8/20/2012 2:45 PM ET
Introduction to financial statements
STOCKS 107: You don't need to be a CPA to understand the basics of the 3 most fundamental and important financial statements: The income statement, the balance sheet and the statement of cash flows.
Although the words "financial statements" and "accounting" send cold shivers down the backs of many people, this is the language of business, a language investors need to know. 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 basic overviews of each financial statement in this lesson and go into much greater detail in Lessons 301-303.
The income statement
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 or loss).
It 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 media -- 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?"
Companies 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.
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 the quarter or full year, although big companies sometimes break down revenues in ways that provide more information (for instance, 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 +4.09%, news) 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 total revenues minus total expenses. However, there are several commonly used profit subcategories that investors should be aware of. Gross profit is calculated as revenues minus cost of sales. It shows how much money is left over to pay for operating expenses (and hopefully provide profit to stockholders) after a sale is made.
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