Understanding Financial Statements: A Beginner's Guide

Today’s episode of “Saving and Investing” features three short videos, each of which is an introduction to a particular financial statement. Learning to read financial statements can help you evaluate the companies in which you would like to invest. (These statements are mandatory parts of corporate financial reports.)

First, Michael Fischer explains balance sheets:

This video has some difficult-to-read subtitles. They are, in order:

• “The left side and right side of a balance sheet are shown at book value (value according to accounting convention).”
• “This ownership interest would also be shown at book value.”
• “Balance sheets for accounting purposes show assets, equity, and debt at book value. And they balance.”
• “Assets (left side), equity, and debt (right side) could also be at market value, and the balance sheet would balance.”
• “For accounting purposes everything is shown at book value, but it is important to understand the principle.”
• “That assets = sources of funding (equity and debt). That is what a balance sheet shows.”

The difference between book value and market value can be confusing. Here’s a definition of book value:

An accounting term that states the equity value of an outstanding share of stock. A stock’s book value is determined by dividing the amount of stockholders’ equity by the number of common shares outstanding. A company’s book value may be of no relevance to its to market value.

The book value is what the company is worth on paper. It’s how much has already been paid into it. Market value, on the other hand, reflects how much the company is actually worth. My understanding is that book value represents the past, while market value represents the future (or present).

Visit the following for more information about balance sheets:

• The wikipedia article on balance sheets.
• The Investopedia’s guide to reading a balance sheet.
• This nice summary of what goes into a balance sheet.

The second video in this set is about income statements:

Once again, YouTube doesn’t do a good job of displaying Michael’s exhibit. Here’s a reconstruction:

REVENUE/SALES $100,000 Less expenses   Cost of Goods 20,000 Salaries 50,000 Rent 6,000 Insurance 1,650 Interest Expense 3,500 Other Expenses 6,850 Total Expenses 88,000 Pretax Profit 12,000 Taxes 4,000     NET INCOME $8,000

For more information about income statements, check out:

• The wikipedia article on income statements.
• The Investopedia’s has an article on understanding the income statement.
• AccountingCoach.com has an explanation of income statements.

The last financial statement with which investors should be familiar is the cash flow statement:

Here’s my transcription of the cash flow statement exhibit:

Operations   Net Income 25,000 Depreciation 4,000 Decrease in Inventories 500 Cash Flow from Operations 29,500 Investing   Van bought -20,000 Cash Flow from Investing -20,000 Financing   Bank Loan 10,000 Proceeds: Outside Investor 10,000 Cash Flow from Financing 20,000 CHANGE IN CASH $29,500

Visit the following for more information about cash flow statements:

• The wikipedia article on cash flow statements.
• The Investopedia’s answer to what is a cash flow statement?.
• AccountingCoach.com has an extensive overview of cash flow statements.

Finally, the U.S. Securities and Exchange Commission offers a Beginners’ Guide to Financial Statements.

Michael Fischer

Michael Fischer spent nine years at Goldman Sachs, advising some of the largest private banks, mutual fund companies and hedge funds in the world on investment choices. For more information, visit Michael's site, Saving and Investing, or purchase his book.

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