3.1 Financial statements

Financial statements are the backbone of corporate finance, offering a snapshot of a company's financial health. These documents, including balance sheets, income statements, and cash flow statements, provide crucial insights into a company's assets, liabilities, revenues, and expenses.

Understanding financial statements is essential for investors, analysts, and business journalists. By examining these reports, one can assess a company's profitability, liquidity, and overall financial performance. This knowledge is vital for making informed decisions and reporting on corporate finance.

Types of financial statements

• Financial statements provide a snapshot of a company's financial health and performance over a specific period
• The three main types of financial statements are the balance sheet, income statement, and cash flow statement
• Each statement offers unique insights into different aspects of a company's finances (assets, liabilities, revenues, expenses, cash inflows, cash outflows)

Components of balance sheets

• A balance sheet is a statement of a company's financial position at a specific point in time
• It follows the fundamental accounting equation: Assets = Liabilities + Equity
• The balance sheet is divided into two main sections: assets on one side and liabilities plus equity on the other

Assets on balance sheets

• Assets are resources owned by a company that have economic value and can be converted into cash
• Current assets include cash, accounts receivable, and inventory which can be converted to cash within a year
• Non-current assets include property, plant, and equipment (PP&E) and intangible assets (patents, trademarks) which are long-term investments
• Total assets are calculated by adding current assets and non-current assets

Liabilities and equity

• Liabilities are a company's financial obligations or debts that must be paid in the future
• Current liabilities include accounts payable, short-term loans, and taxes due within a year
• Non-current liabilities include long-term loans, bonds payable, and pension obligations
• Equity represents the owners' residual claim on the company's assets after liabilities are paid
  • Equity includes common stock, preferred stock, and retained earnings

Income statement overview

• An income statement, also known as a profit and loss (P&L) statement, shows a company's financial performance over a specific period
• It starts with revenue or sales at the top and subtracts various expenses to arrive at the bottom line: net income or net loss
• The income statement follows a multi-step format, with sections for operating and non-operating activities

Revenue and expenses

• Revenue is the total amount of money a company earns from selling goods or services
• Expenses are the costs incurred by a company to generate revenue (cost of goods sold, salaries, rent, depreciation)
• Gross profit is calculated by subtracting cost of goods sold from revenue
• Operating expenses are subtracted from gross profit to determine operating income

Profit vs loss

• If total revenues exceed total expenses, the company reports a net profit or net income
• If total expenses exceed total revenues, the company reports a net loss
• Earnings per share (EPS) is calculated by dividing net income by the number of outstanding shares
  • EPS is a key metric used to evaluate a company's profitability and attractiveness to investors

Cash flow statement basics

• A cash flow statement reports the inflows and outflows of cash during a specific period
• It shows how a company generates and uses cash, broken down into three main categories: operating, investing, and financing activities
• The cash flow statement helps investors and analysts assess a company's liquidity, solvency, and ability to pay dividends

Operating activities

• Cash flows from operating activities include cash received from customers, cash paid to suppliers and employees, and income taxes paid
• Positive cash flow from operations indicates a company is generating sufficient cash to maintain and grow its operations
• Negative cash flow from operations may signal financial distress or unsustainable business practices

Investing and financing activities

• Cash flows from investing activities include purchases and sales of long-term assets (PP&E, investments) and business acquisitions or divestitures
• Cash flows from financing activities include proceeds from issuing stock or debt, dividend payments, and repurchases of stock
• Positive cash flow from investing and financing activities indicates a company is expanding, while negative cash flow suggests divestment or deleveraging

Connections between statements

• The three financial statements are interconnected and provide a comprehensive view of a company's financial position and performance
• Net income from the income statement flows into the retained earnings section of the balance sheet
• Changes in balance sheet accounts (assets, liabilities, equity) are reflected in the cash flow statement
• Analysts often use data from all three statements to calculate key financial ratios and assess a company's overall health

Analyzing financial statements

• Financial statement analysis involves using data from the balance sheet, income statement, and cash flow statement to evaluate a company's performance and make informed decisions
• Analysts calculate various financial ratios to assess a company's liquidity, solvency, profitability, and efficiency
• Ratio analysis allows for comparisons between companies, industries, and time periods

Liquidity and solvency ratios

• Liquidity ratios measure a company's ability to meet its short-term obligations using current assets
  • Current ratio = Current Assets / Current Liabilities
  • Quick ratio = (Current Assets - Inventory) / Current Liabilities
• Solvency ratios assess a company's ability to meet its long-term debt obligations
  • Debt-to-equity ratio = Total Liabilities / Total Equity
  • Interest coverage ratio = EBIT / Interest Expense

Profitability ratios

• Profitability ratios evaluate a company's ability to generate profits relative to its revenue, assets, or equity
• Gross profit margin = Gross Profit / Revenue
• Operating profit margin = Operating Income / Revenue
• Net profit margin = Net Income / Revenue
• Return on assets (ROA) = Net Income / Total Assets
• Return on equity (ROE) = Net Income / Total Equity

Efficiency ratios

• Efficiency ratios measure how effectively a company uses its assets and manages its liabilities
• Inventory turnover = Cost of Goods Sold / Average Inventory
• Receivables turnover = Revenue / Average Accounts Receivable
• Payables turnover = Cost of Goods Sold / Average Accounts Payable
• Asset turnover = Revenue / Average Total Assets

Limitations of financial statements

• Financial statements have inherent limitations that users should be aware of when conducting analysis
• They are historical in nature and may not reflect current market values or future performance
• Management has discretion in choosing accounting methods (depreciation, inventory valuation) which can impact reported results
• Financial statements do not capture non-financial factors that may affect a company's value (brand reputation, customer loyalty, employee morale)

Footnotes and disclosures

• Footnotes provide additional information and explanations about items in the financial statements
• They disclose accounting policies, contingencies, commitments, and events occurring after the balance sheet date
• Footnotes are an integral part of the financial statements and should be carefully reviewed by analysts and investors
• Disclosures provide information about risks, uncertainties, and other factors that may impact a company's financial condition or operating results

Auditor's reports and opinions

• An auditor's report is an independent assessment of whether a company's financial statements are fairly presented in accordance with accounting standards
• The four types of audit opinions are:
  1. Unqualified opinion (clean opinion)
  2. Qualified opinion
  3. Adverse opinion
  4. Disclaimer of opinion
• Analysts should review the auditor's report to identify any issues or uncertainties that may affect the reliability of the financial statements

Detecting financial statement fraud

• Financial statement fraud involves the intentional misstatement or omission of material information in the financial reports
• Fraudulent reporting can mislead investors, regulators, and other stakeholders about a company's true financial condition and performance
• Analysts should be alert to red flags that may indicate financial statement fraud

Red flags in statements

• Unexplained changes in accounting policies or estimates
• Significant transactions with related parties or off-balance sheet entities
• Unusual growth in revenues or profits that is inconsistent with industry trends
• Large discrepancies between net income and cash flows from operations
• Excessive pressure on management to meet financial targets or analyst expectations

Famous accounting scandals

• Enron: Concealed substantial losses and liabilities through complex off-balance sheet partnerships
• WorldCom: Inflated earnings by improperly capitalizing operating expenses as assets
• Tyco: Executives engaged in unauthorized bonuses, forgiven loans, and fraudulent stock sales
• Lehman Brothers: Used repurchase agreements to temporarily remove assets from its balance sheet and mask its true leverage

Reporting on financial statements

• Business journalists play a crucial role in analyzing and interpreting financial statements for their readers
• Effective reporting requires a deep understanding of accounting principles, financial ratios, and industry-specific factors
• Journalists should strive to provide clear, concise, and unbiased insights into a company's financial performance and prospects

Extracting key insights

• Identify trends and patterns in a company's revenue, expenses, profits, and cash flows over time
• Compare a company's financial ratios to its peers and industry benchmarks to assess its relative performance
• Analyze the management's discussion and analysis (MD&A) section to gain insights into the company's strategy, risks, and future outlook
• Look for inconsistencies or red flags in the footnotes and auditor's report that may signal underlying problems

Translating jargon for readers

• Explain key accounting terms and concepts in plain language that a general audience can understand
• Use analogies, examples, and visualizations to illustrate complex financial data and relationships
• Provide context and interpretation to help readers grasp the significance of the numbers and what they mean for the company's future prospects
• Highlight the most important takeaways and implications of the financial statements for investors, employees, customers, and other stakeholders