💳Principles of Finance Unit 5 – Financial Statements

What Are Financial Statements?

• Financial statements provide a structured representation of the financial position, performance, and cash flows of a company
• Used by various stakeholders (investors, creditors, management) to make informed economic decisions
• Prepared according to standardized accounting principles (GAAP or IFRS) to ensure consistency and comparability
• Typically audited by independent certified public accountants (CPAs) to provide assurance on their accuracy and reliability
• Serve as a key source of information for assessing a company's financial health, profitability, liquidity, and solvency
• Help stakeholders understand how effectively a company is utilizing its resources to generate profits and create value

Types of Financial Statements

• Balance Sheet (Statement of Financial Position) reports a company's assets, liabilities, and equity at a specific point in time
• Income Statement (Profit and Loss Statement) presents a company's revenues, expenses, and net income over a specific period
• Statement of Cash Flows shows the inflows and outflows of cash from operating, investing, and financing activities during a specific period
• Statement of Changes in Equity (Statement of Retained Earnings) displays the changes in a company's equity accounts over a specific period
• Notes to the Financial Statements provide additional information and explanations to help users better understand the financial statements

Key Components of Financial Statements

• Assets are resources owned or controlled by a company that are expected to provide future economic benefits (cash, inventory, property, plant, and equipment)
  • Current assets can be converted to cash within one year (accounts receivable, short-term investments)
  • Non-current assets have a longer lifespan and are used in the company's operations (land, buildings, machinery)
• Liabilities are the company's financial obligations or debts that must be settled in the future (accounts payable, loans, bonds)
  • Current liabilities are due within one year (short-term loans, accrued expenses)
  • Non-current liabilities have a maturity date beyond one year (long-term debt, deferred tax liabilities)
• Equity represents the residual interest in the assets of the company after deducting liabilities (common stock, retained earnings)
• Revenues are the inflows of economic benefits arising from the ordinary operating activities of a company (sales of goods or services)
• Expenses are the outflows or depletion of assets incurred to generate revenues (cost of goods sold, salaries, depreciation)
• Net income is the difference between total revenues and total expenses, representing the company's profitability over a specific period

How to Read and Interpret Financial Statements

• Start with the balance sheet to understand the company's financial position and resource availability
  • Assess the composition and quality of assets, liabilities, and equity
  • Evaluate the company's liquidity and solvency by comparing current assets to current liabilities
• Review the income statement to gauge the company's financial performance and profitability
  • Analyze trends in revenues, expenses, and net income over time
  • Compare the company's performance to industry benchmarks and competitors
• Examine the statement of cash flows to understand the sources and uses of cash
  • Assess the company's ability to generate cash from operations, invest in growth, and meet financial obligations
• Study the notes to the financial statements for additional context and explanations
  • Look for information on accounting policies, contingencies, related-party transactions, and other relevant disclosures
• Consider the interrelationships between the financial statements to gain a comprehensive understanding of the company's financial health

Financial Statement Analysis Techniques

• Horizontal analysis (trend analysis) compares financial statement items over time to identify trends and growth patterns
• Vertical analysis (common-size analysis) expresses each financial statement item as a percentage of a base amount (total assets, total revenues) to assess composition and relative importance
• Ratio analysis involves calculating and interpreting financial ratios to evaluate various aspects of a company's performance and financial health
• Benchmarking compares a company's financial metrics to industry averages, competitors, or historical performance to provide context for evaluation
• Forecasting uses historical financial data and assumptions to project future financial performance and cash flows

Common Financial Ratios

• Liquidity ratios measure a company's ability to meet short-term obligations
  • Current ratio = $\frac{Current Assets}{Current Liabilities}$
  • Quick ratio (Acid-test ratio) = $\frac{Cash + Marketable Securities + Accounts Receivable}{Current Liabilities}$
• Profitability ratios assess a company's ability to generate profits relative to its revenues, assets, or equity
  • Gross profit margin = $\frac{Gross Profit}{Net Sales}$
  • Net profit margin = $\frac{Net Income}{Net Sales}$
  • Return on assets (ROA) = $\frac{Net Income}{Average Total Assets}$
  • Return on equity (ROE) = $\frac{Net Income}{Average Shareholders' Equity}$
• Solvency ratios evaluate a company's ability to meet long-term obligations and its financial leverage
  • Debt-to-equity ratio = $\frac{Total Liabilities}{Total Shareholders' Equity}$
  • Interest coverage ratio = $\frac{Earnings Before Interest and Taxes (EBIT)}{Interest Expense}$
• Efficiency ratios measure how effectively a company manages its assets and liabilities
  • Inventory turnover = $\frac{Cost of Goods Sold}{Average Inventory}$
  • Accounts receivable turnover = $\frac{Net Credit Sales}{Average Accounts Receivable}$

Real-World Applications

• Investors use financial statements to make informed decisions about buying, holding, or selling a company's securities
  • Fundamental analysis relies heavily on financial statement data to determine a company's intrinsic value
• Creditors and lenders assess a company's creditworthiness and ability to repay debt based on its financial statements
  • Banks and bondholders use financial ratios to determine the terms and interest rates of loans and bonds
• Management uses financial statements to monitor performance, make strategic decisions, and communicate with stakeholders
  • Budgeting and forecasting processes often start with historical financial statement data
• Regulators and tax authorities use financial statements to ensure compliance with reporting standards and tax laws
  • The Securities and Exchange Commission (SEC) requires public companies to file audited financial statements

Limitations and Considerations

• Financial statements are based on historical data and may not fully reflect a company's current or future performance
• Accounting standards allow for judgment and estimates, which can lead to differences in reported financial results across companies
  • Depreciation methods, inventory valuation, and revenue recognition policies can vary
• Financial statements do not capture non-financial factors that may impact a company's performance or value
  • Intangible assets (brand value, intellectual property), human capital, and environmental impact are not fully reflected
• Fraudulent reporting or accounting irregularities can distort financial statements and mislead users
  • High-profile cases (Enron, WorldCom) highlight the importance of effective auditing and oversight
• Financial statements should be analyzed in conjunction with other sources of information (industry trends, management commentary, news) to form a comprehensive view of a company