Understanding Financial Information for Bankruptcy Lawyers – Understanding Financial
Statements
In the United States, businesses generally present financial information in the form of financial
statements and supplementary disclosures that are prepared in accordance with generally
accepted accounting principles, or “GAAP.” Typically, these financial statements are presented
on an accrual basis and presume that the business will continue to operate. Although there are
other bases of accounting that may be appropriate, this Practical Guidance will focus on accrual
accounting for a continuing business.
Most businesses produce financial statements for both internal audiences and external users.
Issuers of publicly-traded securities are generally required to file periodic financial reports with
the Securities and Exchange Commission (“SEC”) with very specific disclosure requirements.
These financial reports provide various financial information that investors and creditors use to
evaluate a company’s financial performance. It is important to remember that the information is
historical rather than prospective in nature. These financial reports generally present
comparative financial information in four financial statements and certain additional information
contained in notes and other disclosures. The financial statements generally include:
 Statement of operations (income statement);
 Balance sheet;
 Statement of cash flows; and
 Statement of changes in equity or net assets.
To the extent that independent accountants are involved in the financial reports, there should be a
report from the accountant, commonly in the form of an audit opinion.
Income Statement
An income statement shows the revenue earned and the expenses incurred by a company over a
specific time period, through both operating and non-operating activities. The income statement
is organized as follows:
 Revenue includes all of the income generated by the business.

Cost of Goods Sold (“COGS”), sometimes referred to as cost of sales, includes all the
costs directly related to the sale of products (or, if a service company, the costs directly
related to providing the services), including materials consumed, salaries and benefits for
those involved in production, depreciation and amortization of assets, etc.

Gross profit is the difference between revenue and COGS.

Operating expenses include expenses associated with the operations of the business that
are not directly related to producing goods or providing services. These expenses could
include selling, general, and administrative expenses such as the costs to own and
maintain buildings that are not used in producing goods and services. Operating
expenses often include accounting and legal expenses, payroll and benefits for
administrative staff, utilities, maintenance, insurance, rent, repairs and maintenance, etc.

Depreciation and amortization reflect the estimated decrease in value of tangible and
intangible capital assets that are used by the business.

Earnings Before Interest and Taxes (“EBIT”), or operating profit, is gross profit minus
operating expenses and depreciation. EBIT shows the capacity of a business to repay its
obligations.

Net Income is EBIT less taxes and interest expenses.
Below is a sample income statement:
Sample Income Statement
Total Revenue
$100,000
COGS
($30,000)
Gross Profit
$70,000
Operating Expense
($18,000)
Depreciation
($15,000)
EBIT or Operating
$37,000
Profit
Interest Expense
($10,000)
Taxes
($10,000)
Net Income
$17,000
Balance Sheet
The balance sheet shows what a company owns and what it owes at a fixed point in time. The
balance sheet provides detailed information about assets, liabilities, and shareholders’ equity.
The relationship between these categories is as follows: Assets = Liabilities + Owners Equity.
Assets are the property that a company owns. There are three basic types of assets: current
assets, tangible fixed assets, and intangible assets. Current assets are cash or assets that will be
converted to cash within the next year. A company’s current assets may include cash,
inventories, and accounts receivable. Fixed assets represent the tangible, long-lived assets that a
company may own. These are assets that are not scheduled to be converted into cash within the
next year and include buildings, machinery, and land. Lastly, a company’s intangible assets are
those assets that cannot be physically touched, such as intellectual property, branding, customer
relationships, and goodwill. Assets are generally presented at historical cost rather than current
market value. Although some assets may reflect adjustments to reflect reductions in value, assets
are very rarely adjusted upwards to reflect increases in their value above their original cost.
Liabilities are the debts and obligations of a company. There are two basic types of liabilities:
current liabilities and non-current liabilities. Similar to current assets, current liabilities are the
debts and financial obligations of a company that will be repaid within the next year. Accounts
payable and accrued interest, wages, and current maturities of long-term debt can all be
considered current liabilities. Conversely, non-current liabilities are the debts and financial
obligations that will not come due within the next year. Common non-current liabilities are
long-term debt and pension obligations.
Shareholders’ equity is the equity stake currently held by a firm’s owners/investors.
Shareholders' equity comes from two main sources. Paid in capital represents the funds that
were originally invested in the company, along with any additional contributions made
thereafter. Retained earnings represent the profit, after tax, that the company has generated from
its operations.
Below is a graphic representation of assets, liabilities, and shareholders' equity.
Statement of Cash Flows
The statement of cash flows details a company’s sources and uses of cash, including the net
increase or decrease in cash for the period, and reconciles the amount of profit to the movement
in cash in a given period. Generally, cash flow statements are divided into three main parts: cash
flow from operations, investing, and financing. Each part summarizes the cash flow associated
with each of these activities. When working with a troubled company, a recurring refrain is
“cash is king,” and the statement of cash flows often reveals extremely valuable information
about the business.
Operations – Cash flow from operations reflects how much cash is generated from a company's
business operations. Most companies report cash flow from operations using the indirect
method, which reconciles net income or losses to the actual cash inflows/outflows from
operations by adjusting for non-cash items reported on the income statement (e.g., depreciation)
and changes in working capital and other operating assets (e.g., accounts receivable, inventory,
accounts payable, etc.). Negative or declining cash flow from operations is often the first
warning sign that a business is under stress. Another sign of distress may include positive cash
flow generated from accounts payable, frequently referred to as “stretching.” Positive cash flow
is generated when accounts payable balances increase over a period of time (due to slowing of
payments or, in certain cases, non-payment), and is generally an indication that the business
lacks liquidity.
Investing – Cash flow from investing activities shows the cash flow impact of a business’s
investments in its assets during a given period of time. Usually cash changes from investing are
a "cash out" item as cash is used to buy new equipment, buildings, or other assets such as
marketable securities. However, when a company divests of an asset, the cash generated from
the transaction is considered a "cash in" item and is reported as a positive amount in the cash
flow from investing activities section.
Financing – Cash flow from financing activities represents the cash impact of changes in debt,
loans, or the payment of dividends during a given period of time. Changes in cash from
financing are "cash in" when capital is raised, and are "cash out" when interest or dividends are
paid. Thus, if a company issues a bond to the public, the company receives cash inflows;
however, when interest is paid to bondholders, the company is reducing its cash.
Reports of Independent Accountants
When outside accounts are involved in financial reporting, they are generally required to issue
reports indicating their level of involvement from assisting in the preparation of the statements,
reviewing the statements, and/or auditing the information contained therein. If the financial
statements include an audit opinion, there may be “qualifications” to the opinion. Often, the
audit opinion for the financial statements of troubled companies will state that the company may
not be a “going concern.” In those cases, the reader should understand that the financial
statements presume that the business will continue and do not address what may happen if the
company files for protection under the Bankruptcy Code.
Some common financial statement ratios and calculations are analyzed in the chart below.
Common Financial Statement Ratios and Calculations
Ratio
Formula
Purpose
Gross margin
(Revenue – Cost of
A measure of profitability;
Goods Sold) /
indicates the percentage of
Revenue
total sales that the company
retains after incurring the
costs associated with
producing the goods or
providing services
Operating margin
Income from
A measure of profitability;
Operations /
indicates how much of each
Derived From
Income Statement
Income Statement
Revenue
EBITDA margin
Interest coverage
Earnings per share
(EPS)
Price-to-earnings
ratio (P/E Ratio)
Current ratio
Quick ratio
Days cash on hand
(DCOH)
Days sales
outstanding (DSO)
Inventory turnover
ratio
Days payable
outstanding (DPO)
Return on assets
(ROA)
Net Income before
Interest, Taxes,
Depreciation and
Amortization /
Revenue
Net Income before
Interest and Taxes /
Interest Expense
(Net Income –
Dividends on
Preferred Stock) /
Average Outstanding
Shares
Price per Share /
Earnings per Share
dollar of revenue is left after
operating expenses
A measure of profitability;
often used to approximate
operating cash flows
Income Statement
A ratio used to determine
how easily a company can pay
interest on outstanding debt
A measure of profitability;
indicates the amount of profit
earned during a period per
share of common stock.
Income Statement
A valuation ratio; compares a
company’s current share price
against its per-share earnings
Current Assets /
A liquidity ratio; indicates the
Current Liabilities
ability of a business to satisfy
current liabilities with current
assets
(Current Assets –
A liquidity ratio; indicates the
Inventories) /
ability of a business to satisfy
Current Liabilities
current liabilities with its most
liquid current assets
Cash & Cash
A liquidity ratio; indicates the
Equivalents /
number of days of cash
((Operating Expenses operating expenses a
– Depreciation –
company could cover with its
Amortization)/# of
cash on hand
Days)
(Accounts Receivable A working capital ratio;
/ Average Credit
measures the average number
Sales) * Number of
of days that it takes for a
Days
company to collect revenue
from a credit sale
Cost of Sales /
A working capital ratio;
Average Inventory
indicates how many times
inventory is sold and replaced
during a given period
(Accounts Payable /
A working capital ratio;
Cost of Sales) *
indicates how long it typically
Number of Days
takes a company to pay a
trade creditor
Net Income /
A profitability/efficiency
Average Total Assets metric; indicates how efficient
Income Statement
& Balance Sheet
Income Statement
& Balance Sheet
Balance Sheet
Balance Sheet
Income Statement
& Balance Sheet
Income Statement
& Balance Sheet
Income Statement
& Balance Sheet
Income Statement
& Balance Sheet
Income Statement
& Balance Sheet
Debt-to-total-capital
Debt-to-equity
Total Debt / (Total
Debt + Shareholder’s
Equity)
Total Debt /
Shareholder’s Equity
management is at utilizing
assets to generate profits
A leverage ratio; indicates the
relative use of debt and equity
as a source of capital
A leverage ratio; indicates the
relative use of debt and equity
as a source of capital
Balance Sheet
Balance Sheet
The relevance and application of each of these ratios is dependent on the type of business and
industry being evaluated.
Bibliography
Entrepreneur Media, Inc. (n.d.). Entrepreneur. Retrieved December 18, 2012, from Income
Statement: http://www.entrepreneur.com/encyclopedia/term/82202.html#
Investopedia US. (2010, May 23). What is a Cash Flow Statement? Retrieved December 18,
2012, from Investopedia: http://www.investopedia.com/articles/04/033104.asp#axzz2A98o1eiU
U.S. Securities and Exchange Commission. (2007, February 5). Beginners' Guide to Financial
Statements. Retrieved December 18, 2012, from U.S. Securities and Exchange Commission:
http://www.sec.gov/investor/pubs/begfinstmtguide.htm