Lan, J.Z. (2012). Introduction to Financial Statement Analysis. American Association of Individual Investors. 1.1. 16-20
There are many users of financial statements that include the management, investors, creditors, government, and employees. This article was targeted at helping investors on how to use the financial statements in order to make informed investment decisions. The article discusses the three main financial statements that firms publish namely; the income statement, the balance sheet, and the cash flow statement.
The income statement shows the investors how much sales and income that a company generated over a period of time usually twelve months. The income statement also has additional information about the earnings shareholders made per share or earnings per share, and the dividend declared per share. Investors should pay attention to the income statement in order to understand whether a company is experiencing growth or decline as seen in the changes in the sales and the net income.
The balance sheet provides the investor with the financial position of the firm at a point in time. It tabulates the resources i.e. the assets the firm owns, and the how much the firm owes i.e. the liabilities and equity of the firm. The cash flow statement of the firm tells investors how much cash the firm generated from its three activities i.e. operating activities, investing activities, and financing activities. The cash flow statement indicates the liquidity position of the firms. Liquidity is different from profitability. A firm may be profitable but not generate sufficient cash flows to meet its obligations as they fall due.
The article discusses the three key financial statements that firms publish the income statement, the balance sheet, and the cash flow statement. The income statement measures the profitability of the firm over a period of time usually one year. The income statement shows the net revenue i.e. revenue less discounts, the cost of sales, the gross profit, the operating expenses such as wages and salaries, interest expense, depreciation, tax expense, and the net profit/(loss).
The balance sheet shows the assets, and liabilities of the organization. Assets represent resources owned by the organization while liabilities represent obligations that the organization owes. Assets are categorized into current assets and fixed assets. Current assets are those assets that will be used in the ordinary course of business or will be converted into cash within twelve months. Current assets include cash, inventory, receivables, and prepaid expenses. Fixed assets are assets that will last within the business for a period longer than twelve months. Fixed assets include plant, property and equipment, intangible assets such as goodwill patents and copyrights.
Liabilities are divided into two current liabilities that will require to be paid within twelve months, and long-term liabilities that will be repaid in more than twelve months. Equity is s a special category of liability that represents the owner’s interest in the business. Unless the business is liquidated, equity is assumed to be a perpetual source of finance to the business. Owner’s equity includes common stock, preferred stock, retained earnings, and fund balance.
Cash flow statement shows a tabulation of the firm’s cash flow over a period usually a twelve month period. The cash flows shows the cash generated or used in operating activities, investing activities and financing activities.
The income statement provides investors with an important tool of monitoring the revenues, expenses, and the profitability of the firm. The rate of change of these variables gives investors an idea of whether the firm is growing or declining.
The balance sheet provides a snap shot of the firm’s financial position in terms of assets and liabilities. The balance sheet tells the investors how well the firm is financed and where the firm obtains its finances to fund its operations. Changes in the levels of debts indicate changes in the gearing of the firm. If a firm is highly geared it means that it has increased financial risk.
The cash flow statement highlights how much cash the firm spent or generated from particular activities. Of concern to investors is how much cash the firm generated from its operating activities i.e. the amount of cash the firm generated from carrying out its day-to-day activities. If the profits are increasing but the cash generated from operating cash flows are decreasing, would be a possible indicator of creative accounting.
Investing activities refers to the amount of cash the firm spent or generated in purchasing or disposing assets. A negative cash flow from investing activities may indicate that the firm is experiencing growth and the management is confident about the future prospects. On the other hand, a positive cash flow from investing activities may indicate that the business is getting rid of spare capacity.
Financing activities refers to the amount of cash raised by issuing debt or equity or the amount of cash spent redeeming bonds. When a company spends money buying their shares it may mean that the management believes that the shares are undervalued or may mean that the management believes that the company is mature and there may be no other profitable investment opportunities.
Implications for Management
The article guides investors on what are the key areas they should look for in the published financial statements as well as how to interpret the information presented in those financial statements. Such knowledge will result into the demand by investors for more disclosures on the financial statements so that the investors are able to make meaningful comparisons about the performance of the firm over time as well as in comparison to other firms.
Managers will be dealing with more financially knowledgeable investors and will find it more difficult to cook books or engage in other financial reporting malpractices. Because investors will have a better appraisal of the firm’s performance, they will demand a return on their investment that represents a fair assessment of the riskiness of the investment. Firms performing poorly will find it difficult or expensive to raise finance.