Beginners Guide to Reading Historical Financial Documents

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When assessing a company’s financial strength—whether privately owned or publicly traded—one of the first places you are likely to look is at its historical financial documents. These ever-important documents provide a glimpse into the company’s financial position at critical points while also describing how the firm generated profits or losses over time. While they cannot predict the future, understanding financial documents is a foundational part of being able to ask important questions and ultimately make your assessment of a company’s viability.

The four most common historical financial documents and their components are described below.

Balance Sheet

The Balance Sheet summarizes assets, liabilities, and equity at a point in time. Assets are amounts owed to the company or something with a future economic value. Liabilities are obligations or amounts owed to someone else. Equity is the difference between assets and liabilities; they represent ownership claims. Refer to further discussion regarding the components of equity under the discussion of the statement of equity.

Common examples of assets include:

• Cash and cash equivalents – cash equivalents include highly liquid investments.
• Restricted cash – cash not readily available for use.
• Investments – debt or equity securities.
• Accounts receivable – amounts owed by customers in normal course of business.
• Inventories – goods awaiting sale, during production, or to be used in production.
• Prepaid expenses – costs paid in advance for a benefit in the future.
• Property, plant & equipment – tangible assets.
• Intangible assets – assets lacking physical substance such as, for example, trademarks and patents.
• Goodwill – recognized during business combinations as difference between consideration paid and net assets acquired.
• Right-of-use assets – value of lessee’s right to use an asset.
• Tax receivables and deferred tax assets – income taxes paid in advance or future redeemable.

Common examples of liabilities include:

• Accounts payable – amounts owed to vendors.
• Accrued liabilities – estimates of amounts owed.
• Deferred revenue – obligation to customer for which advance payment has been received.
• Debt – owed to creditors.
• Finance lease obligations – lessee’s obligations under a lease.
• Tax payables and deferred tax assets – income taxes owed.

Assets and liabilities are categorized as either current or non-current. Current references whether the amounts are expected to be converted into cash within a year.

There is the possibility that there are assets or liabilities that are referred to as “off-balance sheet,” that are often disclosed elsewhere. For example, an unused letter of credit would be an off-balance sheet commitment.

Income Statement

Also referred to as a Profit and Loss Statement, the Income Statement presents the components of net income or losses over a period. The following are common line items on the income statement, but they may be condensed or broken out in more detail depending on the materiality of the line items:

• Revenue – goods sold or services rendered to customers.
• Cost of revenue – costs related to revenue, also called cost of goods sold or cost of services provided.
• Operating expenses – other operational costs, including selling, general & administrative, or research & development.
• Interest income and expense.
• Other income & expense – non-operational items such as, for example, gain and losses on investments.
• Income taxes.

In addition to the above, the income statement includes the following sub-totals, which are often calculated as a percentage of revenue and used to understand how the company is doing financially as compared to prior periods, expectations, or competitors:

• Gross margin = revenue less cost of revenue.
• Operating income = gross margin less operating expenses.
• Earnings before income taxes = operating income less interest and other income & expense.
• Earnings before interest, taxes, depreciation, and amortization (“EBITDA”) = earnings before income taxes plus interest plus depreciation plus amortization.

Cash Flow Statement

The Statement of Cash Flows is prepared on either a direct (which categorizes inflows and outflows based on their nature) or indirect (which serves as a modified accrual accounting to cash basis) basis.

There are three categories of cash activities:

• Operating – on an indirect basis starts with net income or loss and adjustments for non-cash activities, including the following examples:

• Depreciation and amortization.

• Stock-based compensation.

• Bad debt and inventory reserves.

• Gains (losses) on disposals.

• Changes in operating assets and liabilities.

• Investing – examples include:

• Acquiring and disposing of property, plant & equipment.

• Acquiring and disposing of investments.

• Making and collecting loans with debtors.

• Financing – examples include:

• Borrowing and paying debt with creditors.

• Equity contributions, distributions, and dividends.

In addition to the above, the following information should also be disclosed:

• Supplemental information – includes, for example, income taxes and interest paid.

Non-cash investing and finance activities – includes, for example, property, plant & equipment not yet paid for or conversion of debt into equity.

Statement of Equity

The following are some common components of equity that represent ownership claims in net assets or assets less liabilities of the company:

• Common stock – shares issued at a par value per share.
• Preferred stock – shares issued to owners with additional claims on assets, income, or distributions but often do not have voting rights.
• Treasury stock – shares previously issued and repurchased by the company.
• Additional paid-in capital – value received from owners in excess of par value.
• Retained earnings or accumulated deficit – cumulative amount of undistributed earnings or losses.
• Accumulated other comprehensive income–equity transactions from non-owner sources, typical examples:

• Foreign currency translation.

• Certain pension adjustments.

• Unrealized gains and losses on particular debt and equity security investments.

For certain entities, equity may include members’ or owners’ equity, which includes contributions and distributions.

The statement of equity summarizes the different activities related to the above components. Examples include:

• Current period earnings and other comprehensive income.
• Distributions or dividends to owners.
• Contributions or investments from owners.
• Purchases of treasury stock.
• Share-based compensation expense.
• Exercise of stock options.
• Issuance of stock pursuant to a debt conversion.

Putting it all together

The historical financial documents should be reviewed together to tell a cohesive story about a company’s history. The following are examples of ways to interpret financial statements that lead to more probing questions.

Example A – Inventory increases year over year (balance sheet), which means change in inventory (statement of cash flows) is higher than cost of goods sold (income statement). Potential questions to consider:

• Is the increase in inventory due to lower sales than expected in the current period or to support an expectation of increased sales in the future?
• Does it result in a higher inventory balance as a percentage of the cost of goods sold compared to industry benchmarks?
• How did the company fund the inventory increase?

Example B – Accounts receivable increase year over year (balance sheet), which means revenue (income statement) is higher than change in accounts receivable (statement of cash flows). Potential questions to consider:

• Is the increase due to a collection issue or higher revenue year over year?
• Does it result in accounts receivable as a percentage of revenue being higher than industry benchmarks?
• Will the company collect its receivables before their payables to vendors become due?

In summary, analyzing all historical financial documents is essential to asking the right questions of companies, especially when considering what future results may look like and how they compare to competitors. Understanding financial statements and how they work in unison supports a better grasp of how operations impact profitability or cash flow.

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