Consolidated Financial Statements
What it is:
Consolidated financial statements are the combined financial statements of a company and all of its subsidiaries, divisions, or suborganizations.
How it works (Example):
Let's assume Company XYZ is a holding company that owns four other companies: Company A, Company B, Company C, and Company D. Each of the four companies pays royalties and other fees to Company XYZ.
At the end of the year, Company XYZ's income statement reflects a large amount of royalties and fees with very few expenses -- because they are recorded on the subsidiary income statements. An investor looking solely at Company XYZ's holding company financial statements could easily get a misleading view of the entity's performance.
However, if Company XYZ consolidates its financial statements -- "adding" the income statements, balance sheets, and cash flow statements of XYZ and the four subsidiaries together -- the results give a more complete picture of the whole Company XYZ enterprise.
In Figure 1 below, Company XYZ's assets are only $1 million, but the consolidated number shows that the entity as a whole controls $213 million in assets.
In the real world, generally accepted accounting principles (GAAP) require companies to eliminate intercompany transactions from their consolidated statements. This means they must exclude movements of cash, revenue, assets, or liabilities from one entity to another in order to avoid double counting them. Some examples include interest one subsidiary earns from a loan made to another subsidiary, "management fees" that a subsidiary pays the parent company, and sales and purchases among subsidiaries.
Why it Matters:
Consolidated financial statements provide a comprehensive overview of a company's operations. Without them, investors would not have an idea of how well an enterprise as a whole is doing.
GAAP dictates when and how statements should be consolidated, and whether certain entities need to be consolidated. Companies who only own a minority interest in an entity usually do not need to consolidate them on their statements. For example, if Company XYZ owned only 5% of Company A, it would not have to consolidate Company A's financial statements with its own.
Companies commonly break out their consolidated statements by division or subsidiary so investors can see the relative performance of each, but in many cases this is not required, especially if the company owns 100% of the division or subsidiary.
To learn more about how to read consolidated financial statements, click here to check out our tutorial, Financial Statement Analysis for Beginners.