A company’s financial statement is a collection of financial records that have been recorded and gives readers an insight into how the company is performing numerically. Financial statements include the balance sheet, income statement, and the statement of cash flows. Each statement is interrelated to each other and covers a specific area of the company which is unique.
The balance sheet gives readers information about the resources a company currently has and how the resources were financed. It groups items into three sections: liabilities, assets, and the owner’s equities. Although the balance sheet is an important aspect of financial statements, it does not give the reader a full overview of a company. When reading a balance sheet, an important part to notice is the composition of its assets, liabilities, and equities. Each industry has a unique arrangement of these items. For example, a biotechnology company that focuses on research &development should not have high fixed assets versus a manufacturing company. A red flag should be raised if a company’s balance sheet allocation deviates much from the industry’s norm.
Second, how are the assets being financed? Are they being financed by short-term or long-term liabilities or equities? And why? Theoretically, short-term assets should be financed with short liabilities; however, sometimes, it’s not the case, especially when there are shareholder arrangements involved. Shareholder arrangements is beyond the scope of this blog.
Lastly, look for items such as “Others” that are material. There will always be some items that the company groups together because they are insignificant. However, if the number is large enough then it would require additional digging to find out the impact of these “Others” items. You might not agree with the company and re-categorize some of these “Others” to be meaningful and material to the company’s operation as a going concern.
The income statement (which is also referred to as a profit and loss statement or P&L for short), gives readers a summary of the company’s expenses and profits for the duration of particular period, a year, a quarter... Regardless of whether a company is profitable or not, a good starting point to analyze an income statement is the trend and relationship between its profitability and expenses and compare with its industry norm and cyclicality. For example, a consumer retailer’s fourth quarter in a calendar year normally generates the highest revenue versus a pharmaceutical company that specializes in cancer treatment which should have minimal impact from cyclicality.
Again, look for those “Others” in an income statement, especially the ones categorized as nonoperating related or nonrecurring items. Are they really nonoperating or nonrecurring? Dig more to find out and make adjustments as appropriate.
Lastly, don’t take profitability in an income statement as a measure of the success of a company. Generating profit does not guarantee the company’s going concern which brings us to the statement of cash flow.
The final part of the financial statements is the cash flow statements. It provides a map of the company’s cash during a particular period of time (known as the accounting period). The cash flow statement takes into account all of the cash that enters the company and all of the cash that leaves the company.
As mentioned previously, a company could fail even if it generated exceptional revenue; but, was unable to convert the revenue into cash in time to meet its obligations.
In the other words, employees get paid in cash (just ask yourself how you get paid), lenders get paid in cash, and suppliers get paid in cash. Some get paid on the same day and some180 days after the delivery of products or services; but, they all get paid in cash; or they walk.
Now, all three financial statements integrate with each other. How many days it would take to make a sale? It involves revenue from income statement and accounts receivable from balance sheet. How much cash the company actually receives from sales during the period? It’s taking the beginning account receivable of a period and subtract the ending account receivable balance. How much cash it went out to meet its obligations? It’s the decrease of cash and the decrease of liabilities. Again, this just demonstrates how the three financial statements connect with each other.
That being said, reading only one aspect of a financial statement would very often lead to a wrong and incomplete view. To perform an accurate financial projection analysis must include the fully integrated balance sheet, income statement, and cashflow statement in order to gain a precise insight into a company.