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Demystifying and Analyzing Financial Statements

For some people, financial statements are as complex and daunting as calculus, relativity or rocket science. Financial statements, however, are the backbone of investment decisions. They will tell you how good an investment prospect a certain company is, how a company or a particular security is doing, what it has gone through, and what challenges it faces in the future.

To become a really good investor, you must take the time to understand and analyze a company's financial statement. If you depend on the advice of money managers, then you can only be as good as they are. If you depend on the news to point you towards the right financial decisions, then you are treading on a well-beaten path - one in which the stakes are higher, the competition is much fiercer and the returns much lower.

There is a story behind every financial statement. Understand this story and you'll make the right investment decision. Understanding financial statements may be hard, but with a lot of patience, there's no reason why you should not be able to do it.

Financial Statements Overview

A company's financial statement generally has four components:

The balance sheet is a snapshot overview of the company's financial status and position.
The income statement tells you whether the company is making a profit or operating at a loss.
The cash flow statement tells you something about the company's liquidity and potential cash problems. Does the company have enough cash to operate?
The shareholder's equity statement shows how the company's shareholders are doing.

Each of these components provides a different perspective on the same thing - the health of the company. A danger or an opportunity that may be visible in one component may not be noticeable in another. It is therefore crucial that you analyze a company based on all of the components of its financial statement.

To learn more about the different components of financial statements, let's explore each one in greater detail.

The Balance Sheet

The balance sheet is the summary of a company's financial status at a certain point in time. It has 3 major components: the company's assets, liabilities and shareholders' equity.

Assets
Assets consist of anything that brings money in (income-generating) or anything that can be sold and converted to cash. A company's assets include cash or other cash equivalents (e.g. bonds, stocks and other investment vehicles). They also include physical properties such as buildings, vehicles, equipment, furniture, and inventory. Even intangible properties like brand value, trademarks, goodwill, etc. are considered assets. As long as something has value (whether such value is directly quantifiable or not), it can be considered an asset by a company and it thus has a place at the right-hand side of the company's balance sheet.

In a balance sheet, assets are generally listed according to liquidity (the ease by which they may be converted to cash). The most liquid (e.g. receivables, investments in the money market and inventory) come first and the least liquid (e.g. equipment, buildings, real estate) come last.
Liabilities
Liabilities are the opposite of assets. If assets bring money in (or has the potential to bring money in) to the company, liabilities drain money away.

A company's liabilities consist of its financial obligations such as
- loans taken out to finance the company's expansion or the launch of a new product line,
- mortgages taken out to purchase real estate or to renovate the company's buildings,
- monies owed to suppliers and service providers,
- and other recurring, operating expenses like the employee payroll, consultant fees, utility bills, procurement of office supplies, taxes, and insurance premiums
In a balance sheet, liabilities are usually arranged according to their due dates. They are also ordered according to priority. Short-term liabilities (liabilities that a company expects or needs to pay off before the year is out) come first. Long-term liabilities (liabilities that the company must shoulder for many more years to come) come last.
Shareholders' equity
The shareholders' equity represents the net value of the company at reporting time. It is a company's net value because this is what's left over if all of the company's assets are liquidated and all of its liabilities are paid off. It also represents the part of the company that its owners (the shareholders) actually own.

The three components are related to each other. In a balance sheet, everything must "balance out" - thus its name. Specifically, the sum of a company's liabilities and its shareholders' equity must equal that of its assets. After all, a company's assets have been acquired by incurring liabilities and sourcing capital from investors.

The Income Statement

The income statement is also known as the profit and loss statement because it shows how well or how badly a company is doing. It answers the basic question: is the company turning out a profit or operating at a loss?

Income statements are crucial to investors who are deciding whether or not they will invest in a company. Naturally, investors are drawn to profitable companies and steer clear of non-profitable companies.

Income statements are not that different from your monthly accounting of money. At the top of your accounting statement goes your monthly income, itemized according to their individual sources (e.g. salary, bonuses, etc.). The monthly income is then followed by the monthly expenses, broken down into specific items like rent, groceries, medical bills, and car payments, among others. The total expenses are then deducted from your total income. You have a surplus if something's left over after the deduction; you have a deficit if total expenses exceed the income.

In the case of a company's income statement, however, the period involved is often longer than a month. One year is the norm (and companies often prepare quarterly income statements as well). It itemizes all the income a company has made within the covered period and how much it has spent to earn such income. It is also constructed a bit differently from your average personal income statement (see below).

In a company's income statement, the bottom line is very important. This tells you about a company's revenue within the reporting period. A positive bottom line means revenues for the company. A negative bottom line, on the other hand, means a loss for the company.

The following details how an income statement is constructed and the bottom line derived:

Gross/Net Revenue: Income statements start with the item gross revenues or gross sales. This is simply the total amount of money the company earned from its sale of goods or services within the period covered. Sometimes, the amount of money that the company doesn't expect to collect from sales (returns or discounts) is already subtracted from this item. In this case, this item becomes net instead of gross revenues.
- [Less] Cost of Sales: The cost of sales is the amount of money that was spent on producing the products or services that were sold during the accounting period. Included under this category are the cost of raw materials used and the cost of labor employed to produce the company's revenue-generating goods or services.
  
  Think of the cost of sales as the cost of obtaining the company's gross/net revenues. The cost of sales is deducted from the gross/net revenue.
Gross Profit: Gross profit is simply the difference between the selling price and the production price of the goods and services sold during the accounting period.
- [Less] Operating Expenses: Operating expenses are the expenses not directly related to the production of goods and services but are essential to the company's operations. Included here are the research and development costs of new products, advertising and marketing costs, salaries of administrative personnel, utility costs, rental costs, the cost of obtaining licenses, maintenance costs, etc.
  
  Operating expenses are deducted from the gross profit.
- [Less] Depreciation: Physical property depreciates. Machines wear out and buildings get old. Companies take this into account by accounting for depreciation.
  
  Depreciation decreases the value of equipment, buildings, furniture, and other physical properties over time. Companies spread this cost over the average lifespan of the property and deduct it, with the operating expenses, from the gross profit to derive income from operations.
Income from Operations: This is the total calculated income of the company before interest payments and taxes are added to the equation.
- [Add] Interest Income: Interest income is the income a company gets from its interest-generating assets such as stocks, cash equivalents, interest bearing accounts, bonds, etc.
  
  Interest income is added to income from operations.
- [Less] Interest Expense: Interest expense is the interest payments a company has to shell out to service its loans from banks, suppliers and other creditors.
  
  Note that interest expense is deducted from the income from operations before income taxes are deducted. Loans, therefore, can be used to leverage a company's financial position. Essentially, by deducting its interest expenses from its pre-tax income, a company reduces its tax obligations.
Income before Taxes: This is the company's income after the interest income/payments have been added to income from operations and interest expense has been deducted from their total. This is basically the company's taxable income.
- [Less] Income Tax: This is the tax a company has to pay to the government for its income.
Net Income: This is income before taxes reduced by the amount of income tax the company has to pay for that income. This is the bottom line or the net amount of money that the company has made or lost within the accounting period.

You should be aware that, as useful as the net income is as a measure of a company's profit-worthiness, it doesn't tell the whole story. Some of the figures included in it (like depreciation) are just estimates. Intangibles like brand value, moreover, is not represented in the income statement even if it does affect a company's revenue-generating abilities.
Earnings per Share: Apart from the bottom line, the earnings per share is also important to investors. Earnings per share are calculated by dividing the net income of the company for the period (less preferred stock dividends) by the number of the company's issued and outstanding shares.

Essentially, the EPS tells you how much income every share of the company's stock gets. If you have x number of shares, multiply this with the EPS and you'll get the amount of income you will get should the net income of the company be distributed among its shareholders.

The Cash Flow Statement

Cash is King, as most great businessmen would say. Cash is to business what oxygen is to people. Without it, a business will die. What are the chances that a business will survive? Look at its cash flow statement to find out.

A company's cash flow statement is particularly of interest to

a company's current and potential investors who are naturally interested in the company's financial health,
potential creditors looking for assurance that the company will have enough cash to service its financial obligations,
potential contractors or employees who would like to ascertain that a company will be able to compensate them for their services, and
the company's accountants who have to make everything balance out.

A company with a healthy cash flow has the ability to react to sudden changes in financial circumstances. Companies with healthy cash flows cannot be forced to enter into expensive financial obligations just so it could continue its operations during economic downturns. They can handle external threats such as takeovers and changes in the economic landscape such as new legislations, new taxes, etc.

A company with a healthy cash flow is also more capable of expanding its operations, competing with other businesses and taking advantage of opportunities in the market. As such, cash flow statements are very important in determining the relative strengths of companies.

Cash Flow Activities

A cash flow or a flow of funds statement focuses on the inflows and outflows of cash in a company. The final value that appears on a company's cash flow statement shows the net increase or net decrease of cash for a certain period, disregarding other non-cash transactions that show up in the balance sheets and income statements (e.g. such as depreciation, credit losses, etc.).

Cash flow statements are divided into three segments that describe the different cash flow activities of a company. These are the cash flow of operating activities, cash flow of investing activities and cash flow of financing activities.

Operating Activities Cash Flow
Cash flow from operating activities take into account the flow of cash in all activities related to the company's operation. This includes the production of goods and services, sales and delivery of these goods and services, advertising and marketing costs, and cash received from customers. In the income statement, these items are listed in the cost of goods section as well as in the operating expenses section [depreciation and amortization not included].

According to the IAS 7 or the International Accounting Standard 7, cash flow from operating activities includes cash from the sale of goods and services, cash/dividends from the sale or returns of investments, interest income on loans, cash paid to suppliers for raw materials or services rendered, employee salaries, and interest payments to creditors.
Investing Activities Cash Flow
Cash flow from investing activities take into account the cash movement related to the acquisition or sale of any asset such as investment securities (stocks, bonds, etc), real estate properties, buildings, equipment, etc. It also shows any cash movement from the lending activities of the company as well as from any new acquisitions or mergers.
Financing Activities Cash Flow
The cash flow from financing activities, on the other hand, pertains to the inflow and outflow of cash to and from the shareholders, creditors and lenders as well as any changes in the equity structure of the company. This section includes any cash outflows resulting from the payment of dividends, repurchasing of shares, payment of dividend taxes, and repayment of debts. This also includes any cash inflows resulting from sales of company shares, proceeds from debts, etc.

Important Footnotes and Related Documents to Financial Statements

The footnotes of financial statements as well as related documents are also very important in helping an investor understand the financial health or viability of a company. In most instances, these provide a glimpse on the aspects of financial statements that are harder to quantify or some insights from the people inside the company.

The following are some of the important footnotes and related documents you should check when analyzing financial statements:

Non-Cash Financing Activities
Examples: When shares are issued in exchange for an asset, when non cash assets or liabilities are traded, when debt is converted to equity, and when the company leases to gain an asset
Accounting Practices Disclosures
Examples: Changes in accounting policies and practices, explanations for the formulas used to derive financial measures like inventory turnover, depreciation, etc.
Other footnotes and related documents
Examples: Cost and structure of retirement programs for the company's employees, detailed breakdown of the company's income taxes, stock options granted to employees of the company

Important Ratios and Calculations

The following are some of the important financial measures you should familiarize yourself with to understand financial statements.

Working Capital
This is the difference between the total of current assets of a company minus its total current liabilities. This is a summary measure that you can use to predict how well a company will do financially in the current year.
P/E Ratio
Price to Earnings per Share Ratio indicates how well a stock's earnings performance measures up against its common stock price. This is calculated by dividing the price per share of common stock by its earning per share. Essentially, the P/E Ratio indicates a stock's ROI.
Operating Margin
This ratio expresses the percentage of profit for every dollar of sale. It is calculated by dividing the income from operations value by the net income/revenues of the company.
Debt to Equity Ratio
The Debt to Equity Ratio gives you an idea about a company's debt burden. This is calculated by dividing the total liabilities of a company by the total shareholder's equity. Generally, you should go for a company with a low debt to equity ratio. Such a company is not borrowing more money than it can afford to pay.

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