Analyzing The Financial Statements of Companies

Analyzing The Financial Statements of Companies

When you look at the financials of any company, such as its balance sheet or cash flow statement, you are looking into the performance and condition of the company. Reading the financial statements requires practice and understanding of how financial statements are structured. However, this is something that many stakeholders need to learn so that they can make informed decisions when analyzing potential investments and analyzing existing ones. Here are some tips on how to analyze the financial statements of a company.

Know What Is Where

Before you can analyze anything, you need to understand where all the numbers come from. Hence, you must understand the difference between the balance sheet and income statement. The balance sheet is a snapshot of the company’s assets, liabilities, and equity at a specific time. This means that it may not be reflective of the company’s current financial state, as it will have changed since the snapshot was taken. For example, the snapshot may have been taken at the end of the fiscal year, but the company’s financial state may have improved since then. The income statement, on the other hand, is a period-to-period comparison of the revenue from selling a company’s product or service and its associated expenses. This means that it will be reflective of the company’s current financial situation.

Define Terms

Before you can confidently analyze a company’s financial statements, you need to understand the terms used in them. Here are some terms you need to know when analyzing financial statements.

Assets: The total of everything a company owns, whether financial or not. Assets include cash, stocks, bonds, receivables, inventory, property, and goodwill.

Current assets: These are assets that can be converted into cash within a year. These are typically cash, stock, and receivables.

Current liabilities: These are liabilities that can be paid off within a year. These usually include accounts payable and accrued expenses.

Deferred liabilities: These are liabilities that do not need to be paid in the current period but at a later date.

Debt to equity ratio: This is calculated by dividing the total debt by the amount of equity in the company. This ratio will be helpful for you to understand the financial structure of the company and to see if the company has enough cash reserves to pay off its debt.

Equities: These are the owners’ interests in the company. The two main types of equity are common stock and preferred stock.

Fixed assets: These are items that are expected to last more than one year. Fixed assets can include land, buildings, furniture, and vehicles.

Goodwill: This is the excess paid for a company compared to the fair value of its assets. This is the amount used to buy companies that are privately owned.

Growth rate: The percentage increase or decrease of a certain statistic. The most common growth rates are revenue, net profit, and net income.

Gross profit: The profit before deducting the cost of goods sold. - Gross margin: The gross profit divided by the revenue. This will tell you what percentage of the revenue goes towards the cost of goods sold.

Net profit: The gross profit less taxes and other expenses.

Net profit margin: The net profit divided by the revenue. This will tell you what percentage of the revenue is available for dividend payments or to repay debt.

Operating expenses: These are expenses that are needed to run the business but are not a part of the cost of goods sold.

Check Cash Flows

Cash flow is one of the most important and useful pieces of information for investors to look at. It can tell you how well the company is doing, what its sources of income are, and whether or not it has enough cash to pay off its debts.

Investing activities: This includes the cash used to purchase fixed assets or invest in stock or other securities. It can also include the cash used to purchase or build a new factory.

Financing activities: This includes the cash raised by issuing stocks or bonds, repaying debt with equity or debt, or issuing convertible bonds. This can also include the cash used to repurchase outstanding stocks or buy back convertible bonds.

Cash flow from operations: This is the cash earned from the sale of a company’s products or services.

Cash flow from investing: This is for the cash spent on the purchase of fixed assets.

Cash flow from financing: This is the cash raised from the selling of stocks or debt.

Look at the Balance Sheet

A balance sheet is a snapshot of the company’s assets, liabilities, and equity at a specific time. It is useful in identifying the company’s assets and how they are financed. The assets are what the company owns, the liabilities are what the company owes, and the equity is what is left for the owners of the company.

Current assets: These are assets that can be converted into cash within a year. These are typically cash, stock, and receivables.

Fixed assets: These are assets that have a life of more than one year. These can include a factory, land, buildings, furniture, or vehicles.

Current liabilities: These are liabilities that can be paid off within a year. These usually include accounts payable and accrued expenses.

Long-term liabilities: These are liabilities that will be due after a year. These liabilities include bonds and convertible bonds.

Equity: This is the amount owned by the shareholders. It is calculated by taking the total assets and subtracting the amount of all the liabilities.

Consolidated Income Statement

An income statement shows the company’s revenue and expenses over a period of time. The consolidated income statement shows the combined results of all the companies under the same entity. It is useful in showing how well the different businesses of a company are doing.

Cost of goods sold: This is the amount used to produce or purchase the goods or services a company sells. It includes the materials, labor, fuel, and other expenses needed to produce a product.

Operating expenses: These are the day-to-day expenses a company incurs in order to run itself. These expenses include the salaries of employees, utilities, and other expenses.

Revenue: This is the amount the company earns from selling its products or services.

Use Ratios To Understand The Numbers

You can use ratios to compare the numbers found in the financial statements to one another or to industry averages. Ratios can help understand the profitability, cash/operational cycles, and efficiency of the business operations. There are many financial ratios. Ratios can be benchmarked with other industry players. Here are a few examples:

Profit Margins: This shows the percentage of profit that remains after collecting revenue and paying related costs. The higher the profitability the better.

Debt-to-equity ratio: This is the ratio of the company’s debt to its equity. If the ratio is more than 1, it indicates that the company has more debt than equity. This can be a sign that the company may be having difficulty repaying its debt.

Current ratio: This is the ratio of current assets to current liabilities. This is useful in determining if the company has enough cash to meet its current liabilities. It is calculated by dividing the total current assets by the total current liabilities.

Equity ratio: This is the ratio of the company’s equity to its total assets. This is also known as the return on equity ratio. This ratio is helpful in determining how much profit the owners are getting compared to the amount they have invested in the company.

Look for trends

By comparing the financial statements with previous periods you can see it the profit is going up or down? Has the company improved in certain areas or is it worse off than before? It is also helpful to look at year to year trends over past 3 years of the company. This can also help model predictions about the company with other assumptions about the external market conditions.

Check the commentary and notes

Many financial statements come with commentary and note about the business performance and other regulatory disclosures. To understand elements of the financial statements better, the notes should be looked into. Further breakdowns and details of grouped numbers can be found in notes as well.

Question Everything

There may be some movements in balances or some expenses that you do not understand. May be there is a term that you don't know of. In this case, make a lit of questions and ask someone or search on the internet or look at other industry players. Build up questions when in doubt and seek to resolve through further research.

Summing Up

When you learn how to read financial statements, you gain valuable insight into a company’s financial health and future prospects. To read financial statements, you need to understand the difference between the balance sheet and income statement. You also need to understand the terms used in financial statements. To analyze financial statements, you need to know how to read a balance sheet, understand the different types of assets, liabilities, and equity, and use ratios to compare numbers.