Financial Statements and Financial Statements Analysis
In order to determine the health of a business, you need financial statements. Why should the health of a business interest you? Can a business be healthy or sick? The answer is a definite ‘yes’. For businesses, cash is the lifeblood that drives everything. Healthy businesses either generate enough cash or have access to sources of cash that allow them to grow and prosper. Sick businesses suffer from the opposite, that is, they have serious liquidity problems. Hence as investors, customers, suppliers and employees, you need to understand how healthy or sick a business is.
- As a buyer, you would want to place a value on the business determined by objective and verified information.
- As a supplier, you may need to sell merchandise on credit. For example, a customer can walk inside your door and ask you to sell him one thousand laptops with the condition that he will pay you a month later. Do you want to take this business? How will you know you that the customer will pay one month later? We call this decision a credit decision. Right credit decisions can allow your business to grow, wrong credit decisions can push you into bankruptcy.
- As a customer, you may need to select contractors who have the financial strength to execute large or long-term contracts.
- As an employee, you need to evaluate growth opportunities & financial stability of your prospective employers.
Determining any of the above is a fairly complicated task. We need to assess internal and external factors and information. And make objective and subjective judgments. Financial statements go a long way in performing this analysis. For the purpose of this course we only look at the three most common statements.
- Balance Sheet
- Profit & Loss account (also known as the Income Statement)
- Statement of cash flows
The Balance Sheet
The most recent photo of my nine month old shows a lot: it captures him standing by himself, wearing his favorite pullover and jeans, clutching a half eaten pizza crust in his left hand.
A balance sheet is very similar to a snapshot of a business standing still at a point in time. In simple terms it shows what the company owns and what the company owes at that specific point in time. Everything on a balance sheet falls within these two categories – Owns and owes.
However, just as the photo of my nine-month-old does not show how much he has grown in the past few months, his very first step or his most recent bout with a cold, the information it captures limits a balance sheet.
A balance sheet is static. It does not capture flow or motion. A balance sheet does not show what happened to the firm the day before or what will happen the day after. It can help you assess the financial health of a firm, but that assessment is limited. Similar to a physician needing a number of tests to confirm his diagnosis, you need the Profit and Loss Statement, the Statement of Cash Flows and the Accounting Notes to reach any firm conclusions about a business.
In order to perform meaningful analysis, it is also important that you have a feel for how the firm has transformed in its recent past. This is why it is important to have a number of years of historical financial statements. Use history to get a grip over trends and events that have had a major impact on the firm.
The Income Statement
How many times have you heard the term top line and bottom line? If you haven’t you are just about to hear them. Both the terms refer to the income statement. Top line refers to total revenues, generally the first line (hence top) in the income statement. Bottom line refers to net income or earnings, usually the last line in this statement (hence bottom).
Also known as the statement of operation and the profit and loss account, the Income Statement summarizes what the firm did over a certain period. By looking at the statement you can understand how much customers paid for the product sold by the company in question; how much was spent in producing these products; what were the other costs of running this business; were there any additional significant expenses; how much taxes were paid? And so on.
Are there any issues with the income statement? Yes. You need to be aware that there is a big difference between the net income declared by a company and the actual cash generated by the business. With the income statement you can understand how profitable a business is, but you cannot determine what percentage of the same profits translates into cash. Why is this important? Remember cash is the lifeblood. You can be very profitable but without cash, profits may not mean much.
The second issue is that earnings can be managed. Firms, within limits, can decide the level of earnings they want to declare. Accounting eccentricities can be used to increase as well as decrease declared income. Once again this high-lights the importance of cash as an absolute measure
Statement of Cash Flows
This is the first statement that I look at when evaluating a business. There is an amazing amount of information that can be compressed in one page and the statement of cash flows demonstrates that. At a glance it can tell you how much income was declared, the actual cash generated by the business, how was that cash used, was any additional financing needed and is the business a source or user of cash.
The statement can generally be broken down into three components.
- First, Operating cash flows, which is a summary of the business.
- Second, Investing cash flows, which shows how the cash surplus (deficit) generated by the business has been applied (financed).
- Third, Financing cash flows, which shows if any additional financing was needed or if a change in the financial structure of the company has occurred.