Analyzing financial statements is a way to understand how healthy a company is. Companies exist to make profits and money. And, to do this, they produce goods or provide services. Therefore, financial performance should be a reflection of the company’s operational performance.
The company strives to gain a competitive advantage. That way, they can make more money for their shareholders. And, how successful the company did it, at least, you can evaluate it from the financial statements.
What is the financial statement
A financial statement is a document that contains a company’s financial information. By reading it, you will know the position and financial performance during the reporting period. The three most essential and frequently viewed sections are the balance sheet, income statement, and cash flow statement.
Financial statement provide insight to you about information such as:
- Money the company makes
- Profitability and efficiency of the company in generating profits
- Leverage level and capital composition.
- Company’s liquidity in fulfilling short-term obligations and solvency of the company in meeting long-term obligations
- Dividend payment to shareholders
What is the general purpose of financial reporting?
The company prepares financial reports to inform its financial condition and performance to stakeholders such as investors and creditors. This report helps them to make economic decisions.
Reporting is mandatory for public companies. They publish quarterly or annually. Such reports are part of transparency and good corporate governance.
What makes financial report complete
Complete financial statements usually consist of:
- Balance sheet – provides an overview of the company’s financial position. In it, you will find assets, liabilities, and shareholder equity. Total assets must be equal to total liabilities and shareholder equity (total equity).
- Income statement – tells you about the company’s financial performance during the reporting period. You will find revenue, expenses, and profits in this section. This report is linked to the balance sheet through retained earnings in the shareholders’ equity section.
- Cash flow statement – reports cash in and out. It consists of three parts, operating activities, investing activities, and financing activities. The cash and cash equivalents account in the assets section link this report to the balance sheet.
- Management’s responsibility for financial reporting – contains statements about official responsibility by management related to the integrity and objectivity of financial statements.
- Statement of changes in shareholder equity – presents the effects of all transactions affecting shareholder equity during the reporting period.
- Independent auditor’s report – contains the auditor’s opinion about the quality of information presented in the financial statements.
- Notes to financial statements – discuss each item on the balance sheet, income statement, and cash flow statement in more detail.
The balance sheet, income statement, and cash flow statement are the most critical parts. Users usually focus on all three when analyzing financial statements.
Why financial statement matters
Various parties have interests with the company for several reasons. Shareholders invest their money in the company. Banks and bond investors lend their money to the company. They all want to do it when the company is performing well.
Before making a decision, they need to assess the company’s performance. For this reason, they not only rely on operational information but also on financial data.
But, indeed, not all financial reports are of good quality. Thus, the audit report is the part that you need to pay attention to find out the quality. That way, you could make more accurate decisions.
Who are the users of financial statements
Various stakeholders require a financial statement. They use it to make decisions or studies, including:
- Creditors, such as banks and bond investors, assess business liquidity and solvency. Creditors give loans to companies and, of course, want their money back. Thus, they will evaluate whether the company has enough cash to pay interest and principal or no.
- Competitors – interested in monitoring company profits. They track where companies make profits and how efficiently they do it. Together with operational data, financial statements help competitors understand the company’s competitive advantage.
- Government – uses financial information to calculate corporate taxes.
- Shareholders and stock investors – use financial statements to help them make decisions about their investments in the company. They see how well the company’s current performance and future prospects. They want companies to provide high investment returns, reflected in dividends and rising share prices.
- Employees – use it to see if a company’s financial performance is healthy. A sound company performance makes them more optimistic about the security of their work in the future (less likely to terminate employment).
- Researchers, including students and lecturers – to make reports such as journals and final assignments.
- Equity analysts – use it to evaluate a company’s stock price. It helps them assess the fair price of a company’s stock before making a buy or sell decision.
- Credit rating analysts – use the financial statements to assign ratings.
Three main components of financial statements
Not all parts of the financial statements you must read thoroughly. Some sections are only supporting information. To make an analysis or financial model, you should focus on the balance sheet, the income statement, and the cash flow statement. After that, when you need the details of all three, you can track them in the notes section of the financial statements.
The balance sheet is useful for assessing the company’s financial position and capital composition. In this section, you can see how a company funds its assets, whether through debt or equity. You can also check the company’s ability to meet obligations, both short and long term.
A balance sheet consists of three main parts: assets, liabilities, and shareholder equity (also called equity or owner’s equity). The company presents asset and liability items based on their liquidity order.
Assets represent the company’s economic resources. Liabilities represent creditor claims against company assets. Meanwhile, shareholders’ equity represents residual claims on assets after deducting liabilities. We can write the relation of the three into an accounting equation:
Assets = Liabilities + Shareholder equity
Companies present liabilities and assets into two categories: current and non-current. So, in a complete financial statement, you will see five sub-sections on the balance sheet: current assets, non-current assets, current liabilities, non-current liabilities, and shareholder equity.
The company expects to convert current assets into cash within one year or one operating cycle. The operating cycle refers to the average time in converting funds to purchase inventory or raw materials into sales cash.
Current assets usually consist of:
We also call this long-term asset. Noncurrent assets are less liquid, and to convert them into cash requires more than one year or one operating cycle. Examples of the account are:
- Property, plant, and equipment (PP&E).
- Long-term investments, such as property investment.
- Intangible assets such as goodwill.
This section covers items that companies must pay in one year or one operating cycle. The components consist of:
This section represents items that companies must pay in more than one year. Two of the components are:
- Long -term debt
- Long-term deferred tax liabilities
Shareholders ‘equity shows shareholders’ residual claims on company assets. In other words, it is the amount of money they will receive if all assets are liquidated, and all company obligations are paid.
In this section, you will see several accounts, such as:
- Paid-in capital
- Additional paid-in capital
- Retained earnings
- Accumulated comprehensive income
The income statement presents the company’s financial performance during the accounting period. This section tells you about business operations, and therefore, we also call them statements of operations. Another term for this report is the profit and loss statement.
The three main elements in this report are revenue, expenses, and profit. The difference between revenue and expenses is profit (or loss).
Profit = Total revenue – Total expense
The income statement usually shows accounts such as:
- Cost of goods sold (COGS)
- Gross profit
- Operating expenses, for example, selling, general and administrative expenses (SG&A expenses)
- Operating profit (or operating income)
- Interest income (expense)
- Tax expense
- Net profit (or net income)
Net profit = Revenue- COGS – Operating expenses + Other income (expenses) – Tax expense
Cash flow statement
Cash flow statements present the money in and out of the company. It consists of three parts:
- Cash flow from operations- related to daily business operations.
- Cash flow from investing activities – associated with the acquisition and disposal of long-term assets.
- Cash flow from financing – associated with the collection and repayment of capital.
First thing you should do before analyzing financial statements
You should read the auditor report before analyzing further financial statements. In this section, you will know about the quality of the financial information presented.
The auditor will express an opinion about the reasonableness of the information contained in the financial statements. They work according to accepted accounting standards. Their activities can include a review of internal controls, tests, and verification of data and other necessary activities.
The company’s financial statements must meet the applicable financial reporting standards. Many external users rely on financial statements to make decisions. When financial statements contain inaccurate information, it can lead to wrong decision making.
The best quality is if it gets an unqualified opinion, which shows the financial statements are fairly presented following applicable accounting standards.
Other types of auditor’s opinion of a lower quality are:
- Qualified opinion
- Adverse opinion
- Disclaimer of opinion