Elder statesman and literary genius, Prof Chinua Achebe once said that proverbs are the oil with which words are eaten. Borrowing from that statement, one can rightly say that financial statements are the tools with which investment decisions are made. The Nigerian Stock Exchange, from time to time, releases audited financial statements of companies that are listed on the floor of the exchange. Other exchanges and Securities and Exchange Commissions even have schedules of when companies release or file their financial statements. This practice underscores the importance of company financial statements, to both the general public and investors especially.
Many investors and financial analysts have been able to find the holy grail of investing or even hit “goldmines” by analyzing financial statements. While such financial analysis requires some skills and training, a basic understanding of what financial statements are, is indeed of importance to investors — big and small.
What is a financial statement?
A financial statement is a document that summarizes a company’s economic transactions and presents a measure of its profitability and financial condition. A financial statement is made up of three reports: (1) the balance sheet, (2) income statement or statement of operations, and (3) the statement of cash flows.
The balance sheet
The balance sheet is a snapshot of a company’s resources, called assets and the claims against such resources, called liabilities as well as the owners’ equity. While the assets tell the story of a company’s investment decisions, the liabilities tell the same story about a company’s financing decisions. In most cases, the liabilities do not tell all the stories about the financing decisions, as such, a part of the balance sheet, called owners’ equity tells whatever story that the liabilities fail to tell.
One thing about the balance sheet is that the stories, in numbers, told by the assets and the liabilities must balance with whatever is left to be said by owner’s equity. This is what is called the accounting equation, which says that Assets minus Liabilities must be equal to the owner’s equity. Basically, this simply says that by the time a company pays off all that it owes from all that it owns, whatever remains, should equal what belongs to the owners, the shareholders.
[READ MORE: What business owners need to know about balance sheets]
Uses of the balance sheet
The question that comes to mind is, of what use is the balance sheet to the investor? My answer to that question is simply, it is very important. Unfortunately, the balance sheet does not say it all. As noted by one analyst, “a balance sheet is very much like the bikini. What it reveals is interesting; what it conceals is vital.” One important use of the balance sheet is that it helps to uncover the vital information beyond the numbers when properly analyzed. Michael Murphy, the editor of Overpriced Stock Services Newsletter, once said that, “the potential problems of technology companies always show up first on the balance sheet.”
The balance sheet provides information on the stewardship of a company’s management with respect to its present resources and how such resources were financed. The balance sheet provides information on a company’s financial strengths and flexibility. By analyzing the current assets and liabilities of a company as contained in the balance sheet, an investor may be in a better position to judge a company’s liquidity and its ability to meet its short-term financial commitments. In the same way, an analysis of a company’s long-term liabilities and assets gives an investor a peek at a company’s ability to meet its long-term financial obligations.
Limitations of the Balance Sheet
One limitation of the balance sheet is that it does not reveal the current value of a company, as most of the assets are reported at book value. In some cases, some vital assets of a company may not be part of the balance sheet. Things like brand name or brand loyalty do not make it to the balance sheet. As already noted, the balance sheet is a snap shot image of a company in that it shows the numbers as at a given date, thereby missing important seasonal factors.
Statement of income
This part of the financial statement tells the investor how profitable a company has been over a period of time. A company’s profit is simply the difference between its revenues and expenses. Within the statement of income, there are important sub-classifications that an investor should be aware of: the gross profit, which is the difference between net sales and cost of goods sold; the operating profit, which is the gross profit minus operating expenses; and the net income.
Importance of income statement
The income statement helps investors to carry out fundamental analysis of a company— an analysis that can inform a buy, sell or hold decision. It also helps shareholders carry out peer comparison analyses of companies, as well as ratio analyses and financial projections.
Statement of Cash flow
The cash flow statement is the part of financial statement that reports the net cash from the principal activities of a company. Net cash is cash inflows minus cash outflows. The principal activities of a company with respect to statement of cash flow include operating, investing and financing activities.
Each of these activities generates or uses cash. One important use of the statement of cash flow is that it helps answer the question as to whether the company was able to generate enough cash flow from its operations, or if the needed cash was generated by investing activities by way of selling off its assets, or even by financing activities, coming by way of borrowing or issuing more shares. A company that generates all or much of its cash needs through operating activities is financially healthier than one that does so through the other two activities.
[READ ALSO: What business owners need to know about balance sheets (PART 2)]
In the next piece to this article, I will discuss the basic but important ratios that an investor needs to understand and analyze financial statements.
