Understanding Financial Statements

So what are Financial Statements?

Knowing and understanding how to read financial statements is an essential skill to have, especially as a stock investor. Learning the basics will show you where the company’s money came from, where it went, and where it is now.

Financial statements are accounting reports that summarise the activities of a business and the financial performance over a period of time. Therefore allowing investors, shareholders, lenders and anyone that is interested to understand the financial health of the company.

If you are interested in stock investing you might have heard of the term "Fundamental Analysis". This is a method used to determine if a stock is undervalued or overvalued, a method highly advocated by Warren Buffet the great Value Investor.

Fundamental analysis uses revenues, earnings, future growth, return on equity,

profit margins, and other data to determine a company's underlying value and potential for future growth. All of this data is pulled from a company's financial statements .

There are 3 Key Financial Statements:

- The Income Statement, traditionally known as the Profit and Loss (P&L)

- The Balance Sheet

- Cash Flow Statement

The Balance Sheet

The balance sheet represents a record of a company's assets, liabilities, and equity at a particular point in time. The balance sheet is named by the fact that a business's financial structure balances in the following manner:

Assets = Liabilities + Shareholders' Equity

Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery, and buildings. The Assets are sub-categorised into two main buckets: Current assets, these are typically easily accessible and therefore converted into cash quicker - within a year (high liquidity) and Non-current assets.

The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity.

Liabilities represent debt which must be paid back and is divided between current liabilities (repayable in a maximum period of 12 month) and non-current liabilities.

Equity represents the total value of money that the owners have contributed to the business including retained earnings, which is the profit made in previous years.

The Income Statement

While the balance sheet takes a snapshot view of the business, the income statement measures a company's performance over a specific period of time. Public companies will normally report quarterly and annually.

The income statement reports information about revenues, expenses, and profit or loss that was generated as a result of the business' operations for that period.

Revenue is the total amount of money brought in from sales of products or services. Some companies distinguish between gross and net revenue. When you subtract the returns and discounts from the gross revenues, you arrive at the company’s net revenues.

Cost of Sales tells you the amount of money the company spent to produce the goods or services it sold during the accounting period. These are therefore normally variable costs, if you need to sell more then you'll need to spend more on these items.

Operating expenses go toward supporting a company’s operations for a given period, such as salaries of administrative personnel and costs of researching new products or marketing expenses. These costs cannot be linked directly to the production of the products or services being sold, hence they are separated into a different category.

Profit or Loss, after deducting all of the expenses you'll know how much the company actually earned or lost during the accounting period. This is often called the operating profit before interests or tax expenses. EBITDA is typically the number many companies measure their performance internally. It is the "Earnings before Interests, Tax, Depreciation and Amortization". The “bottom line” or Net profit also sometimes called net income or net earnings is the final profit after deducting Tax, Interests and Depreciation.

Cash Flow Statement

The statement of cash flows represents a record of a company's cash inflows and outflows over a period of time. This is important because a company needs to have enough cash on hand to pay its expenses and to purchase assets. It uses and reorders the information from a company’s balance sheet and income statement.

Typically, a statement of cash flows focuses on the following cash-related activities:

Operating Activities This is the first part of the cash flow which analyses the company’s cash flow from net income or losses. It aims to reconciles the net income (as per the income statement) to the actual cash the company received from or used in its operating activities. It does so by adjusting the net income for any non-cash items, such as adding back depreciation expenses and any cash that was used or provided by other operating assets and liabilities.

Investing Activities the second section of the cash flow statement covers the cash flow from all investing activities. This is the purchases or sales of long-term assets such as property, plant and equipment. If a company buys a piece of machinery, the cash flow statement would reflect this activity as a cash outflow from investing activities because it used cash. If the company decided to sell off some investments from an investment portfolio, the proceeds from the sales would show up as a cash inflow from investing activities because it provided cash.

Financing Activities The final part of a cash flow statement shows the cash flow from all financing activities. Typical sources of cash flow include cash raised by borrowing from banks and selling stocks. Paying back a bank loan would show up as a use of cash flow.

The cash flow statement is important because it's very difficult for a business to manipulate its cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it's tough to fake cash in the bank. For this reason, some investors use the cash flow statement as a more conservative measure of a company's performance.

Ratio Analysis

Okay, so now you understand what the 3 main financial statements consist of, what next? Now is the moment to analyse all of the information and understand the true position of the business to help you make decisions about companies you might want to invest in.

Ratios are typically grouped into four categories:

  • Profitability ratios

  • Liquidity ratios

  • Solvency ratios

  • Valuation ratios

Profitability Ratios

Profitability is key because high revenue alone doesn't always mean high earnings or high dividends. Profitability ratios help provide insight into how much profit a company generates and how that profit relates to other important information about the company. These are used to assess a business's ability to generate earnings relative to its revenue, operating costs, balance sheet assets, and shareholders over time, using data from a specific point in time.

Key profitability ratios include:

  • Gross margin

  • Operating margin

  • Net profit margin

  • EBITDA margin

  • Return on assets (ROA)

  • Return on equity (ROE)

  • Return on investment (ROI)

One of the well known ratios used by investors for a quick check of profitability is the net profit margin (Profit Margin = Net Income \ Revenue). Profit margin levels vary across industries and time periods as this ratio can be affected by several factors. It is therefore helpful to look at a company's net profit margin versus the industry and the company’s historical average (previous years). A red flag could be if the company sees decreasing profit margins from one year to the next. Oftentimes, this suggests changing market conditions, increasing competition, or rising costs. If a company has a very low-profit margin, it may need to focus on decreasing expenses through wide-scale strategic initiatives.

Liquidity Ratios

The liquidity ratios measure how quickly a company can repay its debts or turn assets into cash, also showing how well company assets cover expenses. Liquidity ratios give investors an idea of a company’s operational efficiency.

Key liquidity ratios include:

  • Current ratio

  • Quick ratio

  • Cash ratio

  • Receivables turnover

  • Working capital turnover

The Current ratio (Current ratio = current assets / current liabilities) is a good indicator of the the firm’s short-term liquidity given that both current assets and current liabilities represent activity in the upcoming 12 months. A higher current asset ratio is favorable as it represents the number of times current assets can cover current liabilities. The quick ratio is similar, it just subtracts inventory from current assets.

Solvency Ratios

Also known as leverage ratios used by investors to get a picture of how well a company can deal with its long-term financial obligations. As you might imagine a company with a lot of debt is probably a less attractive investment than one with a minimal amount of debt.

Key solvency ratios include:

  • Debt to total assets

  • Debt to equity

  • Interest coverage ratio

  • Net income to liabilities

Debt to assets and debt to equity are the two key ratios often used for a quick check of a company’s debt levels.

Debt to equity ratio compares a company’s total debt to shareholders’ equity. Both of these numbers can be found on a company’s balance sheet. To calculate debt-to-equity ratio, you divide a company’s total liabilities by its shareholder equity. As a general rule, a number closer to zero is generally better because it means that a company carries less debt compared to its total equity.

Valuation Ratios

These ratios are often used to analyse how attractive a company is as an investment. They integrate the stock price of a publicly traded company to give investors an understanding of how inexpensive or expensive the company is in the market. In general, the lower the ratio level, the more attractive an investment in a company becomes.

Key valuation multiples include:

  • Price to earnings (P/E)

  • Price to book (P/B)

  • Price to sales (P/S)

  • Price to cash flow (P/CF)

The (P/E) ratio is one of the most well-known valuation ratios. It compares a company's stock price to its earnings on a per-share basis. The price to earnings shows the premium that the market is willing to pay, that is how much investors are willing to pay for $1 of earnings in that company. The higher the ratio, the more investors are willing to spend. Different industries have substantially different P/E ratios; so, it is important to compare a company's P/E ratio to that of its industry.

Key take aways

It is important to remember that these ratios aren't an exact science, but rather they are to be used as guidelines. An investor typically aims to look for quality companies with good business models and exciting growth prospects.

The information you need for calculating ratios is easy to come by as the required numbers can be found in a company's financial statements (which can be found on the company's website or financial websites). You can find some of these metrics on Yahoo Finance.

Once you have the raw data, you can plug it right into your financial analysis tools and put those numbers to work for you. I have built one that works in a very simple and automated way, so check it out here if you'd like to save sometime.

Stay tuned if you would like to join a masterclass where I will be analysing a specific company and showing you just how easy it can be to navigate through these financial statements and get some quick and easy conclusions.

In the mean time check out this YouTube video which highlights some of the key points mentioned in this email.

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