Introduction to Financial Statements
The massive amount of numbers in a company’s financial statements can be bewildering and intimidating to many investors. On the other hand, if you know how to analyze them, the financial statements are a gold mine of information.
Financial statements are the medium by which a company discloses information concerning its financial performance. Followers of fundamental analysis use the quantitative information gleaned from financial statements to make investment decisions.
Before we jump into the specifics of the three most important financial statements – income statements, balance sheets, and cash flow statements – we will briefly introduce each financial statement’s specific function, along with where they can be found.
1. The Balance Sheet
The balance sheet represents a record of a company’s assets, liabilities and equity at a particular point in time. The balance sheet is named by the fact that a business’s financial structure balances in the following manner:
Assets = Liabilities + Shareholders’ Equity
Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets.
Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business – including retained earnings, which is the profit made in previous years.
2. The Income Statement
While the balance sheet takes a snapshot approach in examining a business, the income statement measures a company’s performance over a specific time frame. Technically, you could have a balance sheet for a month or even a day, but you’ll only see public companies report quarterly and annually.
The income statement presents information about revenues, expenses and profit that was generated as a result of the business’ operations for that period.
3. Statement Of Cash Flows
The statement of cash flows represents a record of a business’ cash inflows and outflows over a period of time. Typically, a statement of cash flows focuses on the following cash-related activities:
- Operating Cash Flow (OCF): Cash generated from day-to-day business operations
- Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets
- Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds
The cash flow statement is important because it’s very difficult for a business to manipulate its cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it’s tough to fake cash in the bank. For this reason some investors use the cash flow statement as a more conservative measure of a company’s performance.
The financial statements of companies listed in the Philippine Stock Exchange (PSE) can be found on the website of PSE at www.pse.com.ph.
Now that you have a brief background on what the major financial statements are, let us get into the specifics of each of them.
The Income Statement
The income statement is basically the first financial statement you will come across in an annual report or quarterly Securities And Exchange Commission (SEC) filing.
It also contains the numbers most often discussed when a company announces its results – numbers such as revenue, earnings, and earnings per share. Basically, the income statement shows how much money the company generated (revenue), how much it spent (expenses) and the difference between the two (profit) over a certain time period.
When it comes to analyzing fundamentals, the income statement lets investors know how well the company’s business is performing – or, basically, whether or not the company is making money. Generally speaking, companies ought to be able to bring in more money than they spend or they don’t stay in business for long. Those companies with low expenses relative to revenue – or high profits relative to revenue – signal strong fundamentals to investors.
Revenue As An Investor Signal
Revenue, also commonly known as sales, is generally the most straightforward part of the income statement. Often, there is just a single number that represents all the money a company brought in during a specific time period, although big companies sometimes break down revenue by business segment or geography.
The best way for a company to improve profitability is by increasing sales revenue. For instance, Starbucks Coffee has aggressive long-term sales growth goals that include a distribution system of 20,000 stores worldwide. Consistent sales growth has been a strong driver of Starbucks’ profitability.
The best revenue are those that continue year in and year out. Temporary increases, such as those that might result from a short-term promotion, are less valuable and should garner a lower price-to-earnings multiple for a company.
What Are The Expenses?
There are many kinds of expenses, but the two most common are the cost of goods sold (COGS) and selling, general and administrative expenses (SG&A).
Cost of goods sold is the expense most directly involved in creating revenue. It represents the costs of producing or purchasing the goods or services sold by the company.
For example, if SM pays a supplier PHP 15 for a box of soap, which it sells to customers for PHP 20. When it is sold, SM’s cost of good sold for the box of soap would be PHP 15.
Next, costs involved in operating the business are SG&A. This category includes marketing, salaries, utility bills, technology expenses and other general costs associated with running a business.
SG&A also includes depreciation and amortization. Companies must include the cost of replacing worn out assets. Remember, some corporate expenses, such as research and development (R&D) at technology companies, are crucial to future growth and should not be cut, even though doing so may make for a better-looking earnings report.
Finally, there are financial costs, notably taxes and interest payments, which need to be considered. High levels of debt lead to lots of interest payments and more expenses!
Profits = Revenue – Expenses
Profit, most simply put, is equal to total revenue minus total expenses. However, there are several commonly used profit subcategories that tell investors how the company is performing.
Gross profit is calculated as revenue minus cost of goods sold. Returning to SM again, the gross profit from the sale of the soap would have been PHP 5 (PHP 20 sales price less PHP 15 cost of goods sold = PHP 5 gross profit).
Companies with high gross margins will have a lot of money left over to spend on other business operations, such as R&D or marketing. So be on the lookout for downward trends in the gross margin rate over time. This is a telltale sign of future problems facing the bottom line. When cost of goods sold rises rapidly, they are likely to lower gross profit margins –unless, of course, the company can pass these costs onto customers in the form of higher prices.
Operating profit is equal to revenues minus the cost of sales and SG&A. This number represents the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations.
High operating margins can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Operating profit also gives investors an opportunity to do profit-margin comparisons between companies that do not issue a separate disclosure of their cost of goods sold figures (which are needed to do gross margin analysis).
Operating profit measures how much cash the business throws off, and some consider it a more reliable measure of profitability since it is harder to manipulate with accounting tricks than net earnings.
Net income generally represents the company’s profit after all expenses, including financial expenses, have been paid. This number is often called the “bottom line” and is generally the figure people refer to when they use the word “profit” or “earnings”.
When a company has a high profit margin, it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn.
And companies with profit margins reflecting a competitive advantage are able to improve their market share during the hard times – leaving them even better positioned when things improve again.
You can gain valuable insights about a company by examining its income statement. Increasing sales offers the first sign of strong fundamentals. Rising margins indicate increasing efficiency and profitability.
It’s also a good idea to determine whether the company is performing in line with industry peers and competitors. Look for significant changes in revenues, costs of goods sold and SG&A to get a sense of the company’s profit fundamentals.
The Balance Sheet
Investors often overlook the balance sheet. Assets and liabilities aren’t nearly as sexy as revenue and earnings. While earnings are important, they don’t tell the whole story. The balance sheet highlights the financial condition of a company and is an integral part of the financial statements.
The Snapshot Of Health
The balance sheet, also known as the statement of financial condition, offers a snapshot of a company’s health. It tells you how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also commonly called “net assets” or “shareholders equity”.
The balance sheet tells investors a lot about a company’s fundamentals: how much debt the company has, how much it needs to collect from customers (and how fast it does so), how much cash and equivalents it possesses and what kinds of funds the company has generated over time.
The Balance Sheet’s Main Three
Assets, liabilities, and equity are the three main components of the balance sheet. Carefully analyzed, they can tell investors a lot about a company’s fundamentals.
There are two main types of assets: current assets and non-current assets. Current assets are likely to be used up or converted into cash within one business cycle – usually treated as twelve months. Three very important current asset items found on the balance sheet are: cash, inventories and accounts receivables.
Investors normally are attracted to companies with plenty of cash on their balance sheets. After all, cash offers protection against tough times, and it also gives companies more options for future growth.
Growing cash reserves often signal strong company performance. Indeed, it shows that cash is accumulating so quickly that management doesn’t have time to figure out how to make use of it. A dwindling cash pile could be a sign of trouble.
That said, if loads of cash are more or less a permanent feature of the company’s balance sheet, investors need to ask why the money is not being put to use. Cash could be there because management has run out of investment opportunities or is too short-sighted to know what to do with the money.
Inventories are finished products that haven’t yet sold. As an investor, you want to know if a company has too much money tied up in its inventory. Companies have limited funds available to invest in inventory. To generate the cash to pay bills and return a profit, they must sell the merchandise they have purchased from suppliers.
Inventory turnover (cost of goods sold divided by average inventory) measures how quickly the company is moving merchandise through the warehouse to customers. If inventory grows faster than sales, it is almost always a sign of deteriorating fundamentals.
Receivables are outstanding (uncollected bills). Analyzing the speed at which a company collects what it’s owed can tell you a lot about its financial efficiency. If a company’s collection period is growing longer, it could mean problems ahead.
The company may be letting customers stretch their credit in order to recognize greater top-line sales and that can spell trouble later on, especially if customers face a cash crunch.
Getting money right away is preferable to waiting for it – since some of what is owed may never get paid!
The quicker a company gets its customers to make payments, the sooner it has cash to pay for salaries, merchandise, equipment, loans, and best of all, dividends and growth opportunities.
Non-current assets are defined as anything not classified as a current asset. This includes items that are fixed assets, such as property, plant and equipment (PP&E). Unless the company is in financial distress and is liquidating assets, investors need not pay too much attention to fixed assets.
Since companies are often unable to sell their fixed assets within any reasonable amount of time they are carried on the balance sheet at cost regardless of their actual value. As a result, it’s is possible for companies to grossly inflate this number, leaving investors with questionable and hard-to-compare asset figures.
There are current liabilities and non-current liabilities. Current liabilities are obligations the firm must pay within a year, such as payments owing to suppliers.
On the other hand, non-current liabilities represent what the company owes in a year or more time. Typically, non-current liabilities represent bank and bondholder debt.
You usually want to see a manageable amount of debt. When debt levels are falling, that’s a good sign. Generally speaking, if a company has more assets than liabilities, then it is in decent condition.
By contrast, a company with a large amount of liabilities relative to assets ought to be examined with more diligence. Having too much debt relative to cash flows required to pay for interest and debt repayments is one way a company can go bankrupt.
Look at the quick ratio. Subtract inventory from current assets and then divide by current liabilities. If the ratio is 1 or higher, it says that the company has enough cash and liquid assets to cover its short-term debt obligations.
Equity represents what shareholders own, so it is often called shareholder’s equity. As described above, equity is equal to total assets minus total liabilities.
Equity = Total Assets – Total Liabilities
The two important equity items are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders paid for their shares when the stock was first offered to the public. It basically represents how much money the firm received when it sold its shares.
On the other hand, retained earnings are a tally of the money the company has chosen to reinvest in the business rather than pay to shareholders. Investors should look closely at how a company puts retained capital to use and how a company generates a return on it.
Most of the information about debt can be found on the balance sheet – but some assets and debt obligations are not disclosed there. For starters, companies often possess hard-to-measure intangible assets. Corporate intellectual property (items such as patents, trademarks, copyrights and business methodologies), goodwill and brand recognition are all common assets in today’s marketplace. But they are not listed on company’s balance sheets.