Financial statements are the lifeblood of a company. External investors use financial statements to determine the financial position of a company before making their investments.
The internal management team of a company will use the financial statements to benchmark performance, set goals, and create accountability and action plans for team members. For the most part, financial statements are put together the same way across any industry or company.
Once you understand the foundation of financial statements, you can expand that knowledge and analyze any company in any industry.
What Are Financial Statements?
The financial statements of a company are broken down into three different sections, which we’ll touch on in greater detail below. These sections neatly organize the company’s financial performance from three different views.
Each section is important, and one should not make an investment decision, or evaluate the performance of a company, in a vacuum, or by simply using one financial statement and not the other(s).
- The income statement – highlights how much income and profit a company generated for a specific period of time. The income statement is also known as the profit and loss report, or P&I.
- The balance sheet – highlights what the company owns (assets) and what the company owes (liabilities).
- The statement of cash flows – highlights how much cash came in and out of the business for a specific period of time.
Types of Financial Statements
As mentioned above, there are three main types of financial statements.
If you ever want to see what a company owns (also known as assets), or what the company owes (also known as liabilities), you’ll need to view the company’s balance sheet. The balance sheet will cover assets, liabilities, and shareholders equity. There are many important financial metrics and ratios one will pull from the balance sheet, including:
- Months of cash reserves
- The quick ratio
- The debt to equity ratio
The income statement is also known as the profit and loss report or the P&I. This report highlights how much income a company generated for a specific period of time, and how much profit was kept after paying to service that revenue.
You’ll often hear the phrase ‘what’s the bottom line’ – and that is found on the income statement. Simply put, the bottom line indicates how much profit a company generated. Important metrics include:
- EBITDA %
- GP %
- Operating expense %
Cash Flow Statement
The cash flow statement shows how much cash came into the company and how much cash left the company for a specific period of time. If a company is spending more money than taking in, that would be reason for an initial concern.
Not only does this report indicate how much cash came in/out of the business, it will also show where the company is spending money.
How Do Financial Statements Work?
Financial statements are assembled by a company’s accounting and/or finance department. Each transaction throughout the month is recorded in the company’s accounting books, which makes creating such reports possible.
Financial statements are typically found in one of the following three intervals:
Each interval has its own benefit and consequence. Investors and management teams will typically leverage numerous time periods to get a broader understanding of the business and plot a proper trend.
All three financial statements (the balance sheet, income statement, and statement of cash flows), look at what happened. The lack of forward looking guidance or outlook is undoubtedly the biggest disadvantage found with financial statements.
Why Are Financial Statements Important?
The financial statements of a company is like a medical chart a doctor will read for their patients. Before prescribing medicine, treating a symptom or performing surgery, a doctor will need to get familiar with the patient.
The same is true for a company.
A management team cannot take the company to higher levels of success without having an understanding of how the company is performing and what needs to change. Investors may be more cautious investing in companies that have terrible financial performance and who hemorrhage money.
How To Read Financial Statements
All three financial statements cannot be read in a vacuum. Sure it’s important to look at the present day financial picture of a company, but it must be compared against another period of time and macroeconomic factors must be taken into consideration.
For example, imagine you own a surfing business and operate out of New Jersey. This is a very seasonal business and must be treated as such.
Even if you operate your business for the entire year, without question the winter months will be slower than the summer months. If you’re evaluating your performance in January and see you did not generate the revenue or profit you once did in June, that’s not a bad thing.
Review the year over year performance to see if you generated more revenue or profit this January compared to the previous year. Each financial statement deserves to look back on history for a longer period of time.
Many investors find the trailing 3-5 years very important when deciding to invest in a company. The management team may find a year over year analysis more meaningful.
What Should Investors Look For In Financial Statements?
Once you’ve determined what time period you’re going to view for your analysis, there are numerous financial metrics and ratios one will want to view. For example, a few common questions that come to mind include:
- The Income Statement
- Is revenue growing or declining
- Have profits been growing or declining
- Is profit, as a percentage of revenue, growing or declining
- Are operating expenses growing at a quicker rate than revenue
- The Balance Sheet
- How much debt does the company have
- How much cash does the company have
- What assets does the company own
- Are the short term liabilities greater than the cash reserve
- How is a company funding their business (dilution of equity, debt, etc.)
- The Statement of Cash Flows
- What is the company spending money on
- Is money leaving the company quicker than it’s coming in
What Is Not Included in Financial Statements?
A company’s financial statements do not include forward looking guidance. However, this guidance is typically provided in an internal meeting, on a quarterly earnings report.
Additionally, a company may produce a “management discussion and analysis” or MD&A to circulate amongst investors and the management team. Looking in the rears is important, but everyone is more interested in what will occur in the future.
The Health Report of a Company
The three financial statements make up the health report of a company. Outside investors will want to be aware of the financial performance of a company before investing their own cash into the company.
A management team will want to know how their ideas and performance is impacting the company, or what about the business is preventing the company from unlocking more profit. For a publicly traded company, these reports are available on numerous financial sites.
Yahoo and Google both provide a lot of this information for free. Keep the broader picture in mind when reviewing the financials.
It’s normal for a company to have a down month or a down quarter. Compare the current performance against a longer term trend before jumping to any major conclusions.