By Brad Nakase, Attorney
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The world of finance is surrounded by a sea of paperwork—a sea that’s easy to get lost in if you don’t yet understand financial statements. Fortunately, studying the most frequently used financial statements can lift the fog off this proverbial sea, making it much more straightforward to navigate financial analysis.
Financial statements are documents written to outline a company’s business activities. These statements are analyzed to infer a business’s financial well-being and performance, helping make decisions and future projections based on trends observed historically. Simply put, the business world in its current form could not exist without financial statements. These documents convey a company’s financial performance and business activities. As the U.S. Securities and Exchange Commission (SEC) succinctly puts it, “They show you where a company’s money came from, where it went, and where it is now.”
To do their job well, creditors, investors, management, and regulatory authorities rely on financial statement analysis in one way or another. Creditors evaluate financial statements to assess whether a company can repay a debt. Authorities, such as the SEC, rely on financial statements to ensure that public companies meet required accounting standards. Investors use financial statements to understand the potential profitability of investing in a company. Management uses financial statements to make intelligent decisions and communicate with key stakeholders and investors.
From a single financial statement, financial well-being cannot be deciphered—you need clear perspectives painted by different views. Four primary financial statements exist:
1. Income Statement
An income statement is a report generated by a company to communicate earnings over a period of time. This statement reflects revenues and expenses, such as operating revenue, non-operating revenue, and primary expenses, in multiple forms. Typically regarded as the most important of the financial statements, it presents revenues, expenses, net income (what remains after subtracting expenses from revenues), profits/losses, and earnings per share, or the company’s operating results.
Revenues (what a company receives for providing goods or services) minus expenses (the costs incurred to run the company) and taxes paid measure profitability. Read from top to bottom, the income statement begins with revenues, often called the “top line.” Expenses and costs are subtracted next, followed by taxes, resulting in the company’s net income—or profit—before dividends are paid. The term “bottom line” originates here.
Essential tools for analyzing an income statement are vertical and horizontal analyses. Analysts compare every line item to revenue as a percentage using vertical analysis. Horizontal analysis evaluates year-over-year changes in line items, providing insights into trends over time.
2. Balance Sheet
The balance sheet, unlike the income statement that covers a period, is a snapshot of a company’s financial position at a specific moment. It accounts for assets, liabilities, and shareholders’ equity, offering a quick view of a company’s performance and expectations.
Most balance sheets follow this formula:
Assets = Liabilities + Shareholders’ Equity
Assets refer to anything a company owns with quantifiable value. Liabilities represent money owed to others. Shareholders’ equity reflects net worth or the remaining amount if all liabilities are paid and assets are sold.
The balance sheet also displays how much of the assets are financed by debt (liability) and how much by equity (retained earnings and shares). Listed from most to least liquid, assets exceeding liabilities are recorded as total shareholders’ equity, representing the company’s book value or net worth.
Liquidity ratios (like the quick ratio, net working capital, and current ratio) and leverage ratios (like debt-to-equity and fixed charge coverage ratio) are key metrics derived from balance sheets.
3. Cash Flow Statement
The cash flow statement measures how well cash is generated to pay debts, fund operating expenses, and make investments. It shows a company’s sources of cash and its usage for operations and future investments.
Typically, cash flow statements are divided into three sections:
By detailing money exchange between the company and the outside world over a time period, the cash flow statement provides liquidity insights. Analysts consider operational cash flow most important for reflecting the underlying business’s health.
4. Statement of Shareholders’ Equity
The statement of shareholders’ equity shows changes in shareholders’ equity, such as dividend payments, share sales or repurchases, and changes due to profits or losses reported. It outlines treasury stock, retained earnings, common stock, unrealized gains or losses, preferred stock, and additional paid-up capital.
This statement offers investors insights into how equity changes and why.
Understanding a company’s financial position and potential future hinges on analyzing financial statements. Corporate finance professionals identify trends and patterns, ensuring alignment with financial goals and informing strategic decisions. Early risks can be identified through this analysis, enabling corrective actions for financial stability.
Methods like vertical and horizontal analysis, ratio analysis, and advanced techniques such as Dupont analysis measure efficiency, solvency, profitability, and liquidity. Each helps stakeholders decide on the financial health of a company.
Today, financial statements not only demonstrate how much money a company earns but also reveal how risks are managed and how standards like GAAP and IFRS are adhered to. In the vast sea of financial data, analyzing these documents is key to making strategic decisions and building confidence.
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