CHAPTER ONE

Interpreting Financial Statements

Financial statements are like fine perfume; to be sniffed but not
swallowed.
Abraham Briloff

Accounting is the scorecard of business. It translates a company’s diverse activities

into a set of objective numbers that provide information about the firm’s
performance, problems, and prospects. Finance involves the interpretation of these
accounting numbers for assessing performance and planning future actions.
The skills of financial analysis are important to a wide range of people, including
investors, creditors, and regulators. But nowhere are they more important than
within the company. Regardless of functional specialty or company size, managers
who possess these skills are able to diagnose their firm’s ills, prescribe useful
remedies, and anticipate the financial consequences of their actions. Like a ballplayer
who cannot keep score, an operating manager who does not fully understand
accounting and finance works under an unnecessary handicap.
This and the following chapter look at the use of accounting information to assess
financial health. We begin with an overview of the accounting principles governing
financial statements and a discussion of one of the most abused and confusing
notions in finance: cash flow. Two recurring themes will be that defining and
measuring profits is more challenging than one might expect, and that profitability
alone does not guarantee success, or even survival. In Chapter 2, we look at
measures of financial performance and ratio analysis.

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 The Cash Flow Cycle

Finance can seem arcane and complex to the uninitiated. However, a comparatively
few basic principles should guide your thinking. One is that a company’s finances and
operations are integrally connected. A company’s activities, method of operation, and
competitive strategy all fundamentally shape the firm’s financial structure. The
reverse is also true: Decisions that appear to be primarily financial in nature can
significantly affect company operations. For example, the way a company finances its
assets can affect the nature of the investments it is able to undertake in future years.
The cash flow–production cycle shown in Figure 1.1 illustrates the close interplay
between company operations and finances. For simplicity, suppose the company
shown is a new one that has raised money from owners and creditors, has
purchased productive assets, and is now ready to begin operations. To do so, the
company uses cash to purchase raw materials and hire workers; with these inputs, it
makes the product and stores it temporarily in inventory. Thus, what began as cash is
now physical inventory. When the company sells an item, the physical inventory
changes back into cash. If the sale is for cash, this occurs immediately; otherwise,
cash is not realized until some later time when the account receivable is collected.
This simple movement of cash to inventory, to accounts receivable, and back to cash
is the firm’s operating, or working capital, cycle.

FIGURE 1.1
The Cash Flow–Production Cycle

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 Another ongoing activity represented in Figure 1.1 is investment. Over a period of
time, the company’s fixed assets are consumed, or worn out, in the creation of
products. It is as though every item passing through the business takes with it a small
portion of the value of fixed assets. The accountant recognizes this process by
continually reducing the accounting value of fixed assets and increasing the value of
merchandise flowing into inventory by an amount known as depreciation. To maintain
productive capacity and to finance additional growth, the company must invest part
of its newly received cash in new fixed assets. The object of this whole exercise, of
course, is to ensure that the cash returning from the working capital cycle and the
investment cycle exceeds the amount that started the journey.
We could complicate Figure 1.1 further by including accounts payable and
expanding on the use of debt and equity to generate cash, but the figure already
demonstrates two basic principles. First, financial statements are an important window
on reality. A company’s operating policies, production techniques, and inventory and
credit-control systems fundamentally determine the firm’s financial profile. If, for
example, a company requires payment on credit sales to be more prompt, its
financial statements will reveal a reduced investment in accounts receivable and
possibly a change in its revenues and profits. This linkage between a company’s
operations and its finances is our rationale for studying financial statements. We
seek to understand company operations and predict the financial consequences of
changing them.

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 The second principle illustrated in Figure 1.1 is that profits do not equal cash flow.
Cash—and the timely conversion of cash into inventories, accounts receivable, and
back into cash—is the lifeblood of any company. If this cash flow is severed or
significantly interrupted, insolvency can occur. Yet the fact that a company is
profitable is no assurance that its cash flow will be sufficient to maintain solvency. To
illustrate, suppose a company loses control of its accounts receivable by allowing
customers more and more time to pay, or suppose the company consistently makes
more merchandise than it sells. Then, even though the company is selling
merchandise at a profit in the eyes of an accountant, its sales may not be generating
sufficient cash soon enough to replenish the cash outflows required for production
and investment. When a company has insufficient cash to pay its maturing
obligations, it is insolvent. As another example, suppose the company is managing its
inventory and receivables carefully, but rapid sales growth is necessitating an ever-
larger investment in these assets. Then, even though the company is profitable, it
may have too little cash to meet its obligations. The company will literally be “growing
broke.” These brief examples illustrate why a manager must be concerned at least as
much with cash flows as with profits.
To explore these themes in more detail and to sharpen your skills in using
accounting information to assess performance, we need to review the basics of
financial statements. If this is your first look at financial accounting, buckle up
because we will be moving quickly. If the pace is too quick, take a look at one of the
accounting texts recommended at the end of the chapter.

Overview of Financial Statements

The most important source of information for evaluating the financial health of a
company is its set of financial statements, consisting principally of a balance sheet,
an income statement, and a cash flow statement. Although these statements can
appear complex at times, they all rest on a very simple foundation. To understand
this foundation and to see the ties among the three statements, let us look briefly at
each.
A balance sheet is a financial snapshot, taken at a point in time, of all the assets
the company owns and all the claims against those assets. The basic relationship,
and indeed the foundation for all of accounting, is

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It is as if a herd (flock? column?) of accountants runs through the business on the
appointed day, making a list of everything the company owns, and assigning each
item a value. After tabulating the firm’s assets, the accountants list all outstanding
company liabilities, where a liability is simply an obligation to deliver something of
value in the future—or more colloquially, some form of an “IOU.” Having thus totaled
up what the company owns and what it owes, the accountants call the difference
between the two shareholders’ equity. Shareholders’ equity is the accountant’s
estimate of the value of the shareholders’ investment in the firm, just as the value of
a homeowners’ equity is the value of the home (the asset), less the mortgage
outstanding against it (the liability). Shareholders’ equity is also known variously as
owners’ equity, stockholders’ equity, net worth, or simply equity.
It is important to realize that the basic accounting equation holds for individual
transactions, as well as for the firm as a whole. When a firm pays $1 million in wages,
cash declines $1 million and shareholders’ equity falls by the same amount. Similarly,
when a company borrows $100,000, cash rises $100,000, as does a liability named
something like loans outstanding. And when a company receives a $10,000 payment
from a customer, cash rises while another asset, accounts receivable, falls by the
same figure. In each instance, the double-entry nature of accounting guarantees that
the basic accounting equation holds for each transaction, and when summed across
all transactions, it holds for the company as a whole.
To see how the repeated application of this single formula underlies the creation
of company financial statements, consider Worldwide Sports (WWS), a newly founded
retailer of value-priced sporting goods. In January 2021, the founder invested
$150,000 of his personal savings and added another $100,000 borrowed from
relatives to start the business. After buying furniture and display fixtures for $60,000
and merchandise for $80,000, WWS was ready to open its doors.

The following six transactions summarize WWS’s activities over the course of its
first year.
Sold $900,000 of sports equipment, receiving $875,000 in cash, with $25,000 still
to be paid.

Paid $190,000 in wages, including the owners’ salary.

Purchased $380,000 of merchandise at wholesale, with $20,000 still owed to
suppliers, and $30,000 worth of product still in WWS’s inventory at year-end.

Spent $210,000 on other expenses, such as utilities and rent.

Depreciated furniture and fixtures by $15,000.

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 Paid $10,000 interest on WWS’s loan from relatives and another $40,000 in
income taxes to the government.
Table 1.1 shows how an accountant would record these transactions. WWS’s
beginning balance, the first line in the table, shows cash of $250,000, a loan of
$100,000, and equity of $150,000. But these numbers change quickly as the company
buys fixtures and an initial inventory of merchandise. And they change further as
each of the listed transactions occurs.

TABLE 1.1
Worldwide Sports Financial Transactions 2021 ($ thousands)

Abstracting from the accounting details, there are two important things to note
here. First, the basic accounting equation holds for each transaction. For every line in
the table, assets equal liabilities plus owners’ equity. Second, WWS’s year-end
balance sheet across the bottom of the table is just its beginning balance sheet plus
the cumulative effect of the individual transactions. For example, ending cash on
December 31, 2021 is the beginning cash of $250,000 plus or minus the cash involved
in each transaction. Incidentally, WWS’s first year appears to have been a decent one:
Owners’ equity is up $85,000 over the year, on top of whatever the owner paid
himself in salary.
To further convince you that the bottom row of Table 1.1 really is a balance sheet,
the following table presents the same information in a more conventional format.

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 If a balance sheet is a snapshot in time, the income statement and the cash flow
statement are videos, highlighting changes in two especially important balance sheet
accounts over time. Business owners are naturally interested in how company
operations have affected the value of their investment. The income statement
addresses this question by partitioning the recorded changes in owners’ equity into
revenues and expenses, where revenues increase owners’ equity and expenses
reduce it. The difference between revenues and expenses is earnings, or net income.
Looking at the right-most column in Table 1.1, WWS’s 2021 income statement
looks like this. Note that the $85,000 net income appearing at the bottom of the
statement equals the change in owners’ equity over the year.

Worldwide Sports Income Statement,

2021 ($ thousands)

Sales $900
Wages 190
Merchandise purchases 350
Depreciation 15
Gross profit $345
Other expenses 210
Interest expense 10
Income before tax $125
Income taxes 40
Net income $ 85

The focus of the cash flow statement is solvency, having enough cash in the bank
to pay bills as they come due. The cash flow statement provides a detailed look at
changes in the company’s cash balance over time. As an organizing principle, the
statement segregates changes in cash into three broad categories: cash provided (or
consumed) by operating activities, by investing activities, and by financing activities.
Figure 1.2 is a simple schematic diagram showing the close conceptual ties among
the three principal financial statements.

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FIGURE 1.2
Ties among Financial Statements

The Balance Sheet

We will now take a more in-depth look at each of the key financial statements in turn,
beginning with the balance sheet. To illustrate the techniques and concepts
presented throughout the book, I will refer whenever possible to Polaris Inc., the self-
styled “Global leader in Powersports” including snowmobiles, all-terrain vehicles
(ATVs), motorcycles, and boats. In addition to the United States, Polaris has
manufacturing operations in China, France, Mexico, and Poland. It has offices in 14
countries and sells its products in over 100 countries, although 80 percent of sales
originate in the United States. The company’s focus, as embodied in its marketing
tagline “Think Outside” is to create products that enhance the experience of outdoor
enthusiasts.

See polaris.com. Follow Company > Investors > Financials & Filings for financial statements.

Headquartered in Medina, Minnesota, a small town outside of Minneapolis,

Polaris has $7 billion in annual sales, and its stock trades on the New York Stock
Exchange. The firm was founded in 1954 as one of the pioneers of the snowmobile
industry. In the 1980s, Polaris diversified into off-road vehicles when they produced
the first American-made ATVs. In 2011, Polaris extended its reach into on-road
vehicles with its acquisition of the legendary Indian Motorcycle company. Between
2018 and 2019, two more acquisitions added three well-known boat brands to
Polaris’s product portfolio. Polaris’s recent ventures include forays into electric ATVs,
electric motorcycles, and special-purpose electric automobiles. In 2020, 64 percent of

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Polaris’s sales came from snowmobiles and off-road vehicles, with 9 percent coming
from boats, 8 percent from motorcycles, and 19 percent from other products and
services.
Table 1.2 presents Polaris’s balance sheets for 2019 and 2020. If the precise
meaning of every asset and liability category in Table 1.2 is not immediately
apparent, be patient. We will discuss many of them in the following text. In addition,
all of the accounting terms used appear in the glossary at the end of the book.

TABLE 1.2
Polaris Inc. Balance Sheets ($ millions)*

Source: Polaris annual reports

*Totals may not add due to rounding.

Polaris Inc.’s balance sheet equation for 2020 is

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Current Assets and Liabilities
By convention, U.S. accountants list assets and liabilities on the balance sheet in
order of decreasing liquidity, where liquidity refers to the speed with which an item
can be converted to cash. Thus, cash, marketable securities, and accounts receivable
appear at the top, while land, plant, and equipment are toward the bottom. Similarly
on the liabilities side, short-term loans and accounts payable are toward the top,
while shareholders’ equity is at the bottom.

Accountants also arbitrarily define any asset or liability that is expected to turn
into cash within one year as current and all others assets and liabilities as long term.
Inventory is a current asset because there is reason to believe it will be sold and will
generate cash within one year. Accounts payable are short-term liabilities because
they must be paid within one year. Note that over 40 percent of Polaris’s assets are
current, a fact we will say more about in the next chapter.

A Word to the Unwary

Nothing puts a damper on a good financial discussion (if such exists) faster than the
suggestion that if a company is short of cash, it can always spend some of its
shareholders’ equity. Equity is on the liabilities side of the balance sheet, not the asset
side. It represents owners’ claims against existing assets. In other words, that money has
already been spent.

Shareholders’ Equity
The different accounts appearing in the shareholders’ equity portion of the balance
sheet can often be a source of confusion. Polaris has three equity accounts: common
stock, additional paid-in capital, and retained earnings (see Table 1.2). Unless forced
to do otherwise, my advice is to forget these distinctions. They keep accountants and
attorneys employed, but seldom make much practical difference. As a first cut, just
add up everything that is not an IOU and call it shareholders’ equity.

The Income Statement

Polaris’s income statements for 2019 and 2020 are presented in Table 1.3. Looking at
Polaris’s operating performance in 2020, the basic income statement relation
appearing in Table 1.3 is:

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TABLE 1.3
Polaris Inc. Income Statements ($ millions)*

Source: Polaris annual reports and Compustat

January 1 to December 31
2019 2020
Net sales $6,863 $7,108
Cost of goods sold 4,899 5,057
Gross profit 1,964 2,051
Selling, general, and administrative expenses 953 904
Research and development 293 296
Depreciation and amortization 235 261
Total operating expenses 1,481 1,460
Operating income 484 592
Interest expense 78 67
Other nonoperating expense (income) (2) 4
Total nonoperating expenses 76 71
Income before income taxes 408 521
Provision for income taxes 84 107
Net income $ 324 $ 414

*
Totals may not add due to rounding.

Net income records the extent to which net sales generated during the accounting
period exceeded expenses incurred in producing the sales. For variety, net income is
also commonly referred to as earnings or profits, frequently with the word net stuck in
front of them; net sales are often called revenues or net revenues; and cost of goods
sold is sometimes labeled cost of sales. I have never found a meaningful distinction
between these terms. Why so many words to say the same thing? My personal belief
is that accountants are so rule-bound in their calculations of the various amounts
that their creativity runs a bit amok when it comes to naming them.

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 Income statements are commonly divided into operating and nonoperating
segments. As the names imply, the operating segment reports the results of the
company’s major, ongoing activities, while the nonoperating segment summarizes all
ancillary activities. In 2020, Polaris reported operating income of $592 million and
nonoperating expenses of $71 million, consisting largely of interest expense.

Measuring Earnings
This is not the place for a detailed discussion of accounting. But because earnings, or
lack of same, are a critical indicator of financial health, several technical details of
earnings measurement deserve mention.

Accrual Accounting
The measurement of accounting earnings involves two steps: (1) identifying revenues
for the period and (2) matching the corresponding costs to revenues. Looking at the
first step, it is important to recognize that revenue is not the same as cash received.
According to the accrual principle (a cruel principle?) of accounting, revenue is
recognized as soon as “the effort required to generate the sale is substantially
complete and there is a reasonable certainty that payment will be received.” The
accountant sees the timing of the actual

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