Introduction to financial statements

Financial statements give a quantitative picture about any business. For instance one can describe a particular car as "It’s a nice minivan that gives 22mpg and can fit in seven people". But that does not tell us much about the car. To get a clear picture we need to know the details about its Engine, Transmission, brakes, interior, wheels, steering etc. Similarly if one were to describe a state of the business then he has to start with its financial statements. Financial statements are a good starting point for fundamental analysis. The most important point to remember is that financial statements in vacuum are not of much use. They need to be understood with the context of the business. In other words one has to pay close attention as to how the numbers have been calculated. Two identical businesses can have exactly same operations, but there financial statements can differ if they used different accounting guidelines. For instance - If we are comparing Mary and Kathy on how fast they make cookies. Mary might say she takes 1 hr and Kathy may say she takes 45 minutes. Even though both might actually take the same time but the difference might be in the definition of cooking time. For Mary it might include the time to make the dough and for Kathy she might not count that time as cooking time. Similarly each business has a decision of choosing there accounting processes, that one needs to understand in order to evaluate the numbers of its financial statements. All these details are usually in the notes that follow the financial statements in the 10-k report. The 10-k report for any publically traded company can be found at http://www.sec.gov . For foreign corporations whose securities trade in USA, the corresponding report is the 20-F report. And for Canadian businesses it’s the 40-F report. The four major financial statements are 1. Balance sheet, 2. Income statement, 3.Cash Flow statement, 4. Change in stockholder's equity. Before we dive in further, let us first understand the main goal of any business. SOLE PURPOSE OF A BUSINESS: The best way to understand this is to look around the small businesses that we encounter in our day to day lives. This can be a Pizza place, a barber shop or a small car repair shop. The only reason they open everyday is because they want to generate CASH. The more cash they generate the better off they are. Seems quite logical and simple. So if a business is all about cash then why do we need all these complicated financial statements that are embedded in the 10-k report. One can just get its total Bank balance and deduce how the business is doing? Even though the basic purpose of any business in the world is to generate cash, But as the businesses get bigger and bigger then its operations get more and more complicated and it becomes more important to know the following: 1. How the business has generated cash. 2. What's its capability to generate the cash in future? FINANCIAL REPORTING SYSTEM IN USA: Securities and Exchange Commission (SEC) is the main governing body for any company whose securities are publicly traded. SEC sets the rules that govern the disclosure requirements for the company. SEC recognizes FASB statements as authoritative. This is the reason all the publicly traded companies follow FASB’s guidelines for accounting. FINANCIAL ACCOUNTING STANDARDS BOARD (FASB): It’s a private not-for-profit organization whose sole purpose is to set generally accepted accounting principles (GAAP). FASB is made of 5 independent board members who are supposed to severe all the ties with any private organization they had ties before. Its website is http://www.fasb.gov FASB guidelines consist of Statements, Interpretations, staff positions , technical bulletins and concept statements.