5.10: Summary

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5.1 The Income Statement

The income statement reflects a firm’s performance over a period of time. Most financial statements are prepared monthly, quarterly, and annually. The income statement reflects sales less cost of goods sold to arrive at gross profit. Operating costs are deducted to arrive at operating income. Finally, other nonoperational costs like interest and taxes are deducted to arrive at net income.

5.2 The Balance Sheet

The balance sheet reflects the financial position of a firm as of a particular point in time. It is laid out to clearly depict and support the accounting equation: $assets = liabilities + owner ’ s equity .$ A classified balance sheet breaks down the assets and liabilities sections into current and noncurrent for greater transparency.

5.3 The Relationship between the Balance Sheet and the Income Statement

The financial statements are all tied together. The income statement is generated first, as net income is needed in order to determine the ending balance of retained earnings, a key account in the equity section of the balance sheet.

5.4 The Statement of Owner’s Equity

The statement of owner’s equity is divided by each type of equity the firm has: common stock, preferred stock, additional paid-in capital, and retained earnings, for example. Beginning balances are provided, and all key transactions impacting equity are provided in order to show how ending balance were derived. Key transactions commonly include recording net income or loss, issuing additional stock, and paying out dividends.

5.5 The Statement of Cash Flows

Under accrual accounting, transactions are recorded when they occur, not necessarily when cash moves. This creates a timing difference. Net profit, therefore, does not necessarily mean a firm has cash, and a net loss doesn’t mean they don’t have any cash. To reconcile net income to actual cash flow and see how a firm generates and uses its funds, a statement of cash flows is prepared. The statement reflects cash flow from operating activities, financing activities, and investing activities.

5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)

Operating cash flow reflects the cash generated by (or used by) the core business function. Free cash flow to the firm (FCFF) or simply free cash flow (FCF) is calculated by deducting capital expenditures from operating cash flow. FCF reflects the cash available to repay debts, pay dividends to shareholders, and contribute to cash needs for growth.

5.7 Common-Size Statements

Common-size statements are a restatement of the financial statements with all dollar figures restated as a percentage. On the income statement, each line is restated as a percentage of net sales. On the balance sheet, each line is restated as a percentage of total assets. Common-size statements are useful for analysis and are particularly helpful in comparing firms of different sizes.

5.8 Reporting Financial Activity

Publicly traded firms must file company and financial data with the Securities and Exchange Commission (SEC) on a regular basis. Key reports include the quarterly report, called a 10-Q, and the annual report, called a 10-K.

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