4 February 2011

The Financial Statement - A Primer

After talking a business friend of mine, he hammered home the importance of learning how to read a financial statement. After I told him “I’m not really interested in all that stuff, I’ll just get someone else to look at it for me” he said “Alex, it’s mandatory! Without knowing how to read them, you’re a sitting duck!”

With that in mind, and eager to make sure that I start off on the right footing, I decided to explore this in great detail and acquire the skills necessary to be able to read financial statements well. It took a while for me to knuckle down and learn what I needed to, seeing as I always had a fear of ‘numbers’ and that the idea of a financial statement seemed extremely complex and confusing. In this post, I intend to share the knowledge I acquired in this area as best I can, without putting you to sleep! This is the first of a 5 part series. [Part1, Part 2, Part 3, Part 4, Part 5]

The first thing I learnt was that there are 4 different sections for financial statements that all come together to help you understand how a company works and how well it is performing. They are:- The Income Statement, The Balance Sheet, The Cashflow Statement and The Statement Of Shareholders Equity

In this post, I will be focusing on my key learning’s with reference to the Income Statement and presenting them to you, albeit in a simplified manner.

Usually, on the first line of an income statement you will see ‘Total Revenue’ [also referred to as the top line]. This can also be referred to as Gross Revenue, which basically means all of the money that came in from selling the business’ product or service before any deductions have been made.

On the next line, generally speaking you will come across ‘Cost Of Goods Sold’.

This refers to the initial cost of the goods the company bought before they were sold to the customer. For example, we’re talking raw materials, initial cost of a buying product before selling it on at a profit, etc. This is also referred to as variable expenses.

This then leaves us with the Gross Margin [Also referred to as Gross Profit], the third line of the income statement, which is the total revenue for the business, minus the cost of goods sold or, if in the service business, the cost of service.

With more deductions on the way to find out how much a company has actually earned, Operating Expenses [also referred to as fixed costs] are deducted from the gross margin. These refer to the cost of running the business; things such as salaries, rent, marketing, insurance etc are all covered here.

This then provides you with the Operating Income, often referred to with a funny abbreviation: ‘EBIT’, which stand for “Earnings Before Interest And Taxes”. On the next line these are applied. Interest on income refers to the interest made from savings and Interest Expenses most refers to money that is paid out on loans.

Once these elements have been calculated, it provides with you the NET INCOME, commonly referred to as the bottom line! This is where you can see quite clearly the income that is left after all expenses from gross revenue has been calculated and taken into consideration.

Although this is a simplified version, with this information I have been able to practice reading the income statements of various business’ albeit with their marginal differences with references to the names of different parts of the statement, which I have been told matter very little, as long as the numbers tell the story.

In the next instalment of this series I will be documenting my learning’s on the other parts of reading financial statements, which all come together to make understanding them fun, quick and easy!

You might want to check out 'Business Cashflow: Read Between The Lines' for  more info on how to see exactly what is going on with a company and to learn how to analye it.


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