A good understanding of financial statements is a vital part of an in-house lawyer’s knowledge.
Whether you’re helping your organisation stay compliant in its accounting obligations, or part of a team looking into a potential merger or acquisition, understanding the numbers is key.
Key financial statements – what do they tell us?
Preparing a financial statement is an exercise in aggregation. Accountants add up all the organisation’s transactions and make adjustments required by accounting standards. The report then shows how the organisation performed during the accounting period and its resulting financial position.
Typically, a set of accounts consists of five elements:
- Statement of financial position (balance sheet);
- Statement of income and expense (profit and loss account);
- Statement of cash flows (cash flow statement);
- Statement of changes in equity; and
- Notes to the accounts.
1. Statement of financial position (balance sheet)
This is a snapshot of the organisation’s financial position and a listing of its resources and obligations on the year-end date.
The core principle of the statement of financial position is the balance sheet equation:
Assets = liabilities + stockholder’s equity, where:
Assets are resources the organisation owns. They’re expected to provide future economic benefit by generating income or reducing outgoings. The two types of assets are:
- Fixed assets (or non-current assets). A fixed asset provides value beyond one accounting period. It appears at its net book value, which is its original cost, minus depreciation, minus any write-down in value due to permanent impairments. For this reason, an asset’s net book value is always declining. Key categories of fixed assets are:
- Land (rarely depreciated);
- Computer hardware and software;
- Fixtures and fittings;
- Plant and machinery;
- Investments in other companies;
- Intangible assets such as brands, trademarks and licensing agreements; and
- Goodwill, which is the premium in the price paid for an acquisition above the value of its assets and liabilities. This asset only arises from an acquisition.
- Current assets. These are cash, cash equivalents or assets that can be converted into cash within one year. The key current assets are:
- Inventory (or stock);
- Prepaid expenses;
- Liquid investments; and
- Cash and cash equivalents such as Bitcoin.
Liabilities are claims on assets by creditors, excluding owners. They represent the organisation’s obligations to make payments of cash, goods or services. Liabilities comprise:
- Current liabilities: obligations payable within one year, such as:
- Payments to suppliers;
- Interest to lenders but not yet paid;
- Short-term borrowing such as bank loans and overdrafts; and
- Expenses not yet payable to a third party, but already incurred, such as wages.
- Long-term liabilities: payments due beyond the next twelve months. They’re usually a form of debt and the terms of the agreements are typically included in disclosures accompanying the financial statements. Examples of long-term liabilities include:
- Long-term loans;
- Deferred compensation;
- Pension obligations; and
- Obligations under finance leases.
Stockholders’ equity, also known as net worth, net book value and shareholder’s equity, is the amount of an organisation’s equity owned by the shareholders. Stockholder’s equity represents claims on the organisation’s assets by its owners after paying creditors and comprises:
- Contributed capital: the money the shareholders invest; and
- Retained earnings: the net total of profits and losses the organisation has generated since inception less all dividends paid out.
Stockholders' equity is a theoretical figure showing how much money the shareholders would receive if the organisation were to be liquidated.
2. Statement of income and expenses (profit and loss statement)
The statement of income and expenses records all the money the organisation earned and the expenses it incurred between the start and finish dates of the accounting period.
It uses the accrual and matching principles to tie recognition of revenue and expenses to business activities. The key elements of the statement of income and expenses are:
- Turnover (or revenue or sales). This is the gross amount of money coming into a business from its trading activities. In most GAAP regimes, revenues are recognised when an organisation makes a sale or provides a service, regardless of when it receives the payment. Revenue recognition is prone to aggressive, and potentially fraudulent, accounting practices. For example, a company may ship orders to customers just before year-end and record it so as to artificially inflate revenue, even though the goods will be coming straight back after the year-end;
- Cost of sales (or cost of goods sold). This is the total cost of creating and selling a product or service. It includes costs for direct labour, materials and overheads and, often, commissions paid to intermediaries involved in the sales. Subtracting the cost of sales from revenue produces the gross margin (or gross profit) figure. This is a measure of how effective an organisation is in pricing its product or service and how effectively it controls its direct costs;
- Operating expenses. These are the organisation’s general expenses, such as:
- Utility bills;
- Travel and entertainment, and
- Office supplies.
- Profit before taxation (PBT). PBT is the operating profit adjusted by adding all financing income, such as interest received from investments, and deducting all financing expenses, such as interest payable on overdrafts and equipment leases;
- EBIT and EBITDA. Some organisations use EBIT (earnings before interest and tax) and EBITDA (earnings before interest, tax, depreciation and amortisation) to create ‘quick and dirty’ measures based on PBT, but with certain non-operating expenses stripped out. Some private equity firms use EBIT to compare portfolio investments with the impact of financing costs excluded. EBITDA goes further and strips out the costs associated with heavy upfront investments in fixed assets, which might otherwise artificially depress standard profit measures. Many people claim that EBITDA is a proxy for cash flow. However, this is only true if there are no major changes in debtors, creditors and stock, which together are known as working capital;
- Profit for the year (or profit after tax or earnings). Profit after tax (PAT) represents the organisation’s earnings after all taxes are deducted from PBT. Because it’s the final profit figure, PAT is the definitive measure of an organisation’s ability to generate a return; and
- Dividends. Dividends are payments made to shareholders from PAT, proportionate to the number of shares they own. They’re not considered an expense as they are discretionary payments to the stockholders in return for their support.
Deducting operating expenses from gross margin produces operating profit.
3. Statement of cash flows
Running out of cash is one of the biggest reasons for business failure.
Because the statement of income and expenses is prepared under the accrual principle, it could include substantial non-cash revenues and expenses. Furthermore, increasingly sophisticated accounting techniques are making it difficult for investors to assess an organisation’s underlying financial health.
For this reason, financial regulators have introduced the statement of cash flows. This sets out how an organisation sources and uses cash during an accounting period. The statement of cash flows has three sections:
- Cash flows from operating activities, a summary of all cash movements relevant to the provision of goods and services. It usually opens with the operating profit from the statement of income and expenses, then shows an adjustment for non-cash items. Finally, it deducts cash tax paid;
- Cash flows from investing activities, a record of amounts relating to acquisitions and disposals of long-term assets. These could include the purchase of a new factory, the sale of a business or returns on investments; and
- Cash flows from financing activities, which lists transactions related to owners, creditors and other finance providers, such as bank loan repayments, new share issues and dividend payments. Under the IFRS accounting framework, cash flows relating to interest payments appear in this section, while under US GAAP they are recorded under operating activities. In conjunction with the main statement of cash flows, there are usually additional, detailed disclosures for cash interest and cash taxes paid, either at the bottom of the statement or in the notes to the statement.
4. Statement of changes in equity
The statement of changes in equity is a reconciliation of the beginning and ending balances in the stockholder’s equity during an accounting period. It normally shows:
- Net profit or loss;
- Dividend payments;
- Proceeds from the issuance or purchase of shares;
- Effects of changes due to errors in prior periods; and
- Effects of changes in the value of certain assets (such as investments).
5. Notes to the accounts
The notes section of a financial statement should aid understanding of the document by:
- Explaining the organisation’s choice of accounting practice as permitted under accounting standards;
- Breaking down complex expense items into their constituent parts;
- Providing extra information, such as staff costs, directors’ remuneration and related party transactions; and
- Detailing finances associated with discontinued operations.
The notes are an integral part of the organisation’s financial disclosure. As they can greatly affect your interpretation of the financial statements, it’s a good idea to read them first to understand the context of the document as a whole.
Bear in mind, too, that some organisations bury uncomfortable information in this part of their accounts.
Financial statements can be complex documents, particularly in the case of large organisations. They represent the aggregation of every transaction the organisation makes and combine this with details about its assets, liabilities, shareholders’ equity and cash flow to present a picture of its financial position. With this in mind, read the notes section first to get a feel for the overall context of a financial statement. Be on the lookout too for any negative data buried in this section.