How to conduct a Financial Statement Analysis

Financial Statements are company-issued accounting reports with past performance information that a firm issues periodically (usually quarterly and annually). Companies in the US are required to file their financial statements with the Securities and Exchange Commission (SEC) on a quarterly and annually basis. The information in the annual report must also be sent to the shareholders every year. Financial statements are important tools through which investors, financial analysts and other interested parties like the creditors obtain information about a corporation. They are also useful for managers within the firm as a source of information for corporate financial decisions.

Generally Accepted Accounting Principles (GAAP): GAAP or Generally Accepted Accounting Principals provide a common set of rules and a standard format for public companies to use when they prepare their reports. This standardization also makes it easier to compare financial statements of different firms. Investors also need an assurance that the information supplied by the company is accurately prepared.

Types of Financial Statements: Every public company is required to produce four financial statements: the balance sheet, the income statement, the statement of cash flows and the statement of stockholders’ equity.

Balance Sheet: A balance sheet of a company lists the firm’s assets and liabilities, providing a snapshot of the firm’s financial position at a given point of time. The balance sheet includes the assets, the liabilities and the shareholders’ equity.

Assets: The assets of a company include the long term assets, current assets and expenses to be written off. Long term assets include land, buildings, equipment, goodwill, patents, trademarks, etc. Current assets include cash, accounts receivable, inventories, prepaid expenses, etc.

Liabilities: The liabilities of a company include long term liabilities, current liabilities and share holders’ equity. Long term liabilities include long term debt, capital lease obligations, deferred taxes and other long term liabilities. Current liabilities include accounts payable, notes payable, current maturities of long term debt.

Shareholders’ Equity: The sum of current liabilities and long term liabilities is total liabilities. The difference between the firm’s assets and total liabilities is the shareholders’ equity. It is also called the book value of equity. It represents the net worth of the company. In the real world, this is a difficult proposition as the firm’s market value of the asset and liabilities differ from their book value. The assets of the company are based on their historical cost rather than on their market value. Same is the case with liabilities also. For these reasons the book value of equity is an inaccurate assessment of the actual value of the firm’s equity. This is not surprising that it will differ substantially from the amount investors are willing to pay for the equity. The total market value of a company’s equity equals the market price per share times the number of shares, referred to as the company’s market capitalization. The market value of stock does not depend on the historical cost of the company’s assets; instead it depends on what investors expect those assets to produce in the future.

Balance Sheet Analysis: A great deal of useful of information from a firm’s balance sheet can be obtained. These include Market to Book Ratio, Debt- Equity Ratio, Enterprise Value, etc.

Income Statement: The Income Statement is a list of the company’s revenues and expenses over a period of time. The last or the bottom line of the income statement shows the company’s net income, which is a measure of its profitability during the period. The income statement is sometimes called a profit and loss statement and the net income is referred to as the company’s earnings.

Statement of Cash Flows: The income statement provides a measure of the company’s profit over a given time period. However, it does not indicate the amount of cash the firm earned. There are two reasons that net income does not correspond to cash earned. First, there are non-cash entries on the income statement, such as depreciation and amortization. Second, certain uses of cash, such as the purchase of a building or expenditures on inventory, are not reported on the income statement. The company’s statement of cash flows utilizes the information from the income statement and balance sheet to determine how much cash the company has generated and how that cash has been allocated, during a set period. From the perspective of an investor attempting to value the firm, the statement of cash flows provides what may be the most important information of the four financial statements. The statement is divided into three sections: operating activities, investment activities and financing activities.

There are several other pieces of information contained in the financial statements warrant brief mention: the management discussion analysis, the statement of shareholders’ equity and notes to the financial statement.

This article is in continuation with our previous articles on Finance which include: Financial Ratio Formulae, Present Value, Net Present Value, Internal Rate of Return, Present Value Annuity, Profitability Index, Bond Valuation, Capital Structure, Corporate Finance, CAPM Model, Mergers & Acquisitions, Private & Venture Capital.

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