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From Zero to Pitch: Understanding Financial Statements

By Siyu Wu

March 7, 2016

It is impossible to create a strong and well-supported investment recommendation without thorough analysis of the financial statements, which is why the next few installments will give an overview of the three key financial statements and how they can be used in valuation.

Financial statements are a valuable resource because they reveal a lot of objective information about company and industry health. The information allows for comparing different companies to evaluate a company’s’ past and future performance. All public companies are required to make their financial statements available to the public, so you can easily find a company’s 10K (annual report) and 10-Q (quarterly report) on its website. 

Balance Sheet

The balance sheet serves as a financial snapshot at a single point in time for the company. There are three main parts of the balance sheet: assets, liabilities, and shareholder’s equity. The relationship between the three components is: assets = liabilities + shareholder’s equity.

Assets are the resources that the company owns that are expected to generate future value for the company. They can be separated into two categories. Current assets can be converted to cash within one year and include cash, accounts receivable (money owed to company by its customers), and inventory (assets that will be turned into products). Non-current assets are those that cannot be easily converted to cash, including property, plants, equipment (PP&E), and goodwill.

Liabilities are what the company owes, and also can be categorized into current and non-current liabilities. Current liabilities include accounts payable (money owed to suppliers), salaries payable (money owed to workers), and short term debt.

Shareholders’ equity refers to the difference between assets and liabilities, which includes stock representing equity ownership in a corporation, retained earnings that are reinvested in the core business or used to pay debt, and treasury stock.

The balance sheet gives information about the liquidity of a company, the company’s assets, and its ability to meet long-term fixed expenses. However, it is limited in that it does not include certain resources, such as human capital.

Income Statement

The income statement shows the profitability a company over a certain period of time. The basic relationship here is: revenues - expenses = net income. Revenues are the sales the firm makes from selling goods and services, calculated by multiplying the price of good by the volume sold. Expenses are the costs a firm incurs to produce goods, also including administrative expenditures, depreciation, interest, and income taxes.

Finding the net income allows us to analyze the company’s earnings, which are used to pay dividends, repurchase shares, and reinvest. Specifically, the earnings per share (EPS) indicates how much a stock earned per share and is calculated by net income divided by number of shares outstanding.

Companies release quarterly earnings data, which allows investors gauge the profitability of the firm. Prior to earnings being released, Wall Street analysts will predict a consensus on the EPS. If reported earnings beats this estimate, the stock tends to go up. If the reported earnings falls short, then the stock may go down.

The income statement (AKA profit and losses) summarizes a firm’s profits and losses and also gives us the opportunity to calculate ratios to see how operations have changed. However, it is difficult to compare these ratios for companies in different industries. Also, there are many different accounting practices that limit the comparability of these numbers. Thus, it’s important to look at footnotes on the statement!

Cash Flows Statement

The statement of cash flows shows information about the company’s cash inflows and outflows, which is different from net income in that the cash flow cannot be manipulated through accounting practices. The income statement uses accrual accounting to smooth the cash flow, with issues such as revenue and cost recognition. These facts are not hidden in the cash flow statement. This statement indicates a firm’s liquidity and long-term solvency.

The cash flow statement is composed of three sections: operating activities, investing activities, and financing activities. In operating activities, inflows refer to cash received from customers while outflows occur through buying inventory, paying salaries, and paying suppliers. In investing activities, inflows include the sale of PP&E and outflows include capital expenditures and acquisitions of other firms. In financing activities, inflows come from cash received from borrowing or issuing stock, and outflows come from repaying debt or dividends.

Free cash flow (FCF), which is operating cash flow subtracted by capital expenditures, and represents what the company has left over at the end of a period after paying the money needed to maintain its asset base. This is an important metric that indicates the amount of cash a company produces.

This article focused on introducing the three financial statements so that we may go into detail about financial ratios and metrics we can calculate from the information provided by each financial statement.

The balance sheet, income statement, and cash flows statement each show important but different financial information about a firm, all of which is critical in evaluating the company’s stock.

Siyu Wu is from Colorado and is currently a sophomore at Princeton University, pursuing a degree in Economics and certificates in Finance and East Asian Studies. She hopes to synthesize her interest in China and East Asia with her passion for finance to eventually work in a career related to international finance and Asian capital markets.

 

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