Reading & Understanding Financial Statements

date

Apr 19, 2024

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understanding-financial-statements

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Published

🤔Motivation

For a long time, particularly during the first few years after I graduated, my approach to evaluating businesses was quite subjective. As an engineer with a computer science background, I tended to assess companies solely based on their technical vision and the caliber of talent on their team. My criteria were often influenced by how exciting the company’s mission seemed and the amount of funding they had secured.

However, I began to recognize the flaws in assessing companies solely based on these factors, whether for investment or career considerations. This method proved too subjective and short-sighted, perhaps only appropriate for choosing internships.

As I observed the various upheavals in Silicon Valley, I learned that reviewing financial statements is an essential tool for gauging a company's health. This approach has proven beneficial not only for making informed decisions about investments but also for selecting potential employers.

Here are my notes after reviewing publicly available materials from Harvard Business School. I found these resources extremely helpful for learning the correct methods to analyze a company's financial statements.

Balance Sheet

https://online.hbs.edu/blog/post/how-to-read-a-balance-sheet

A balance sheet is a financial document designed to communicate exactly how much a company or organization is worth—its so-called “book value.” The balance sheet achieves this by listing out and tallying up all of a company’s assets, liabilities, and owners’ equity as of a particular date, also known as the “reporting date."

Balance Sheet Equation

Asset

An asset is defined as anything that is owned by a company and holds inherent, quantifiable value. A business could, if necessary, convert an asset into cash through a process known as liquidation.

Current assets: anything a company expects it will convert into cash within a year

Cash and cash equivalents
Prepaid expenses
Inventory
Marketable securities
Accounts receivable

Noncurrent assets: long-term investments that aren’t expected to be converted into cash in the short term

Land
Patents
Trademarks
Brands
Goodwill
Intellectual property
Equipment used to produce goods or perform services

Liabilities

A liability is the opposite of an asset. While an asset is something a company owns, a liability is something it owes.

Current liabilities: any liability due to the debtor within one year

Payroll expenses
Rent payments
Utility payments
Debt financing
Accounts payable
Other accrued expenses

Noncurrent liabilities: long-term obligations or debts which will not be due within one year

Leases
Loans
Bonds payable
Provisions for pensions
Deferred tax liabilities

Owners’ Equity

Owners’ equity, also known as shareholders' equity, typically refers to anything that belongs to the owners of a business after any liabilities are accounted for.

Money, which is contributed to the business in the form of an investment in exchange for some degree of ownership (typically represented by shares).

Earnings that the company generates over time and retains.

Income Statement

https://online.hbs.edu/blog/post/income-statement-analysis

Also known as profit and loss (P&L) statements, income statements summarize all income and expenses over a given period, including the cumulative impact of revenue, gain, expense, and loss transactions. Income statements are often shared as quarterly and annual reports, showing financial trends and comparisons over time.

Note: An income statement tallies income and expenses; a balance sheet, on the other hand, records assets, liabilities, and equity.

What is on an Income Statement

Revenue: The amount of money a business takes in during a reporting period

Expenses: The amount of money a business spends during a reporting period

Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever it is a business sells

Gross profit: Total revenue less COGS

Operating income: Gross profit less operating expenses

Income before taxes: Operating income less non-operating expenses

Net income: Income before taxes less taxes

Earnings per share (EPS): Division of net income by the total number of outstanding shares

Depreciation: The extent to which assets (for example, aging equipment) have lost value over time

EBITDA: Earnings before interest, depreciation, taxes, and amortization

Income Statement Analysis

Vertical Analysis

Definition: Vertical analysis refers to the method of financial analysis where each line item is listed as a percentage of a base figure within the statement.

Use cases: This type of analysis makes it simple to compare financial statements across periods and industries, and between companies, because you can see relative proportions. It also helps you analyze whether performance metrics are improving.

Horizontal Analysis

Definition: Whereas vertical analysis focuses on each line item as a percentage of a base figure within a current period, horizontal analysis reviews and compares changes in the dollar amounts in a company’s financial statements over multiple reporting periods. It’s frequently used in absolute comparisons, but can be used as percentages, too.

Use cases:

you can tell what’s been driving an organization’s financial performance over the years and spot trends and growth patterns
review of a company’s consistency over time
company’s growth compared to competitors.

Importance of Income Statement

Financial analysis of an income statement can reveal that the costs of goods sold are falling, or that sales have been improving, while return on equity is rising. Income statements are also carefully reviewed when a business wants to cut spending or determine strategies for growth.

Cash Flow Statement

https://online.hbs.edu/blog/post/how-to-read-a-cash-flow-statement

The purpose of a cash flow statement is to provide a detailed picture of what happened to a business’s cash during a specified period, known as the accounting period. It demonstrates an organization’s ability to operate in the short and long term, based on how much cash is flowing into and out of the business.

Operating activities detail cash flow that’s generated once the company delivers its regular goods or services, and includes both revenue and expenses.

Investing activities include cash flow from purchasing or selling assets—think physical property, such as real estate or vehicles, and non-physical property, like patents—using free cash, not debt.

Financing activities detail cash flow from both debt and equity financing.

How Cash Flow is Calculated

Direct Method: To calculate the operation section using the direct method, take all cash collections from operating activities, and subtract all of the cash disbursements from the operating activities.

Indirect Method: This method depends on the accrual accounting method in which the accountant records revenues and expenses at times other than when cash was paid or received—meaning that these accrual entries and adjustments cause the cash flow from operating activities to differ from net income.

Interpret a Cash Flow Statement

cash flow statements can reveal what phase a business is in: whether it’s a rapidly growing startup or a mature and profitable company. It can also reveal whether a company is going through transition or in a state of decline.

investor might decide that a company with uneven cash flow is too risky to invest in

or they might decide that a company with positive cash flow is primed for growth

a department head might look at a cash flow statement to understand how their particular department is contributing to the health and wellbeing of the company and use that insight to adjust their department’s activities

Positive cash flow vs Negative Cash Flow

Positive cash flow does not necessarily translate to profit, however.

Negative cash flow may also be caused by a company’s decision to expand the business and invest in future growth, so it’s important to analyze changes in cash flow from one period to another, which can indicate how a company is performing overall.

Annual Report

https://online.hbs.edu/blog/post/how-to-read-an-annual-report

An annual report is a publication that a public corporation is required by law to publish annually.

First section: includes a narrative of the company’s performance over the previous year, as well as forward-looking statements: Letters to shareholders from the chief executive officer, chief financial officer, and other key figures, as well as graphics, photos, and charts.

Second section: strips the narrative out of the picture and presents a variety of financial documents and statements.

Note: Unlike other pieces of financial data—and because they include editorial and storytelling—annual reports are typically professionally designed and used as marketing collateral. Annual reports are sent to shareholders every year before an annual shareholder meeting and election of the board of directors, and often accessible to the public via the company’s website.

10-K report

10-K reports are organized per SEC guidelines and include full descriptions of

a company’s fiscal activity

corporate agreements

risks

opportunities

current operations

executive compensation

market activity.

You can also find detailed discussions of operations for the year, as well as a full analysis of the industry and marketplace.

It must be filed with the SEC between 60 to 90 days after the end of a company’s fiscal year.

If you need to review a 10-K report, you can find it on the SEC website.

What is included

Letters to shareholders: These documents provide a broad overview of the company’s activities and performance over the course of the year, as well as a reflection on its general business environment. An annual report usually includes a shareholder letter from the CEO or president, and may also contain letters from other key figures, such as the CFO.

Management’s discussion and analysis (MD&A): This is a detailed analysis of the company’s performance, as conducted by its executives.

Audited financial statements: These are financial documents that detail the company’s financial performance. Commonly included statements include balance sheets, cash flow statements, income statements, and equity statements.

A summary of financial data: This refers to any notes or discussions that are pertinent to the financial statements listed above.

Auditor’s report: This report describes whether the company has complied with generally accepted accounting principles (GAAP) in preparing its financial statements.

Accounting policies: This is an overview of the policies the company’s leadership team relied upon in preparing the annual report and financial statements.