Financial Statements Explained

Now that you have a good idea of how businesses generate cash and how profits are recorded on financial statements, let's look at each of the three main financial statements in detail. Unfortunately, not all businesses are as simple as a hot dog stand, so we need to introduce some additional complexity if we want to analyze real companies. But fear not—as we walk through the balance sheet, income statement, and cash flow statement, we'll look at a few real-world companies to see what their financial statements can tell us about how their businesses are functioning.

Wherever possible, I'll refer to excerpts from the financial statements of Dell and Hewlett-Packard (H-P), taken from the two firms' io-k filings with the SEC. (The Dell excerpts contain data through January 31, 2003, and the H-P excerpts contain data through October 31, 2002.) We'll start with the balance sheet, move on to the income statement, and finish with the statement of cash flows. At the start of each section, you'll see a financial statement from the originally named (and fictitious) "Acme Corporation" that will show you how each statement is organized.

Warning: This chapter may be tough going in parts, but it's possibly the most important chapter of the entire book, since reading financial statements is the foundation for analyzing companies. If you find yourself confused about a concept or getting tired, put down the book and take a break. There's no rush—it'll be here when you get back!

The Balance Sheet

The balance sheet (see Figure 5.1)—sometimes called a "statement of financial position"—tells you how much a company owns (its assets), how much it owes (its liabilities), and the difference between the two (its equity). Equity represents the value of the money that shareholders have invested in the firm, and if that sounds odd, think of it just like your mortgage—your equity in your home is the home's value minus the mortgage. Stockholders' equity in a firm is the value of the firm's assets minus its liabilities.

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