE & EXPENSES, CASH VERSUS ACCRUAL
Dol
...
Chapter 16
EXHIBIT 16.2 EARNINGS BEFORE INTEREST, TAXES, DEPRECIATION,...
EXHIBIT 16.4 SUMMARY CASH FLOW RECONCILIATION
Chapter 18
EXHIBIT 18.1 SUMMARIZED EXTERNAL FINANCIAL STATEMENTS OF BUSINESS (WITHOUT F...
Chapter 19
EXHIBIT 18.1 SUMMARIZED EXTERNAL FINANCIAL STATEMENTS OF BUSINESS (WITHOUT F...
List of Illustrations
Chapter 3
EXHIBIT 3.1 AUDITED FINANCIAL STATEMENTS—INCOME STATEMENT
Dollar Amou
...
Chapter 4
EXHIBIT 4.1 AUDITED FINANCIAL STATEMENTS—BALANCE SHEET
Dollar Amounts
...
Chapter 5
EXHIBIT 5.1 AUDITED FINANCIAL STATEMENTS—STATEMENT OF CASH FLOWS
Doll
...
Chapter 6
EXHIBIT 6.1 CONNECTING ANNUAL INCOME STATEMENT WITH YEAR-END BALANCE SHEET...
EXHIBIT 6.2 CONNECTING BALANCE SHEET CHANGES WITH STATEMENT OF CASH FLOWS...
Chapter 7
EXHIBIT 7.1 SALES REVENUE & ACCOUNTS RECEIVABLE
Chapter 8
EXHIBIT 8.1 INVENTORY & ACCOUNTS PAYABLE
EXHIBIT 8.2 COSTS OF SALES REVENUE & INVENTORY
Chapter 9
EXHIBIT 9.1 OPERATING EXPENSES & PREPAID EXPENSES
Chapter 10
EXHIBIT 10.1 DEPRECIATION & AMORTIZATION EXPENSE AND LONG-TERM ASSETS...
Chapter 11
EXHIBIT 11.1 OPERATING EXPENSES & ACCOUNTS PAYABLE
Chapter 12
EXHIBIT 12.1 BUSINESS EXPENSES & ACCRUED LIABILITIES
Chapter 13
EXHIBIT 13.1 INCOME TAX EXPENSE & INCOME TAXES PAYABLE
Chapter 14
EXHIBIT 14.1 INTEREST EXPENSE, ACCRUED LIABILITIES, & LOANS PAYABLE
Chapter 15
EXHIBIT 15.1 NET INCOME, RETAINED EARNINGS, & EARNINGS PER SHARE (EPS)...
Chapter 16
EXHIBIT 16.1 CASH FLOW FROM OPERATING (PROFIT-MAKING) ACTIVITIES
EXHIBIT 16.3 CASH FLOW FROM INVESTING & FINANCING ACTIVITIES
Chapter 20
EXHIBIT 20.1 FINANCIAL ENGINEERING OF THE INCOME STATEMENT
Chapter 21
EXHIBIT 21.1 ADJUSTED SUMMARIZED EXTERNAL FINANCIAL STATEMENTS OF BUSINESS (...
Guide
Cover
Table of Contents
Title Page
Copyright
LIST OF EXHIBITS
PREFACE TO THE TENTH EDITION
Begin Reading
ABOUT THE AUTHOR
INDEX
Advertisement
End User License Agreement
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HOW TO READ A FINANCIAL REPORT
WRINGING VITAL SIGNS OUT OF THE NUMBERS
Tenth Edition
TAGE C. TRACY
Copyright © 2025 by Tage C. Tracy. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permission.
Trademarks: Wiley and the Wiley logo are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries and may not be used without written permission. All other trademarks are the property of their respective owners. John Wiley & Sons, Inc. is not associated with any product or vendor mentioned in this book.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Further, readers should be aware that websites listed in this work may have changed or disappeared between when this work was written and when it is read. Neither the publisher nor authors shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.
Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic formats. For more information about Wiley products, visit our web site at www.wiley.com.
Library of Congress Cataloging-in-Publication Data is Available
ISBN 9781394268696 (Paperback)
ISBN 9781394268702 (ePDF)
ISBN 9781394268719 (ePUB)
Cover Design: Wiley
Cover Image: © John Wiley & Sons, Inc.
LIST OF EXHIBITS
Exhibit 2.1 Unaudited Summary of Cash Flows, Simple Format
Exhibit 3.1 Audited Financial Statements—Income Statement
Exhibit 3.2 Unaudited Single-Step Income Statement
Exhibit 4.1 Audited Financial Statements—Balance Sheet
Exhibit 5.1 Audited Financial Statements—Statement of Cash Flows
Exhibit 5.2 Unaudited—Revenue & Expenses, Cash Versus Accrual
Exhibit 6.1 Connecting Annual Income Statement with Year-End Balance Sheet
Exhibit 6.2 Connecting Balance Sheet Changes with Statement of Cash Flows
Exhibit 7.1 Sales Revenue & Accounts Receivable
Exhibit 8.1 Inventory & Accounts Payable
Exhibit 8.2 Costs of Sales Revenue & Inventory
Exhibit 9.1 Operating Expenses & Prepaid Expenses
Exhibit 10.1 Depreciation & Amortization Expense, and Long-Term Assets
Exhibit 11.1 Operating Expenses & Accounts Payable
Exhibit 12.1 Business Expenses & Accrued Liabilities
Exhibit 13.1 Income Tax Expense & Income Taxes Payable
Exhibit 14.1 Interest Expense, Accrued Liabilities, & Loans Payable
Exhibit 15.1 Net Income, Retained Earnings, & Earnings per Share
(
EPS)
Exhibit 16.1 Cash Flow from Operating (Profit-Making) Activities
Exhibit 16.2 Earnings Before Interest, Taxes, Depreciation, & Amortization (EBITDA)
Exhibit 16.3
Cash Flow from Investing & Financing Activities
Exhibit 16.4 Summary Cash Flow Reconciliation
Exhibit 18.1 Summarized External Financial Statements of Business (Without Footnotes)
Exhibit 20.1 Financial Engineering of the Income Statement
Exhibit 21.1 Adjusted Summarized External Financial Statements of Business (Without Footnotes)
PREFACE TO THE TENTH EDITION
It’s with a heavy heart that I must pass along the sad news that this will be the first edition of How to Read a Financial Report that will be completed without my dad’s direct involvement. My father, Professor Emeritus John A. Tracy, passed away in 2022. In honor of him, the 10th edition of How to Read a Financial Report has been updated, keeping in mind his undeniable spirit, dedication, and passion for educating you, the reader. His goal, which I carry forward, was always to communicate important concepts and topics associated with reading and understanding financial reports and financial statements. What my dad started, I’m deeply honored to continue. The purpose of this book is helping readers master the art of translating complex accounting and financial topics into easy to understand content that almost any interested party can quickly learn and apply in the real world. So, in tribute to TOP, The Old Pro, the nickname I tagged him with years ago: May the mission he started roughly 40 years ago continue for eternity.
In my dad’s words:
This book has stood the test of time and reminds all of us that fortifying your understanding of financial reports and statements has been, is, and will always be essential and indispensable evergreen knowledge. After 40 years in print, spanning ten editions, it has survived countless economic and financial challenges—and is still going strong. My son Tage joined me as coauthor in the previous edition, and I willingly share credit with him for the book’s continued success.
The 10th edition of How to Read a Financial Report continues to emphasize an important theme similar to the previous editions of the book; that is, it catches up with significant changes, trends, and strategies in financial reporting since the previous edition was released in 2020. It also broadens our discussion of how financial results are communicated, provides a rundown of important terminology, and offers new and critical material that will further your ability to analyze and interpret a company’s financial results. This edition also includes a robust discussion of financial fraud and financial engineering.
Overall, the architecture of the book remains unchanged. The framework of the book has proved highly successful for 40 years, so I’d be a fool to mess with this winning formula.
Cash flows are underscored and emphasized throughout the book and remain a central focus of the current edition. In business, everything starts and ends with cash flow, which is a concept I never stray too far from. If there’s one lesson to remember in the business world, never, ever run out of cash!
As with all previous editions, this book explains the connectivity of the different pieces of information reported in financial statements. In reading financial statements you need to know how the different elements are connected. You cannot grab one piece of information in one place and ignore its other dimensions and contexts. Financial statements are, essentially, spreadsheets, although they do not demonstrate what’s connected to what. This book tackles this topic head on and provides clear and concise exhibits and explanations of exactly how each of the big three financial statements are connected.
I have prepared all the exhibits in the book as Excel worksheets. To request a copy of the workbook file of all the exhibits, please feel free to contact me via email at [email protected].
In summary, I express my sincere thanks to all of you who have sent compliments about our book and how it has assisted you to better understand financial reports and financial statements. The royalties from sales of the book are nice, but the messages from readers form the real icing on the cake.
Not many books of this ilk make it to the tenth edition. It takes a trusting and committed working partnership between the author and the publisher. I most sincerely thank the many people at John Wiley & Sons who have worked with me and my dad for over four decades to produce and deliver such a wonderful book.
In closing, Gordon B. Laing was the original editor and sponsor of this book. His superb editing was a blessing. We couldn’t have done it without him.
Tage C. Tracy
Anthem, Arizona
May 2024
Part OneFUNDAMENTALS
1ARMING YOU WITH ESSENTIAL KNOWLEDGE
In past editions of this book, Chapter 1 dove right into the critical concept of gaining a clear understanding of how businesses produce and consume cash. In fact, we opened with this all-important statement:
Savvy business managers, owners, lenders, investors, and analysts pay a significant amount of attention to cash flows. Cash flows represent the heartbeat and pulse of every business, and without producing a steady heartbeat and healthy pulse of positive cash flows, a business would soon most likely end up on life support—or worse yet, die.
For this edition, I felt that I should begin by providing an explanation of the primary differences between what constitutes a financial report and the purpose and role of financial statements. While I touch on the elements of preparing financial reports, the primary focus of this book is how to read and understand financial statements, which make up the nerve center of the financial report. (Do not fret, as I will get to the critical concept of cash flows in Chapter 2 and again in Chapter 5.)
What Is a Financial Report?
To start, it would be helpful to clarify the difference between the purpose and function of financial statements and a company’s financial reports. In this context, I am referring to publicly traded companies and other large businesses that are required, by regulatory bodies such as the SEC, or by third parties such as a large lender, to issue quarterly or annual financial reports. An important concept to keep in mind is that financial statements represent a part (albeit a critical part) of a company’s financial report. Looking at it differently, it would be extremely difficult to produce a financial report without including financial statements, but financial statements can be produced and presented to third parties without a full financial report. In effect, financial statements by themselves are a financial report.
It is important to keep in mind that while a company’s financial statements represent the backbone for analyzing and evaluating its financial performance, financial reports include extensive additional financial, business, legal, and regulatory material that accompany the financial statements. The actual financial statements may take up anywhere from three to six pages of an external business financial report, while the complete financial report may often exceed 100 pages (thanks to management providing their discussion and assessment of operating results, along with the required footnotes that accompany audited financial statements).
Although this book is about how to read and understand financial statements, understanding what additional content and data is most often included in financial reports, and why, makes sense because I focus on two primary tranches of additional information: management discretionary disclosures and financial statement footnotes (including supporting schedules). I describe these as follows:
Management discussion of operating results (MDOR
)
:
The MDOR, sometimes referred to as the MD&A (management discussion and analysis), is a section of a business’s financial report that is generally reserved for management to provide an assessment or overview of key operating results, market trends, industry data, strategies, and so on that management believes would be beneficial to external parties to help them more fully understand the operating results of a business. The MDOR is usually located at the front of the financial report that is prepared periodically and externally distributed. Quite often, it starts with a shareholder or investor letter prepared by the company’s board chair or CEO. There is no doubt that the MDOR can provide useful information to external parties, but it should be noted that, generally speaking, the information in the MDOR has not been audited by an independent CPA firm. Rather, it contains information that is presented by a company’s management team. Translation: The MDOR tends to include a broader range of business information that has been internally prepared by the company and incorporates more opinions and perspectives than audited financial statements, which tend to stay factual in nature.
Financial statement footnotes and supporting schedules:
In contrast to MDOR disclosures, financial statement footnotes and supporting schedules (sometimes referred to as supplemental reports) are part of the audited financial statements, prepared by an independent CPA firm with support from company financial executives and legal counsel. Often, these are located toward the back of the externally prepared financial report, just after the financial statements. The goal of financial statement footnotes is to provide additional clarity, support, and detail to validate and substantiate the information provided in the financial statements. For example, if a company has established a reserve for a potential liability due to uncertain legal actions brought against the company, the footnote will help shed additional light on the nature of the legal action and potential damages. Financial statement footnotes tend to avoid presenting management opinions and are more likely to stick to the facts. Yet, even here, I must point out an irony in the accounting and financial reporting world; that is, while the purpose of audited financial statements and associated footnotes is to present external financial reports that are prepared by independent, third-party CPAs and are factual in nature, almost all audited financial statements and associated footnotes rely heavily on the use of estimates when calculating operating results. This concept underscores the importance of remembering that accounting is often just as much an art as a science! In short, footnotes and supporting schedules represent an essential part of every CPA-prepared or CPA-audited financial report. Financial statements would be naked without their footnotes.
In summary, it is important to remember that this chapter refers to financial information as presented in external financial reports—those that circulate outside the business. These financial reports and communications are designed mainly for use by outside business shareowners, analysts, company lenders, governmental agencies, and the like, with the business shareowners, executive management team, and creditors (e.g., lenders, strategic partners and vendors, etc.) representing the three primary stakeholders in the business. Internal business executives, managers, and staff have access to significantly more information than that released in the company’s external financial reports. This information is incredibly detailed in nature and is usually highly confidential, so external disclosure is tightly guarded. A more thorough discussion on internally generated business financial information appears in our sister book, How to Write a Financial Report, and is supported by the words of wisdom bestowed on us by Warren Buffett: When analyzing financial information, “the devil is in the details.” It goes without saying that invaluable internal financial information is both highly sought after and closely guarded, given its importance.
Financial Information and the Big Three Financial Statements
It should be obvious that business managers, company lenders, investors, regulatory agencies, and countless other parties need to clearly understand an entity’s financial performance, in a timely manner. This is common sense, no doubt, but you would be absolutely amazed at how often this basic concept is overlooked or, for lack of a better term, neglected by even the senior most internal company executive management teams.
Expanding on this thought, I would like to further note that all, yes all, businesses, organizations, non-for-profits, and governments (referred to as “entities” throughout this chapter), in one fashion or another, should produce reliable financial information on which business and economic decisions are made. Here again, this should be common sense, but I selectively used the term should because not all entities actually produce reliable financial information. Do not ask us how these entities prepare tax returns, execute financial management tasks, or make business and economic decisions, but in the spirit of full transparency, assuming all entities actually maintain accounting systems and produce reliable financial information can be a fatal error.
Focusing on entities that produce reliable financial information, I would like to note that financial information comes in all shapes, sizes, and forms ranging from something as small as preparing a flash report that summarizes the sales performance of a sales representative in a specific geographic region to something as large as Apple, Inc. producing its annual report for shareholders and other external readers to peruse.
The primary means of communicating an entity’s financial information to external parties is via its financial statements, the preparation of which is one of the main functions performed by accountants. In a sense, accountants act as the financial scorekeepers of the entity as it is their job to ensure that complete, accurate, reliable, and timely (i.e., CART) financial statements are produced.
Financial statements are sent regularly by an entity to both internal and external parties including lenders, investors, financial analysts, regulatory bodies, internal management—and anyone else with a legitimate interest in the business for that matter. The entity’s financial statements should include three primary statements including the balance sheet, which communicates the entity’s financial condition at a point in time; the income statement, which reports the entity’s profit-motivated activities over a period of time (e.g., for a full calendar year or 12 months); and the statement of cash flows, which reports how an entity produces and consumes cash over the same period of time as the income statement. Collectively, I refer to these as the big three financial statements.
You will notice that I use that darn word should again, as quite often you will come across less sophisticated and private entities that elect to omit the statement of cash flows from its financial information. Maybe it is a result of ignorance, not having enough time, or just being lazy, but as I begin our discussion on the big three financial statements, it should become abundantly clear just how important all three primary financial statements are and the key role each one plays. Here I provide an expanded explanation of each of the big three financial statements:
The balance sheet:
The financial condition of a business is communicated in an accounting report called the
balance sheet
. In its simplest form, the balance sheet reports the assets owned by a business, the liabilities owed by the business (to third parties), and the net ownership equity (assets minus liabilities), all at a point in time.
The income statement (or P&L):
The financial performance of a business that reports and measures its profit- or loss-making activities is presented in an accounting report called the
income statement
. In its simplest form, the income statement reports sales revenue, costs of goods sold, operating expenses, other expenses or income, and finally, whether a net profit or loss was generated and covers a period of time (e.g., 12-month period of 1/1/24 through 12/31/24).
The statement of cash flows:
Finally, the last of the big three financial statements, and often the most important (but least understood), is the
statement of cash flows
. In its simplest form, this financial statement reports a business’s cash sources (i.e., how it generates cash), uses (i.e., how it consumes cash), and net change. Similar to the income statement, the statement of cash flows covers a time period which is almost always consistent with the time period reported in the income statement.
It should be noted that alternative titles for these financial statements are common. For the balance sheet, alternatives include “statement of financial condition” or “statement of financial position.” An income statement may be titled “statement of operations” or “earnings statement” as well as the “profit and loss” or, more simply, the P&L. For consistency, I stick with the names balance sheet and income statement. The statement of cash flows is almost always called just that (but sometimes referred to as a cash flow statement).
Finally, I would like to mention that in almost all cases when financial statements are distributed to external parties, the financial statements are supplemented with additional information in the footnotes and supporting schedules. One quite common supporting schedule is the statement of changes in stockholders’ (owners’) equity. The broader term financial report refers to all this, plus any additional commentary from management, narrative explanations, graphics, and promotional content that accompany the financial statements, footnotes, and supporting schedules. Distribution of the financial reports of a private business may be restricted to its top-level managers, its shareholders, and major creditors. Federal laws require publicly owned businesses to make their financial reports publicly available.
Let’s Speak the Proper Language
One element people often overlook when reading financial reports and financial statements is that you must learn to speak “accountantnesse” or “financesse.” That is, accountants and financial professionals often use a variety of specific terms and acronyms to describe financial information. While I do not expect you to become an expert overnight, mastering the following basic list of standard financial terminology should be helpful in your quest to learn how to read a financial report (ensuring that you are well versed with financial lingo). Here are some basic terms and acronyms for you to digest:
Top line: A company’s net sales revenue generated over a period of time (e.g., for a 12-month period).
COGS or COSR: Pronounced like it is spelled; stands for costs of goods sold (for a product-based business) and costs of sales revenue (for a service-based or hybrid service- and product-based business). COGS or COSR tend to vary directly (or in a linear fashion) with the top-line sales revenue.
Gross profit and margin: Sometimes used interchangeably, gross profit equals your top line less your COGS or COSR. The gross margin (a percentage calculation) is determined by dividing your gross profit by the top line.
Op Ex: A rather broad term that is short for operating expenses, which may include selling, general, administrative, corporate overhead, and other related expenses. Unlike COGS or COSR, Op Ex tends to be fixed in nature and will not vary directly with the top-line sales revenue.
SG&A: Selling, general, and administrative expenses. Companies may distinguish between Op Ex and SG&A to assist parties with understanding the expense structure of its operations in more detail.
Bottom line: A company’s net profit or loss after all expenses have been deducted from net sales revenue. Being “in the black” indicates that a net profit is present and being “in the red” indicates that a net loss was generated.
Breakeven: The operating level where a company generates zero in profit or loss as it “broke even.” Additionally, it is the amount of sales revenue that needs to be generated to cover all COGS/COSR and Op Ex.
Contribution margin: You may hear companies reference the term
contribution margin
. What this generally refers to is the profit generated by a specific operating unit or division of a company (but not for the company as a whole). Most larger companies have multiple operating units or divisions, so the profit (or loss) of each operating unit or division is calculated to determine how much that specific unit or division “contributed” to the overall performance of the entire company.
Cap Ex: While Op Ex is associated with the income statement, Cap Ex stands for capital expenditures and is a calculation of how much a company invested in tangible or intangible assets during a given period (for equipment, machinery, new buildings, investments in intangible assets, etc.).
YTD, QTD, MTD: These are simple and stand for year to date, quarter to date, or month to date. For example, a flash report may present QTD sales for the period of 10/1/24 through 11/15/24 (so management can evaluate sales levels through the middle of a quarter).
FYE and QE: These two items stand for fiscal year-end and quarter-end. Most companies utilize a fiscal year-end that is consistent with a calendar year-end of 12/31/xx (which would make their quarter-ends 3/31/xx, 6/30/xx, 9/30/xx, and 12/31/xx). Please note that several companies utilize FYEs that are different than a calendar year-end to match their business cycle with that of a specific industry. For example, companies that cater to the education industry may use a FYE of 6/30/xx to coincide with the typical operating year for schools or colleges (which tend to run from 7/1/xx through 6/30/xx).
Not only will you find referrals to these terms and acronyms throughout the book, but you will also quickly discover that in the real world, these terms and acronyms are used frequently. The better armed you are with this knowledge, the more credibility you will carry when you end up having to swim with the financial sharks out in the dog-eat-dog world of global capitalism.
A Final Word before You Dive into the Rest of the Book
The primary goals of including this new chapter into the book were threefold. First, I want to start our discussion with a concise explanation of the difference between financial reports and financial statements. Second, I hope to clearly identify the importance of the big three financial statements. Third, I want to arm you with some additional terminology to help you gain a better understanding of the world in which accountants and financial professionals live. If you can master these three objectives out of the gate, you will find that you already have a leg up when diving into financial reports and financial statements.
Moving ahead, I will first turn our attention toward providing you invaluable insight and knowledge on how to actually read financial statements (the heart and soul of the financial report) to better understand critical connections between the big three financial statements, which are covered in depth in Part Two. This is followed by real-life tools and reference material on how to analyze financial statements, (as covered in Part Three), to evaluate the operating performance and financial health of a business. I also sprinkle in a couple of chapters on how companies can game (for lack of a better term) the presentation of operating results in financial statements through the use of financial engineering, and I’ve included a chapter on identifying potential financial fraud, a topic that is of utmost importance given the recent implosions of FTX in 2023 and Wirecard in 2020 (companies that operated in the cryptocurrency and fintech spaces, respectively).
2STARTING WITH CASH FLOWS
As stated in Chapter 1, I cannot emphasize the importance of this concept (as it is well worth repeating):
Savvy business managers, owners, lenders, investors, and analysts pay a significant amount of attention to cash flows. Cash flows represent the heartbeat and pulse of every business and without producing a steady heartbeat and healthy pulse of positive cash flows, a business would soon most likely end up on life support—or worse yet, die.
Given the importance of generating cash flows, I cover this topic out of the gate before I jump into discussing the income statement (Chapter 3) and the balance sheet (Chapter 4). I would also like to remind you of some simple logic underlying the big three financial statements, which were introduced in Chapter 1:
First,
understand
the income statement (covered in
Chapter 3
).
Second,
trust
the balance sheet (examined in
Chapter 4
).
Third, and most importantly,
rely
on the statement of cash flows (explored in depth in
Chapters 2
and
5
).
As you work through this book, it will become readily apparent as to why it is essential to understand a company’s cash inflows and outflows. More importantly, you must recognize how you can use this information to better ascertain the financial performance and reliability of a company’s overall financial performance.
Summary of Cash Flows for a Business
A business’s cash inflows and outflows appear and are reported in a summary of cash flows, most often referred to as the statement of cash flows (one of the big three financial statements). For our example in Exhibit 2.1, I use a technology business that has been operating for many years. This established business has historically generated a profit on an annual basis but more recently, it hit a bit of a bump in the road as it pivoted its business interests toward selling more software products and fewer hardware products. Equally important, it maintains a solid financial condition to ensure the company has ample liquidity and cash to support ongoing operations. The company has a good credit history and financial lending groups extend it loans on competitive terms. Its present stockholders would be willing to invest additional capital in the business, if needed.
None of this comes easy (as most business owners will attest). It takes a strong management team and sound business model to generate consistent profits, manage and secure capital (both debt and equity), and, for lack of a better term, stay out of financial hot water. Many businesses fail these imperatives, especially when the going gets tough, whether it be from difficult macroeconomic conditions, increased competition, or rapidly changing customer demands.
Exhibit 2.1 introduces you to our fictitious technology company, QW Example Tech, Inc., which I will use throughout the book as our basis for presenting, reading, and analyzing financial information, statements, and reports. Further, I will also present multiple years of financial information to assist with providing more insight into how to better understand and read financial statements.
Before I provide a more detailed explanation of the cash inflows and outflows summarized in Exhibit 2.1, please keep these three points in mind:
The format presented in
Exhibit 2.1
is not within the guidelines dictated by generally accepted accounting principles (GAAP), but rather has been simplified for ease of review and understanding. This is why the header to
Exhibit 2.1
references summary of cash flows and not a financial statement. In
Chapter 5
, I present a formal statement of cash flows in Exhibit 5.1 that is within the guidelines established by GAAP. One consistency across the exhibits will be that the change in cash between the two years will be exactly the same (which should be expected).
Second, note the reference to “unaudited.” This reference is always extremely important to keep in mind because, when a qualified third party (e.g., a CPA firm) is retained to audit financial information, the report issued will clearly state that the financial information has been audited. If no mention is made to the financial information being audited or it clearly states that the financial information is unaudited, this usually indicates the financial information has been prepared internally by the company. This is not to say the financial information is incorrect or inaccurate, but rather to indicate that it has not been examined, reviewed, evaluated, or audited by an independent third party, so there is a higher risk of errors or omissions.
Third, in
Exhibit 2.1
I reference profit in lieu of income for ease of presentation and understanding. It is important to keep in mind that, for most businesses, profit or net profit is synonymous with the term income or net income, which I use interchangeably throughout the book.
EXHIBIT 2.1 UNAUDITED SUMMARY OF CASH FLOWS, SIMPLE FORMAT
Dollar Amounts in Thousands
Summary of Cash Flows
For the Fiscal Year Ending
12/31/2023
Cash Flows from Profit-Making Activities
From sales of products & services to customers, which includes some sales made last year
$ 58,261
For acquiring products & services that were sold, or are still being held for future sale
$ (19,650)
For operating & other expenses, some of which were incurred last year
$ (33,888)
For interest on short-term and long-term debt, some of which applies to different years
$ (407)
For income tax, some of which was paid on last year’s taxable income
$ (438)
Net cash flow from profit-making activities during year
$ 3,879
Cash Flows from Other Sources and Uses
From increasing amount borrowed on interest-bearing notes payable, net of repayments
$ 3,000
From repayments of loans and other amounts borrowed during the year
$ (2,240)
From issuing additional capital stock (ownership shares) in the business
$ 2,500
For building improvements, new machines, new equipment, and intangible assets
$ (5,500)
For distributions or dividends to stockholders from profit
$ (250)
Net cash decrease from other sources and uses
$ (2,490)
Net cash increase (decrease) during year
$ 1,389
Exhibit 2.1 summarizes the company’s cash inflows and outflows for the year that ended 12/31/23 and shows two separate groups of cash flows.
Presented first are the cash flows of its profit-making activities—cash inflows from sales and cash outflows for expenses. Next, the other cash inflows and outflows of the business are presented. This includes capital raised from loans or the sale of stock, repaying borrowings, investing capital in assets, and distributing some of its profit to shareowners.
I assume you’re fairly familiar with the cash inflows and outflows listed in Exhibit 2.1. Therefore, I’ll be brief in describing the cash flows at this early point in the book:
The business received $58,261,000 during the year from selling products and services to its customers. It should be no surprise that this is its largest source of cash inflow. Cash inflow from sales revenue is needed for paying expenses. During the year the company paid $19,650,000 for the products and services it sells to customers as well as incurring sizable cash outflows for operating expenses ($33,888,000), interest on its debt (borrowed money of $407,000), and income taxes ($438,000). The net result of its cash flows of profit-making activities is a $3,879,000 cash increase for the year—an extremely important number that managers, lenders, and investors watch closely.
Moving on to the second group of cash flows during the year, the business increased the amount borrowed on notes payable by $3,000,000 repaid $2,240,000 of borrowings during the year, and its stockholders invested an additional $2,500,000 in the business. Together these three external sources of capital provided a net of $3,260,000, which is in addition to the internal $3,879,000 cash from its profit-making activities during the year. On the other side of the ledger, the business spent $5,500,000 for building improvements, new machines and equipment, and intangible assets. Finally, the business distributed $250,000 in the form of a dividend to its stockholders.
The net result of all cash inflows and outflows is a $1,389,000 cash
increase
during the year. It should be noted that when you see an increase in cash, you shouldn’t jump to any conclusions. In and of itself, a net increase in cash is neither good nor bad. You need more information than appears on the summary of cash flows to come to any conclusions about the financial performance and situation of the business.
What Does the Cash Flows Summary Not Tell You?
In Exhibit 2.1 we see that cash, the all-important lubricant of business activity, increased $1,389,000 during the period (in this case, a year). In other words, the total of cash inflows exceeded the total of cash outflows by this amount for the period. The cash increase and the reasons for it are important information. The summary of cash flows tells us part of the story, but cash flows alone do not tell the whole story. A business’s managers, investors, lenders, and other stakeholders need to know two additional pieces of information that are not reported in an organization’s summary of cash flows. They are:
