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107-Introduction to Financial Statements
  Course 107:
  Introduction to Financial Statements
  Although the words "financial statements" and "accounting" send cold shivers
  down many people's backs, this is the language of business, a language
  investors need to know before buying stocks. The beauty is you don't need to
  be a CPA to understand the basics of the three most fundamental and important
  financial statements: the income statement, the balance sheet, and the
  statement of cash flows. All three of these statements are found in a firm's
  annual report, 10-K, and 10-Q filings.
  
  
  The financial statements are windows into a company's performance and health.
  We'll provide a very basic overview of each financial statement in this lesson
  and go into much greater detail in Lesson 301-303.
  
  
  The Income Statement
  
  What is it and why do I care?
  The income statement tells you how much money a company has brought in (its
  revenues), how much it has spent (its expenses), and the difference between
  the two (its profit). The income statement shows a company's revenues and
  expenses over a specific time frame such as three months or a year. This
  statement contains the information you'll most often see mentioned in the
  press or in financial reports--figures such as total revenue, net income, or
  earnings per share.
  
  The income statement answers the question, "How well is the company's business
  performing?" Or in simpler terms, "Is it making money?" A firm must be able to
  bring in more money than it spends or it won't be in business for very long.
  Firms with low expenses relative to revenues--and thus, high profits relative
  to revenues--are particularly desirable for investment because a bigger piece
  of each dollar the company brings in directly benefits you as a shareholder.
  
  Revenues, Expenses, and Profit
  Each of the three main elements of the income statement is described below.
  
  Revenues. The revenue section is typically the simplest part of the income
  statement. Often, there is just a single number that represents all the money
  a company brought in during a specific time period, although big companies
  sometimes break down revenues in ways that provide more information (e.g.,
  segregated by geographic location or business segment). Revenues are also
  commonly known as sales.
  
  Expenses. Although there are many types of expenses, the two most common are
  the cost of sales and SG&A (selling, general, and administrative) expenses.
  Cost of sales, which is also called cost of goods sold, is the expense most
  directly involved in creating revenue. For example, Gap GPS may pay $10 to
  make a shirt, which it sells for $15. When it is sold, the cost of sales for
  that shirt would be $10--what it cost Gap to produce the shirt for sale.
  Selling, general, and administrative expenses are also commonly known as
  operating expenses. This category includes most other costs in running a
  business, including marketing, management salaries, and technology expenses.
  
  Profits. In its simplest form, profit is equal to total revenues minus total
  expenses. However, there are several commonly used profit subcategories
  investors should be aware of. Gross profit is calculated as revenues minus
  cost of sales. It basically shows how much money is left over to pay for
  operating expenses (and hopefully provide profit to stockholders) after a sale
  is made. Using our example of the Gap shirt before, the gross profit from the
  sale of the shirt would have been $5 ($15 sales price - $10 cost of sales = $5
  gross profit). Operating profit is equal to revenues minus the cost of sales
  and SG&A. This number represents the profit a company made from its actual
  operations, and excludes certain expenses and revenues that may not be related
  to its central operations. Net income generally represents the company's
  profit after all expenses, including financial expenses, have been paid. This
  number is often called the "bottom line" and is generally the figure people
  refer to when they use the word "profit" or "earnings."
  
  
  The Balance Sheet
  
  What is it and why do I care?
  The balance sheet, also known as the statement of financial condition,
  basically tells you how much a company owns (its assets), and how much it owes
  (its liabilities). The difference between what it owns and what it owes is its
  equity, also commonly called "net assets," "stockholder's equity," or "net
  worth."
  
  The balance sheet provides investors with a snapshot of a company's health as
  of the date provided on the financial statement. Generally, if a company has
  lots of assets relative to liabilities, it's in good shape. Conversely, just
  as you would be cautious loaning money to a friend who is burdened with large
  debts, a company with a large amount of liabilities relative to assets should
  be scrutinized more carefully.
  
  Assets, Liabilities, and Equity
  Each of the three primary elements of the balance sheet is described below.
  
  Assets. There are two main types of assets: current assets and noncurrent
  assets. Within these two categories, there are numerous subcategories, many of
  which will be explained in Lesson 302. Current assets are likely to be used up
  or converted into cash within one business cycle--usually defined as one year.
  For example, the groceries at your local supermarket would be classified as
  current assets because apples and bananas should be sold within the next year.
  Noncurrent assets are defined by our left-brained accountant friends as, you
  guessed it, anything not classified as a current asset. For example, the
  refrigerators at your supermarket would be classified as noncurrent assets
  because it's unlikely they will be "used up" or converted to cash within a
  year.
  
  Liabilities. Similar to assets, there are two main categories of liabilities:
  current liabilities and noncurrent liabilities. Current liabilities are
  obligations the firm must pay within a year. For example, your supermarket may
  have bought and received $1,000 worth of eggs from a local farm but won't pay
  for them until next month. Noncurrent liabilities are the flip side of
  noncurrent assets. These liabilities represent money the company owes one year
  or more in the future. For example, the grocer may borrow $1 million from a
  bank for a new store, which it must pay back in five years.
  
  Equity. Equity represents the part of the company that is owned by
  shareholders; thus, it's commonly referred to as shareholder's equity. As
  described above, equity is equal to total assets minus total liabilities.
  Although there are several categories within equity, the two biggest are
  paid-in capital and retained earnings. Paid-in capital is the amount of money
  shareholders paid for their shares when the stock was first offered to the
  public. It basically represents how much money the firm received when it sold
  its shares. Retained earnings represent the total profits the company has
  earned since it began, minus whatever has been paid to shareholders as
  dividends. Since this is a cumulative number, if a company has lost money over
  time, retained earnings can be negative and would be renamed "accumulated
  deficit."
  
  
  The Statement of Cash Flows
  
  What is it and why do I care?
  The statement of cash flows tells you how much cash went into and out of a
  company during a specific time frame such as a quarter or a year. You may
  wonder why there's a need for such a statement because it sounds very similar
  to the income statement, which shows how much revenue came in and how many
  expenses went out.
  
  The difference lies in a complex concept called accrual accounting. Accrual
  accounting requires companies to record revenues and expenses when
  transactions occur, not when cash is exchanged. While that explanation seems
  simple enough, it's a big mess in practice, and the statement of cash flows
  helps investors sort it out.
  
  The statement of cash flows is very important to investors because it shows
  how much actual cash a company has generated. The income statement, on the
  other hand, often includes noncash revenues or expenses, which the statement
  of cash flows excludes.
  
  One of the most important traits you should seek in a potential investment is
  the firm's ability to generate cash. Many companies have shown profits on the
  income statement but stumbled later because of insufficient cash flows. A good
  look at the statement of cash flows for those companies may have warned
  investors that rocky times were ahead.
  
  The Three Elements of the Statement of Cash Flows
  Because companies can generate and use cash in several different ways, the
  statement of cash flows is separated into three sections: cash flows from
  operating activities, from investing activities, and from financing
activities.
  
  The cash flows from operating activities section shows how much cash the
  company generated from its core business, as opposed to peripheral activities
  such as investing or borrowing. Investors should look closely at how much cash
  a firm generates from its operating activities because it paints the best
  picture of how well the business is producing cash that will ultimately
  benefit shareholders.
  
  The cash flows from investing activities section shows the amount of cash
  firms spent on investments. Investments are usually classified as either
  capital expenditures--money spent on items such as new equipment or anything
  else needed to keep the business running--or monetary investments such as the
  purchase or sale of money market funds.
  
  The cash flows from financing activities section includes any activities
  involved in transactions with the company's owners or debtors. For example,
  cash proceeds from new debt, or dividends paid to investors would be found in
  this section.
  
  Free cash flow is a term you will become very familiar with over the course of
  these workbooks. In simple terms, it represents the amount of excess cash a
  company generated, which can be used to enrich shareholders or invest in new
  opportunities for the business without hurting the existing operations; thus,
  it's considered "free." Although there are many methods of determining free
  cash flow, the most common method is taking the net cash flows provided by
  operating activities and subtacting capital expenditures (as found in the
  "cash flows from investing activities" section).
  Cash from Operations - Capital Expenditures = Free Cash Flow
  
  
  The Bottom Line
  Phew!!! You made it through an entire lesson about financial statements. While
  we're the first to acknowledge that there are far more exciting aspects about
  investing in stocks than learning about accounting and financial statements,
  it's essential for investors to know the language of business. We also
  recommend you sharpen your newfound language skills by taking a good look at
  the more-detailed discussion on financial statements in Lessons 301-303.