The guts of an annual financial report are the three primary financial statements explained in previous chapters. To review briefly:
1. Income Statement: This is the summary of a company's sales revenue and expenses for the year (the profit-making activities of the business) and, of course, it reports the company's final profit, or net income for the year. A publicly owned business corporation must report earnings per share in its income statement. A nonpublic company doesn't have to report earnings per share, but it is useful information to its shareholders.
2. Balance Sheet: Also called the statement of financial condition, this is a summary of the company's assets, liabilities, and owners' equity at the close of business on the last day of the income statement period. To understand a balance sheet you need to understand the differences between the basic types of assets used by a business (inventory versus fixed assets, for instance), and the difference between operating liabilities (mainly accounts payable and accrued expenses) versus debt on which the business pays interest. Also, you should know the difference between the two different sources of owners' equity—capital invested by the owners in the business versus profit earned but not distributed to owners, which is called retained earnings.
3. Cash Flow Statement: Profit generates cash flow, but the amount of cash flow from profit during the year is not equal to net income for the year. This third financial statement starts with a section summarizing cash flow from profit for the year, which is an extremely important number. The statement also reports other sources of cash for the year, and what the company did with its available cash during the year. The cash flow statement exposes the financial strategy of the business.
In short, the three financial statements revolve around the three financial imperatives of every business—to make profit, to remain in healthy financial condition, and to make good use of cash flow. The three financial statements usually fit on three pages of an annual financial report, one statement on each page.
Although generally accepted accounting principles (GAAP) do not strictly require it, most businesses—large and small—present two-year or three-year comparative financial statements. This permits easy comparison of the year just ended with last year, and the year before that. The federal agency that regulates financial reporting by public corporations, the Securities & Exchange Commission, requires comparative financial statements. More than 12,000 public companies are audited by the largest five CPA (certified public accountant) firms (called the Big Five, which used to be the Big Eight not too many years ago before mergers). Chapter 17 explains audits.
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