Chapter 7.11: Financial Statement Analysis: A Key to Historical Performance
Financial statements give an account of a company’s performance during a given period. However, a single period’s performance suggests little about the company when looked at in isolation. It must therefore, be looked at in conjunction with the company’s past performance. A comparison in this way, brings out the strengths and weaknesses of the company and provides insight into its future. This is called financial statement analysis.
In this section, we will look at the important financial statements of a company as well as their utility when used as a part of historical analysis.
What are the different financial statements issued by companies
There are three basic financial statements that can be found in the annual and quarterly reports of a company. They are the income statement, balance sheet and cash flow statement—the three pillars of financial statement analysis. There is also a section called notes to accounts in every annual report. Here, each component of the three financial statements is explained in greater detail. We will discuss the three financial statements one by one.
Important Financial Statements of a Company
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Income statements :
All the incomes and expenses of a company are recorded in the income statements. It is sometimes also called the statement of profit and loss. It starts with the company’s sales revenue for the period and keeps adjusting it for other incomes and expenses that occurred during the period. The resulting figure is the net income/profit for the year. This is the portion of sales that is left behind after all other incomes have been added to it and all the expanses subtracted from it. It is used to pay dividend to shareholders. Whatever remains of it after the dividend has been paid is called retained earnings. It is reserved for later use in the business.
Incomes and expenses are divided into operating and non-operating, depending upon whether they have originated from the company’s core operations or not. Operating items include depreciation, employee compensation, selling costs, costs of inputs used for production etc. Non-operating items include, proceeds from the sale of an asset, interest cost etc. The amount we get after all these have been subtracted from sales is called the pre-tax profit. On subtracting the period’s tax expense from this, we arrive at net income or net profit. This is the amount we refer to when we talk about the profitability of a company.
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Cash flow statements :
All the expenses and incomes of a company are mentioned in the income statements. However, not all of these are in cash. For example, the income statement reflects the period’s sales revenue as an income but doesn’t say what portion of this was actually earned in cash and what in the form of future receivables. It is important for investors to know this configuration because non-cash figures are either only notional or are promises that cash flows will occur in the future. In both cases, they are less liquid than cash and highly uncertain. The cash flow statement removes this uncertainty by presenting the actual cash inflows and outflows of the business during a period. It also divides cash flows by their nature into operating, investing and financing. This displays the major sources that brought in cash and those that led to an outflow of it. We will discuss this in greater detail in the section on the cash flow statement.
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Balance sheets :
The balance sheet talks about the assets and liabilities that a company has at its disposal. Assets and liabilities are divided into fixed and current. Fixed assets and liabilities stay with the company for a long time. Fixed assets include land, machine, building and others that provide benefit in the long run. These assets, with the exception of land, lose value every year. This loss in value is known as depreciation.
Long term liabilities of a company include long term debt and other obligations that it has to pay in the long run. Current assets and liabilities exist only for short while. Current assets include, accounts receivable, inventories, short-term securities and cash, whereas current liabilities include short-term loans and accounts payable. Some of the assets and liabilities mentioned on the balance sheet are intangible as they do exist but not in tangible form. Examples include patents, copyrights, software programs in case of IT companies, and deferred tax. We will look at these in detail in the section on the balance sheet.
Another figure mentioned on the balance sheet is equity. It is the sum of all the funds that shareholders offer the company in exchange for its share. It mainly includes the book value of outstanding shares, retained earnings and some reserves. Please note that the book value of the company’s shares is not the same as their current market price. This is because the amount mentioned on the balance sheet is the original value of the shares, when they were sold/issued and not the value they subsequently rose to. A company buys its assets using equity and the money it borrows in the form of debt. Thus, the value of a company’s assets is always equal to the sum of its liabilities and equity.
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Conclusion :
It must be noted that this description is based on the most commonly found financial statement formats. Companies can modify the way they present these statements slightly, but the components in each case will be the same.
You will frequently find two sets of financial statements in an annual report – stand alone and consolidated statements. This happens in the case of companies that have a parent – subsidiary structure. Standalone statements represent the figures of the parent company alone. The revenues, profits, assets etc. of the subsidiaries are not a part of it. In the consolidated statements, all these are included to the parent company’s statements.
Why you need to understand past company performance
The historical performance forms the basis for understanding the current financial statement of a company. Financial statements only talk about a company’s performance in the present period. If they are viewed in light of similar statements from previous periods, you can understand the interplay of factors that affects this performance. On this basis, one can not only evaluate the present period’s performance but also comment upon the company’s future prospects. Otherwise financial statement analysis would not be worthwhile. There are three
Why to understand company past performance
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Trend analysis :
Equity analysts like to observe changes in the values of various components of the financial statements from period to period and discover patterns. They believe that such patterns are based on a cause-and-effect relationship. If they can dig deeper, they may be able to reveal the underlying causes.
This can be of consequence in predicting the present and future performance of the company. Sometimes, a trend analysis reveals a path-breaking new strategy or a radical shift in approach on the part of a company. This opens up a new layer of understanding into the company’s operations and may change the outlook on it substantially.
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Benchmarking :
An analyst may ascertain a benchmark for the company’s performance based on past data. The company’s present performance may be compared with this benchmark to see how it has done. In case there is major divergence from the benchmark, one may explore further to reveal the causes.
A very important tool for both benchmarking and trend analysis is ratio analysis. Certain financial ratios may be calculated for each of the past periods. The comparison of these ratios with their present value sometimes reveals vital facts that otherwise might have not come to attention at all.
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Future projections :
Equity investors project a company’s future performance to decide whether to buy its shares or not. Past economic performance forms the basis of these projections. How do you know what the value of sales or fixed assets of the company will be over the next ten years?
For making these calculations, trends such as growth rates of the past few years are observed. They are then adjusted for improvements the company might introduce in the future. Based on these, values of these variables in future periods is calculated. These values are used to calculate the fair price of the company’s stock as on the date.
Need for financial and information transparency
Investors, who use the financial statement analysis approach to stock picking, clearly depend on the reliability of data present in the financial statement of a company. It is therefore imperative for companies to provide facts and figures honestly and, in general, make a fair representation of their operations. Providing financial information accurately, explicitly and in a readily available fashion to its users is called transparency. We saw in one of the earlier sections that free information flow is important for market efficiency. A lack of transparency obstructs the free flow of information and hurts market efficiency. Transparency can be expected in two ways.
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Financial Transparency :
Firstly, companies must be open about their operations and the uses to which they put shareholder funds. This is known as financial transparency. Managements sometimes use shareholder funds in ways that are not necessarily complementary to shareholder interests. This is generally done to perpetuate their own position and expand their sphere of influence.
This reflects in the form of lack of information and the presence of unusual items on the financial statement of a company. Investors must look at this with suspicion. There are many red flags and warning signals available for shareholders on the financial statement of a company. We have already looked at these in the previous section. Investors should be mindful of these.
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Informational Efficiency :
The other aspect of transparency deals with how freely and voluntarily the company makes information available to those who are interested in it. This is called informational efficiency. Again, companies are less forthcoming when it comes to releasing information when they have something to hide. Investors must be suspicious in such events and look for red flags.
The board of directors also has a central role to play in the maintenance of transparency. Thus, investors must ensure that the board is as independent as possible.
What next?
Now we are aware of the various kinds of financial statements and what they contain. In the following sections we will look at each of these independently and understand financial statement analysis. We will start by looking at the income statement. click here.
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