Financial Reports

Investment advisers use these statements, plus auditor opinions and SEC filings, to evaluate companies and make suitability recommendations. Knowing which document answers which question is the fastest way to answer an exam item correctly.

The balance sheet tells you where the company stands right now. The income statement and statement of cash flows tell you what happened over time. Both perspectives are needed to evaluate a company properly.

How Does the Income Statement Show Profitability?

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.

"Top line" means revenue; "bottom line" means net income. If a question references a company's "bottom line," it is asking about net income, not revenue.

Exam Tip: Gotchas

Operating income and EBT (pre-tax income) are not the same line and are not interchangeable. Operating income only reflects the core business (gross profit minus operating expenses). You still have to apply the non-operating items, mainly interest expense but also interest income and investment gains or losses, to get from operating income down to EBT.

"Pre-tax income" and "EBT" are two names for the exact same number, not two separate calculations. Both mean earnings after every expense except income taxes. If a question gives you pre-tax income and asks for EBT (or vice versa), it is not asking you to calculate anything further; they are the same figure.

What Is 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

What Does the Balance Sheet Show?

The balance sheet provides a snapshot of a company's financial position at a specific point in time.

What Is the Balance Sheet Equation?

Or equivalently:

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.

What Belongs in Each Balance Sheet Category?

How Do You Calculate Working Capital?

• Measures short-term liquidity and ability to meet near-term obligations
• Positive working capital = company can cover short-term debts

What Is Shareholders' Equity?

• Shareholders' Equity = Assets - Liabilities
• Also called net worth or book value
• Represents the residual claim of owners after all debts are paid

Why Does Every Transaction Hit Two Entries?

Double-entry accounting requires every transaction to impact two ledger entries to keep the equation balanced.

The two entries either land on the same side of the equation and offset each other (an asset-for-asset swap, like inventory), or land on different sides and move together (an asset and a liability, or an asset and equity, both rising or both falling). Either way, the equation never drifts out of balance.

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 two-ledger-entries rule applies even with no outside party involved. Depreciation is purely internal (no cash changes hands), but it still reduces an asset's book value on one side and shareholders' equity on the other.

How Does the Statement of Cash Flows Track Actual Cash?

The statement of cash flows shows where cash came from and where it went during a period.

What Are the Three Components of Cash Flow?

Which Classification Applies Under US GAAP?

If the item appears on the income statement, classify it as operating. Dividends received appear on the income statement as investment income, so they are operating. Dividends paid never appear on the income statement, since paying a dividend is a distribution of profit to owners rather than an expense, 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.

Dividends received and dividends paid are opposites here, and it is easy to blur them into one blanket "dividends" rule. Dividends received show up on the income statement as income (operating). Dividends paid never show up on the income statement at all (they reduce retained earnings, not net income); they only surface as a financing outflow on the statement of cash flows.

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.

How Do You Calculate Operating Cash Flow?

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

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).

What Does an Auditor's Opinion Tell You?

• 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.

Which SEC Filing Should You Reach For?

The Securities and Exchange Commission (SEC) requires public companies to file periodic reports.

• 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.

What Belongs in an Annual Report?

• 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

What Should You Check on Exam Day?

• Match the question's time cue to the right statement: "as of" or "point in time" means the balance sheet; "for the period" or "quarter/year ended" means the income statement or cash flow statement.
• Distinguish operating income (EBIT) from pre-tax income (EBT); non-operating items separate the two, and EBT is the same figure as pre-tax income.
• Keep the cash flow classification rule straight: interest paid, interest received, and dividends received are operating; dividends paid is financing.
• Do not compute operating cash flow as revenue minus expenses or assets minus liabilities; it is net income plus depreciation, amortization, and other non-cash items, adjusted for working capital changes.
• Rank the auditor opinions from best to worst: unqualified, qualified, adverse, disclaimer, and remember "unqualified" is the clean opinion despite how it sounds.
• Know which filing is audited (10-K, annually) versus unaudited (10-Q, quarterly) versus event-driven (8-K, within 4 business days), and that the 10-K is not the shareholder annual report.