Financial Reports
Publicly traded companies issue three primary financial statements that together provide a complete picture of financial health. Investment advisers use these statements, along with auditor opinions and Securities and Exchange Commission (SEC) filings, to evaluate companies and make suitability recommendations.
| Statement | What It Shows | Time Frame |
|---|---|---|
| Balance Sheet | Financial position (what company owns vs owes) | Snapshot at a point in time |
| Income Statement | Profitability (revenues minus expenses) | Period of time (quarter/year) |
| Cash Flow Statement | Sources and uses of cash | Period of time (quarter/year) |
Think of it this way: The balance sheet tells you where the company stands right now. The income statement and cash flow statement tell you what happened over time. Both perspectives are essential to evaluate a company properly.
The Income Statement
The income statement (also called P&L or profit and loss statement) summarizes revenues and expenses over a period of time. Investors use it to evaluate profitability and compare year-over-year trends and margins.
| Line Item | Calculation |
|---|---|
| Revenue (Sales) | Total income from goods/services sold |
| - Cost of Goods Sold (COGS) | Direct costs of producing goods/services |
| = Gross Profit | Revenue - COGS |
| - Operating Expenses (Selling, General & Administrative, or SG&A) | Salaries, rent, utilities, marketing, depreciation |
| = Operating Income (Operating Profit) | Gross Profit - Operating Expenses |
| +/- Non-Operating Items | Interest income, interest expense, gains/losses on investments |
| = Pre-Tax Income (EBT) | Earnings before income taxes |
| - Income Taxes | Federal and state taxes on earnings |
| = Net Income | The "bottom line" - what remains for shareholders |
- "Top line" = revenue. "Bottom line" = net income. If a question references a company's "bottom line," it is asking about net income, not revenue.
EBITDA
- EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization
- Used to compare profitability across companies by removing effects of capital structure, tax jurisdiction, and accounting choices
- Not a GAAP measure, but commonly referenced on the exam
The Balance Sheet
The balance sheet provides a snapshot of a company's financial position at a specific point in time.
The Balance Sheet Equation
Or equivalently:
Think of it this way: If you sold everything a company owns and used the proceeds to pay off all debts, whatever is left belongs to the shareholders. That leftover amount is the "net worth" or "owners' equity."
This equation must always balance. Every transaction affects at least two items on the balance sheet to keep it in balance.
Balance Sheet Components
| Category | Examples |
|---|---|
| Current Assets (convertible to cash within 1 year) | Cash, cash equivalents, accounts receivable, inventory, short-term investments |
| Non-Current Assets (long-term) | Property, plant & equipment (PP&E), long-term investments, intangible assets (goodwill, patents) |
| Current Liabilities (due within 1 year) | Accounts payable, short-term debt, accrued expenses, current portion of long-term debt |
| Non-Current Liabilities (due beyond 1 year) | Long-term debt, bonds payable, pension obligations |
| Shareholders' Equity | Common stock, retained earnings, additional paid-in capital, treasury stock (contra) |
Working Capital
- Measures short-term liquidity and ability to meet near-term obligations
- Positive working capital = company can cover short-term debts
Shareholders' Equity
- Shareholders' Equity = Assets - Liabilities
- Also called net worth or book value
- Represents the residual claim of owners after all debts are paid
Double-Entry Accounting
- Every transaction must impact two ledger entries to keep the equation balanced
Exam Tip: Gotchas
Shareholders' equity is NOT the market value of a company's stock. It is the accounting (book) value: the difference between assets and liabilities on the balance sheet. Market value is determined by the stock price multiplied by shares outstanding (market capitalization).
The Cash Flow Statement
The cash flow statement shows where cash came from and where it went during a period.
Three Components of Cash Flow
| Section | What It Covers | Inflow Examples | Outflow Examples |
|---|---|---|---|
| Operating Activities | Day-to-day business operations | Cash from sales, interest received, dividends received | Payments to suppliers, employee salaries, interest paid, taxes paid |
| Investing Activities | Long-term asset purchases/sales | Sale of PP&E, sale of investment securities, collection of long-term loans | Purchase of PP&E, purchase of investment securities, making long-term loans |
| Financing Activities | Raising and repaying capital | Issuing stock, issuing bonds/debt | Paying dividends, repurchasing stock (treasury stock), repaying debt principal |
Key Classification Rules (US GAAP)
| Item | Classification | Rationale |
|---|---|---|
| Interest paid | Operating | Appears on income statement |
| Interest received | Operating | Appears on income statement |
| Dividends received | Operating | Appears on income statement |
| Dividends paid | Financing | Does NOT appear on income statement; distribution to owners |
Think of it this way: If the item appears on the income statement, classify it as operating. Dividends paid do not appear on the income statement; they are a distribution to owners, so they are financing.
Exam Tip: Gotchas
Interest paid is an operating activity (not financing), even though it relates to borrowed money. Dividends paid is a financing activity (not operating), even though it relates to profitability.
The statement of cash flows reconciles accrual-based net income to actual cash generated. A company can report positive net income on the income statement while having negative operating cash flow (and vice versa), because accrual accounting recognizes revenue when earned, not when cash is collected.
Calculating Operating Cash Flow (Indirect Method)
Most companies use the indirect method, which starts with net income and adjusts for non-cash items to arrive at actual cash generated:
- Formula: Operating Cash Flow = Net Income + Depreciation + Amortization + Other Non-Cash Items ± Changes in Working Capital
- Start: Net income (from the income statement)
- Add back: Depreciation, amortization, and other non-cash charges
- Adjust for: Changes in working capital (accounts receivable, inventory, accounts payable)
Why non-cash items get added back:
- Depreciation and amortization reduced net income on the income statement
- No cash left the business when these entries were recorded; they are accounting allocations of prior cash outlays
- To get from accrual net income back to actual cash, you reverse the non-cash deductions
Think of it this way: Net income answers "did we earn a profit?" Operating cash flow answers "how much cash did the business actually generate?" The indirect method bridges the two.
Exam Tip: Gotchas
- Operating cash flow is NOT revenues minus expenses. That formula gives net income (income statement).
- Operating cash flow is NOT assets minus liabilities. That formula gives shareholders' equity (balance sheet).
- Operating cash flow is NOT operating income minus interest expense. That gives pre-tax income, a profitability measure.
- The correct answer adds back depreciation and other non-cash items to net income (indirect method).
Auditor Disclosures
| Opinion | Meaning | Severity |
|---|---|---|
| Unqualified (Clean) | Financial statements are fairly presented in all material respects in conformity with GAAP | Best outcome - no issues found |
| Qualified | Fairly presented EXCEPT for a specific matter; misstatement is material but not pervasive | Moderate concern - largely reliable with noted exceptions |
| Adverse | Financial statements do NOT present fairly; misstatement is material and pervasive | Most severe negative opinion - statements are unreliable |
| Disclaimer of Opinion | Auditor is unable to form an opinion; insufficient evidence | No opinion expressed - auditor cannot determine reliability |
- Public companies filing with the SEC must have financial statements audited by an independent certified public accountant (CPA)
- The auditor issues an opinion on whether the financial statements are fairly presented in accordance with GAAP
- Unqualified = the goal; indicates financial statements can be relied upon
- Qualified = specific issues but statements are still largely useful; misstatement is material but not pervasive
- Adverse = worst opinion; misstatement is material AND pervasive; statements are unreliable
- Disclaimer = auditor was unable to gather enough evidence to form any opinion; scope limitation is material and pervasive
When recommending a stock to a customer, you would most want to see an unqualified (clean) opinion.
Exam Tip: Gotchas
- "Unqualified" sounds negative but is actually the BEST opinion (clean bill of health). "Qualified" sounds positive but indicates a problem. This naming convention is a common exam trap.
- The key distinction between qualified and adverse: a qualified opinion means the misstatement is material but NOT pervasive. An adverse opinion means the misstatement is material AND pervasive. The same distinction applies between qualified and disclaimer.
Corporate SEC Filings
The Securities and Exchange Commission (SEC) requires public companies to file periodic reports.
| Filing | Type | Content | Deadline |
|---|---|---|---|
| Form 10-K | Annual report | Comprehensive financial and business overview; includes audited financial statements, Management's Discussion & Analysis (MD&A), risk factors, legal proceedings | 60 days after fiscal year-end (large accelerated filers); 90 days (non-accelerated filers) |
| Form 10-Q | Quarterly report | Unaudited financial statements, interim MD&A, updates since last 10-K | 40-45 days after quarter-end |
| Form 8-K | Current report | Disclosure of material events (e.g., mergers, acquisitions, executive changes, bankruptcy) | Within 4 business days of the triggering event |
| Proxy Statement (DEF 14A) | Annual meeting materials | Executive compensation, board nominees, shareholder voting matters | No later than 120 days after fiscal year-end |
- Form 10-K is the most detailed annual filing and must include audited financial statements
- Form 10-Q financial statements are unaudited (reviewed, not fully audited)
- Form 8-K is event-driven, not on a regular schedule; filed when something significant happens
Exam Tip: Gotchas
- The 10-K is NOT the same as the annual report to shareholders. The 10-K is filed with the SEC and is generally more detailed. The annual report is distributed to shareholders and may contain more marketing-oriented content.
- Only the 10-K requires audited financial statements. The 10-Q contains unaudited (but reviewed) financials.
Annual Reports
- The annual report is a document distributed to shareholders summarizing the company's financial performance for the year
- Often includes a letter from the CEO/chairman, financial highlights, and forward-looking statements
- May incorporate or reference the Form 10-K
- Less detailed than the 10-K; may include photographs, graphics, and narrative designed for a general audience
- Companies are required to provide annual reports to shareholders before the annual meeting