If you’re new to finance, you may be wondering about the hype around so-called “financial statements.” To their users, financial statements are creative, holistic, and efficient representations not only of a company’s financial performance, but also its innermost business mechanics.
Based on financial statements alone, users can deduce company performance, efficiency, competitiveness, and prospects. And they can do all this without even knowing what the company sells.
Business people who understand financial statements have a competitive edge, whether to effectively manage the company or trade its shares. The importance of financial statements to those who read them cannot be overstated, but it does come with a catch.
In this article, I’ll provide a list of financial statement users, shortly explain the three financial statements, and outline 7 reasons why they’re so important. I’ll also explain their limitations and how this has led to financial loss for many.
Importance of Financial Statements to Users (In Short)
Succinctly, financial statements are important because they provide reliable, unbiased information on a company’s performance, its assets, its obligations and debts to others, and its cash flows, which allow users to evaluate ways to improve these metrics, and/or whether to invest.
We’ll break this down further in the sections below.
Who uses financial statements?
Users of financial statements include:
- Retail investors,
- Institutional investors,
- Company managers,
- Tax authorities,
- Private equity firms,
- Sales managers,
- Market analysts,
- Stock analysts,
- Financial advisors, and
- Financial analysts.
What are the financial statements?
The financial statements consist of the income statement, the balance sheet, and the cash flow statement. These documents are a result of double-entry accounting, which is common practice in virtually every country on the planet. We can therefore understand companies from all over the world using them.
Skeptics may claim there are diverging guidelines on how to construct these statements, which is true to some degree, but the fundamentals are universal.
While a complete explanation of each is outside the scope of this article, I’ll provide a quick description in the table below.
|Statement||Purpose||Popular Items on the Statement||How Values Accumulate|
|Income Statement||Show company earnings in one accounting period||Revenue, net profit||Sum of values in one accounting period, then added to the balance sheet at the end of the period and reset to zero on the P&L at the end of the period|
|Balance Sheet||Show the total assets, liabilities, and equity values at a given point in time||Working Capital, Fixed Assets, Debt, Equity||Standing total of values representing the entire life of the company, never reset to zero|
|Cash flow statement||Show the movements of cash from operations, investing, and financing activities in one accounting period||Cash flows from Operations, Cash flows from Investing, Cash flows from financing||Sum of values in one accounting period, then reset to zero at the end of the period|
So how do you read this table? The best way is to always consider the balance sheet first. While many analysts focus only on the income statement because it shows business performance, the balance sheet is the quintessential statement from an accounting point of view.
Why? Because it shows the total holdings of the company at any point in time.
Assets are either physical or non physical property, or rights to cash and future payments of cash. Liabilities show what the company owes to others, whether it’s money to supplier or to banks. Equity shows the difference between assets and liabilities. It is the value that shareholders have in the company after all debts are paid.
These are all cumulative values over time — they do not represent transactions in one accounting period, but rather all accounting periods since the creation of the company. To see values in one period, we must subtract the ending balance from the starting balance.
The income statement, on the other hand, shows income and expenses of various types over the course of one accounting period. The difference between income and expense is net profit, and net profit is transferred to the balance sheet at the end of a period.
This is why we say the balance sheet rules all — it includes everything from the income statement and more.
The cash flow statement can be constructed directly by taking a sum of all transaction on the bank accounts during an accounting period. This is the direct method, but it’s rare in practice. Instead, companies use values from the income statement and adjust them for non cash items on the balance sheet in the same period. This is called the indirect method.
You can learn more about financial statements in this article on Financial Analytics.
Reason 1: Understanding Performance with Net Income
The income statement tells users how much sales a company generates, the costs it needs to spend in order to generate those sales, the costs it incurs for daily operations (lighting, water, rent), the current cost of large assets, interest paid on loans, and taxes.
After all of these costs are subtracted from sales, the result is net profit. Net profit is what the company keep on its balance sheet at the close of the period.
By analyzing the development of revenue and costs over time, users can identify if the company is getting better at generating profit.
In particular, users look at margins. If a company’s gross margin (sales – costs to generate sales) is increasing and sales is not decreasing, then the company is getting more efficient, for example. This is improved performance.
Reason 2: Understanding Position with Capital Structure
The balance sheet users us what assets and liabilities the company has. It’s “position” is often referred to as capital structure — that is, what relative portion of assets are debt and equity, respectively.
If a company has $100 in total assets, $20 in equity, and $80 in liabilities, we know that the company is heavily dependent on others to fund its assets (80%).
Unless the company has made very large purchases with loans as an investment to improve performance, companies with lots of liabilities usually have lower margins OR have high sales on credit.
However, if equity composes 80% of assets, the company is not usually dependent on others. That said, if they just received a huge cash injection by selling shares, they may not be efficient. In any case, their position is an indicator of what to investigate for users.
Reason 3: Understanding Efficiency with Ratios on P&L and Balance Sheet Values
Efficiency is either (1) how well the company generates profit, or (2) how well it converts assets into earnings. The two metrics we use to understand efficiency are margin and return on assets. Margin is calculated as ([Revenue] – [Cost]) / [Revenue], and return on assets is calculated as [Net Income] / [Total Assets].
For example, imagine Company A earns $100,000 in revenue, has $70,000 in cost of sales, and has $5,000 in assets. Imagine that Company B has $100,000 in revenue, has $60,000 in cost of sales, and $10,000 in assets.
This means Company A has a margin of ($100,000 – $70,000) / [$100,000] = 30%, and a return on assets of 6 ($30,000/$5,000). Company B has a margin of ($100,000 – $60,000) / ($100,000) = 40%, and a return on assets of 4 ($40,000/$10,000).
Company A is less efficient in its operations, but generates more money per dollar spend on big assets. Company B is more operationally efficient, but it requires twice as much investment in big assets. Depending on the cash situation of the companies, investors may prefer one over the other.
Reason 4: Understanding Ownership with Capital Structure on the Balance Sheet
As mentioned above, a company’s assets can be funded by either equity or liabilities. Together, these are a company’s capital structure. Equity is, in simple terms, the value of money contributed by investors. In public companies, equity shows the value of shares at the time of issuance. In private companies, it shows the value contributed by each shareholder.
Equity shows financial statement users of what a company’s ownership consists. In some cases, there may be stock options outstanding that, if converted, would lead to a dilution of shares. Users who want to maximize share value, either by trading or managing the company, want to fully understand a company’s equity.
Reason 5: Understanding Financing with Long Term Debt on the Balance Sheet
The capital structure compliment to equity is liabilities. We talked about financial position above, which is a high-level approach to evaluating the balance sheet. One step further is understanding how the company uses equity and debt to fund the purchase of large assets.
In most cases, a balance sheet shows the split between current and long term liabilities. Within the long term section, you will usually see long term debt, or long term notes payable. These refer to large loans taken in order to fund the purchase of large assets.
An easy way to measure how much of a company’s assets are financed by these loans is to use the long-term-debt-to-total-assets ratio. The formula is [LT debt] / [Total Assets].
For example, imagine a company has total assets of $100,000 and long term debt of $20,000. The ratio is this 20% which means the remaining 80% assets are funded by some combination of operational cash inflow and equity. The company is therefore very little dependent on creditors.
Reason 6: Understanding Future Performance with Projections
Financial statements of historical and current values are of vital importance. However, many users are more curious about the company’s expectations for the future. While the past year’s revenues tell users if the company’s performance is in its range of interest, the user must feel like this growth will continue into the future if she/her wants to invest.
Financial analysts play a critical role at this stage. They’re directly responsible for creating projections of all three financial statements based on management input and assumptions. In some public companies’ SEC filings, there are forward-looking statements that show these projections.
While the projections in filings are based on historical values, users of financial statements often create their own forward-looking projections. Forward looking statements allow users to determine whether they will interact with the company further.
Check out this article if you’re interested in learning how to create a complete 3-statement financial model.
Reason 7: Understanding Solvability with Working Capital
It has been said that revenue is vanity, profit is sanity, but cash is king. When users look at financial statements, they’re looking before all else to see if the company has enough cash to cover its costs. We refer to this state as solvent. Solvency is found in what we call working capital on the balance sheet.
Working capital consists of current assets and current liabilities. These are items that will need to be settled within one year. The difference between current assets and current liabilities is working capital.
For example, if the company has 100 current assets and 50 current liabilities, it has a working capital of 50 (100 – 50). This would mean it is solvent. When working capital is negative, a company need to secure some form of short-term debt to fulfill its obligations.
Users look at working capital religiously — regardless of if they’re managers, investors, or analysts.
The ∫-Shape Innovation Curve: What the Financial Statements Can’t Tell You
Financial statements provide huge value. They allow users to understand performance, financial position, company efficiency, ownership, financing, future performance, solvability, and much more.
But as any financial professional will tell you, financial statements don’t tell the whole story. While they are of utmost importance to their users, they cannot account for the curb of innovation: the S-shape curve.
The S-shape curve theory states that every industry undergoes innovation in a “life cycle” that straddles growth as an s-shaped curve. An innovative company starts as extremely innovative. Over time, its growth starts to skyrocket upwards on the “∫.” But then, it begins to plateau. At the middle of the S, another S had already begun to develop.
This is the cycle of innovation. As one company grows, another finds ways to improve the product or service, and eventually takes over.
The innovative company starting at the middle of that ∫ has very little market share at the start. However, just like the first company, it starts to grow in market share, just as the first company. Over time, the second company steals the market share of the first company.
The catch-22 is that in order to maintain its competitiveness, a company must improve its efficiency, but that efficiency may lead it to ignore other possible innovations that, in the short term, be much less profitable and operate in a smaller market., but in the long-term they will procure enormous gains.
The financial statements cannot accommodate the ∫-shape curve. The company will always attempt to maximize its efficiency — even if that efficiency is short-term and does not consider potential upsets in the market.
Investors who rely on financial statements must be aware that even though a company is high-performance, financially well positioned, has stable ownership, is solvent, and has managers who believe in it’s growth, it may completely ignore the cycle of innovation! Investors who inject loads of cash up front can lose in the long run.
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