Companies produce three main financial statements that reflect their business activities and profitability for each accounting period. These statements are the balance sheet, the income statement and the cash flow statement. The cash flow statement shows how well a business manages its cash flow to fund operations and any expansion efforts. In this article, we will look at the balance sheet and the income statement and their differences.
Investors and creditors analyze the balance sheet to determine the extent to which management is leveraging a company’s resources. The balance sheet presents assets, liabilities and equity. Total assets should equal the sum of total liabilities and equity. The liabilities section reflects how these assets are funded. Equity is the difference between assets and liabilities, or the money left over to shareholders for the company to pay off all of its debts.
To best analyze the key areas of the balance sheet and what they tell us as investors, let’s look at an example.
Example: Apple Inc.
Below is Apple’s balance sheet (AAPL) at the end of its fiscal year 2017.
The top section contains short-term assets, which are short-term assets typically used up in a year or less.
- Total current assets were $ 128.6 billion (highlighted in blue).
- Cash amounted to approximately $ 20.3 billion.
- Negotiable securities (short-term investments) approached $ 54 billion.
- Accounts receivable is money owed to Apple for the sale of its products and services and amounts to $ 17.8 billion. A debt can be due in 30, 60 or 90 days depending on the agreed terms. Investors want to see receivables increase over time because this indicates increased sales. But we don’t want debts to age.
- Inventories $ 4.8 billion These can be raw materials or supplies used in manufacturing products or finished products waiting to be sold or shipped.
Long-term assets are next.
- Long term investments totaled $ 194.7 billion.
- Tangible fixed assets (PPE) are called fixed assets because they are not consumed within a year and they generate income over the long term. Apple recorded $ 33.7 billion in PPE.
- Other assets and intangible assets, which include brands and intellectual capital, complete the assets section.
- Total assets were $ 375.3 billion at Apple’s fiscal 2017 end.
Current liabilities are short-term liabilities with less than one year.
- Current liabilities totaled $ 100.8 billion (highlighted in purple).
- Accounts payable are Apple’s short-term supplier debts of $ 49 billion.
- Increased expenses are expenses yet to be paid, but which have a high probability of being paid. Apple recorded $ 25.7 billion in accrued liabilities.
Long term liabilities
Not all of Apple’s long-term liabilities are broken down, but they typically include:
- Debt including long-term debt and bank indebtedness, which amounted to $ 97 billion for Apple.
- Rent, taxes and utilities payable.
- Dividends payable.
- Retained earnings the money is not paid out as dividends, but withheld to be reinvested in the business or to pay off debt. Apple recorded $ 98.3 billion in retained earnings.
- Equity is the sum of total assets minus total liabilities and is useful in calculating the financial health of a business. Equity represents the net worth or equity of a business, which for Apple was $ 134 billion. This is the money that is left to shareholders, assuming the company pays off all debts in the event of a liquidation.
The income statement, often referred to as the income statement, shows income, costs, and expenses over a period that is typically a quarter or a fiscal year. The income statement tells investors whether a business is making a profit or a loss. In addition, the income statement provides valuable information on income, sales and expenses.
JC Penney Company
Below is JC Penny’s (JCP) income statement for its fiscal year ending February 3, 2018. The top section includes the total revenue or sales for the period.
- Net sales (i.e. revenue) was $ 12.5 billion. Sales and income are also called top row because of their location at the top of the income statement.
- Cost of goods sold was $ 8.17 billion. This represents the costs of producing goods and services over the periods. COGS are direct costs and are only the expenses involved in the production process.
- Selling, general and administrative expenses costs are other expenses that are not directly involved in production. For JC Penney, general and administrative expenses were $ 3.4 billion.
- Total costs or expenses were $ 12.39 billion.
- Operating result was $ 116 million after subtracting total expenses from total revenues.
- Net interest expense of $ 325 million represents the cost of servicing the debt and puts JC Penney in the red for the year.
- Net revenue for the year was a loss of 116 million dollars. Net income is also referred to as net profit or bottom line because it is the final number and located at the bottom of the income statement.
JC Penney is a prime example of the importance of looking at the big picture. While $ 12.5 billion in revenue looks impressive, the costs of servicing the debt mean the company has incurred a loss for the year. It should be noted that examining a company’s financial data works best when compared over multiple time periods and with other companies in the same industry.
The bottom line
The balance sheet shows what a company owns (assets) and owes (liabilities), as well as long-term investments. Investors examine the balance sheet for clues as to the effectiveness of management in using debt and assets to generate income that is carried over to the income statement.
The income statement shows the financial health of a business and whether a business is profitable or not. Income and expenses are closely watched. It is crucial for management to increase revenues while controlling costs. For example, income may increase, but if expenses increase faster than income, the business may eventually incur a loss. Investors and analysts closely monitor the operational portion of the income statement to assess management performance.
However, investors and analysts take a closer look at the balance sheet, as the balance sheet and income statement together provide a more complete picture of a company’s current health and future prospects.