UNDERSTANDING FINANCIAL STATMENTS

A company’s financial statements contain some of the most valuable insights an investor can gain. You can learn how profitable a business is, how much they are in debt to their creditors, how well they are managing their expenses, and a whole host of other useful information. There is also a certain element of objectivity financial statements bring to the table and while they are by no means perfect (with plenty of room for accountants using their own discretion), they do allow us to make fair judgments about how a company has performed and to some extent, their likelihood of continuing that performance into the future.

There are four key sections to financial statements: the Statement of Earnings, the Statement of Financial Position, the Statement of Cash Flows, and the Notes to the Financial Statements. On this page you will find an overview of each of these sections, what to focus on if you’re just starting out, and other things I feel are worthwhile sharing from my years performing both internal and external financial statement analysis.

—  THE STATEMENT OF earnings—

A key measure of profitability, and one of the most talked about in the financial press.

The Statement of Earnings is usually the first (and most focused on) Financial Statement you will come across when reading a company’s quarterly and annual reports. Simply put, it summarizes how much a company has earned (or lost) over a certain period of time such as one quarter, two quarters, or a year. If available, comparisons over previous periods are also shown in order to give context to the reader. In this section, you can take a glance at a sample statement below (courtesy of the Corporate Finance Institute) and then follow along as I discuss some of the items which go into each of the four main categories: net sales and cost of sales, operating expenses, interest and other expenses, and income taxes.

—  NET SALES AND COST OF SALES —

All companies have sales, and growing companies have growing sales. This is the first line in the income statement (often referred to as the “top line”) and is arguably one of the most important. Sales can be of goods or services, such as the sale of merchandise or the the sale of consulting time to clients. Sales can also be in cash form or on credit, with the former being the most secure while credit sales carry some risk, but we’ll get into more of that later.

On the Statement of Earnings will be Net Sales, which is notably different than just Sales. Net Sales accounts for three main types of adjustments: allowances, returns, and discounts, each described below.

Consider a situation where you purchased a coffee table from a furniture store for $500, but when it was delivered you noticed that it had some small defects. You call up the company to report it, and negotiate a $50 credit instead of returning the item. On the Company’s Statement of Earnings will be Gross Sales of $500 less the $50 credit provided to you to equal Net Sales of $450. This type of adjustment is referred to as customer allowances.

The next type of adjustment to sales is for customer returns. Customer returns are exactly what they sound like - a customer returns the product for a reason covered by the company’s return policy. Returns are essentially a reversal of the sale, but there may be some cost recovery mechanisms in place such as restocking or other administrative fees associated with the return.

The final type of adjustment to sales is for sales discounts. For various reasons, a Company may offer its customers an incentive to pay their invoice early. For example, an invoice may state that you only have to pay 98% of your balance (2%) if you pay by a certain date. Or, it may state that you only have to pay 98% of the invoice if you pay in cash or e-transfer. These methods are good options for companies experiencing high customer default rates (i.e. customers not paying their bills on time or at all) and want to ensure they get their cash on time and in full.

On the Statement of Earnings, you likely will only see a singular Net Sales figure, however more information may be contained in the Notes to Financial Statements (see last section of this page). If a company is involved in multiple types of sales, you may also see Management break down Net Sales into each of these segments. Even though it is not required of them, a transparent company will usually make this additional effort as they undoubtedly classify this information this way internally anyways.

Right below net sales you will find cost of sales, which is subtracted from net sales to calculate gross income. The cost of sales is widely defined as all the costs associated with the successful sale of a product or service. For example, if a company’s business is selling clothing, the cost of sales would include the cost of the supplies needed to make the clothing, among other things.

As analysts, we try our best to normalize the income statement by calculating everything as a percentage of sales. A steady (or growing) gross income percentage of sales (known as gross margin) is usually a good sign that the company is selling something its customers value. These companies either do not have to reduce the price of the good or service it is selling.

—  OPERATING EXPENSES —

Operating expenses are simply the expenses a business incurs through its normal business operations. Common operating expenses include employee salaries, building rental expenses and utility expenses. These are cash expenses. In other words, they represent actual withdrawals from the company’s bank account. Included in operating expenses are non-cash expenses as well, such as equipment depreciation. Depreciation is a non-cash expense because there aren’t actually any cash withdrawals taking place; instead, accountants estimate these expenses based on the useful life of an asset.

To illustrate this principle, let’s say a company purchases a large transportation vehicle for $100,000. Recognizing this expense all at once would make the Company’s income statement look terrible for the period in which the vehicle was purchased. Fortunately, accounting rules allow companies to “smooth out” this expense over multiple periods. If the Company reasonably estimates that the vehicle will last for 10 years before it needs to be replaced, it is allowed to report just $10,000 of expense each year.

In addition to categorizing operating expenses as either cash or non-cash, we may also categorize them as actual expenses vs. estimated expenses. Much like how a company may not receive prompt payment for the sale of product, it may also not promptly receive invoices from its suppliers and other vendors. When these situations arise (which is often), accountants must make reasonable estimates of these expenses based on the information they have available at reporting time. For generally fixed expenses such as property taxes, this is straightforward. However for expenses which widely fluctuate on a regular basis, this estimating process is difficult but nevertheless necessary. By not making the effort to reasonably estimate known expenses, a company would effectively be overstating its income and engaging in financial statement manipulation.

After subtracting the cost of sales and operating expenses from net sales, operating income is calculated. Operating margin, which is simply operating income as a percentage of net sales, is a key financial measure analysts focus on.

—  INTEREST AND OTHER EXPENSES —

Interest expense represents the interest payments the Company makes on its debt obligations. Companies often times borrow money in order to fund its business operations and in exchange for these cash injections, it agrees to pay regular payments to its debt holders. Interest expense is not classified as an operating expense because it really doesn’t have much to do with the company’s normal business activities. The company could eliminate interest expense altogether if it chose to repay all of its debt at once, or not take out any loans to begin with.

Other expenses are a catch-all category for non-operating expenses. One of the more common other expenses occurs when a company disposes of a fixed asset. Consider the example earlier where the Company estimated the useful life of the vehicle at 10 years. If, however, after 8 years (and $80,000 of expense recognized on the $100,000 asset) the truck is rendered unusable, the Company must recognize the remaining $20,000 expense at once. This would fall under the Other Expenses category and because the reason is more due to the initial poor estimations rather than the company’s normal business operations, it is not classified as operating income.

—  Income taxes —

Corporate income taxes are collected by government, both at the local level (state, provincial or territorial) and the federal level, and are levied as a percentage of earnings. Depending on where the Company does business, corporate income tax rates can vary substantially, so knowing each company’s effective tax rates is useful when trying to project net income. Corporate tax rate overhauls such as the one which occurred in the United States several years ago can provide immediate cash injections (savings) for a company and allow them to be more flexible with how they operate going forward.

After subtracting cost of sales, operating expenses, interest and other expenses, and income taxes from net sales, you will arrive at net income, which is the ultimate measure of profitability. Dividing this by the number of shares outstanding would result in Earnings Per Share (EPS), which is one of the most reported figures by the financial press.

—  THE STATEMENT OF FINANCIAL POSITION—

A snapshot of what the company owns, what it owes, and what’s left over.

The Statement of Financial Position, otherwise known as the Balance Sheet, summarizes what the company owns (assets), what it owes (liabilities), and what’s left over (shareholder’s equity). You can think of Shareholder’s Equity as what would be leftover if the company were to sell everything it owns and pays off all of its debt. This is not to be confused with market value, however, as the market may be willing to pay far in excess of this residual amount.

It is called a Balance Sheet because the accounting equation of Assets = Liabilities + Equity must always be in balance, but that’s something accountants have to worry about. For an investor, many things can be learned from a balance sheet analysis such as how much a company’s assets are growing, how much debt it is in, and how much it is owed from unpaid sales on credit. In this discussion I will go over each of the three sections of the Balance Sheet, which items you are likely to find, and some key ratios you can calculate to compare a company’s progress against itself and its competitors.

—  ASSETS —

On the Statement of Financial Position, Assets are broken out into two categories: current and non-current. Generally speaking, current assets are anything that the company expects to have use or otherwise have resolved over the course of the next year. Non-current assets (sometimes referred to as long-term assets) are assets with useful lives over one year.

Classic examples of current assets are cash, accounts receivable, inventory, and prepaid expenses. If you think about cash, it’s extremely likely that the cash in a company’s account today will be used for something within the next year. Accounts receivable, which are sales made on customer credit (but which the cash has not yet been received), should also be resolved within one year. Inventory represents unsold goods - again, these will ideally be converted into actual sales within one year. Finally, a simple example of a prepaid expense is rent. Rent is usually owed in advance at the beginning of each month, and it is an asset that gets continually drawn down to zero as the month progresses.

Non-current, or long-term assets, consist of property, plant and equipment (PPE) assets such as vehicles, computers and machinery, intellectual assets such as patents, and investments in other companies. In addition to these common non-current assets, there are intangible assets such as goodwill. Goodwill is the excess of what the Company paid for an asset versus what the fair value of that asset is. Excess goodwill that is persistent over time may indicate that a Company overpaid for an asset or business.

—  LIABITILIES —

Similar to assets, liabilities are also broken down into current and non-current. Again, categorization of a liability is dependent on whether it is expected to be resolved within one year or not.

Current liabilities typically include accounts payable, short-term debt, dividends payable and income taxes payable. Accounts payable represent payments owed to the company’s vendors and suppliers, its own employees and other entities. Short-term debt may represent the interest on debt that is coming up within the next year. Dividends payable is a current liability which represents any dividend payments the Company has committed to making within the next year. Finally, income taxes payable are due at least once per year - the Company recognizes estimated income taxes each period until it is time to file their tax returns and make payment.

Non-current liabilities are largely debt obligations lasting more than one year. For example, if a company has borrowed money that it is due to pay back in 10 years, 9 years’ worth of debt would be classified as non-current while the upcoming 1 year would be classified as current. The same goes for lease obligations, any bonds the company has outstanding, and any other liability that is due in more than one year. One additional long-term liability is deferred revenue, which occurs when a Company is paid in advance for goods or services it has not yet delivered. If, for example, a construction company receives $50,000 as a deposit for a house they are building, they are not able to report that as revenue until a certain portion of the house is completed.

—  EQUITY —

As mentioned earlier, equity is simply the difference between the sum of all the company’s assets and all of its liabilities. The Equity portion of the Balance Sheet may even be negative as there is no guarantee the company’s assets are worth more than their liabilities. This is especially true of startups, while mature companies are more likely to have positive shareholder’s equity.

The two main categories of shareholder’s equity are Share Capital and Retained Earnings. Share capital represents the capital earned through the issuance of new shares. A company may issue common shares or preferred shares in order to raise this capital - the differences with these is largely due to voting rights and a claim on residual assets in the case of insolvency. Retained Earnings are profits or losses transferred over from the Statement of Earnings each period. Think of Retained Earnings as banked earnings - a Company earns $100,000 after all expenses and taxes in a year, then transfers this money over to Retained Earnings and starts over.

—  THE STATEMENT OF CASH FLOWS—

Sometimes overlooked, but it contains some of the company’s most valuable information.

The Statement of Cash Flows is one of the three main financial statements included in a company’s quarterly and annual reports. While the Statement of Earnings (Income Statement) contains “headline” information such as Earnings Per Share and the Statement of Financial Position (Balance Sheet) gives a snapshot of all the company’s assets, liabilities and equity on a given date, the Statement of Cash Flow looks at the actual cash transfers between two periods. It’s a good way to tell if the company is doing a good job at managing its cash, which is incredibly important because cash is how the company will be funding new opportunities, paying down debt, and many more things. The Statement of Cash Flows is organized into three sections: operating, investing, and financing cash flows, and I will give a brief description of each below.

—  CASH FROM OPERATING ACTIVITIES —

The first section of the Statement of Cash Flows describes cash generated from operating activities. As you may have guessed, this is just the cash a company generates from its normal ongoing business activities such as the sale of merchandise. These cash inflows are offset by cash outflows such as the cost to manufacture or purchase that merchandise. If this is starting to sound more like a normal income statement to you, then you’re not that far off. The main difference is that it only deals with cash transfers; it doesn’t have any of the non-cash items you would find on an income statement. Depreciation is a good example of a non-cash item - companies must report it as an expense, but there’s not actually any transfer of cash going on.

It is for this reason that the easiest way to come up with the cash flow from operating activities is to just start with net income and then adjust it for any non-cash items. So if a company’s net income is $100 and the only non-cash item on the income statement is $10 of depreciation, the cash flow from operating activities would be $110. Take a look at Alimentation Couche-Tard’s partial cash flow statement below, courtesy of Reuters.

The cash from operating activities should be the main source of cash for a company. After all, if it isn’t earning enough cash to run the business then something isn’t quite right. Companies which steadily grow their operating cash flows are viewed favorably because they have so much more flexibility with what they can do with that extra money.

—  CASH FROM investing ACTIVITIES —

The second section of the Statement of Cash Flows describes cash generated from investing activities. This will include any investments the company needs to keep the business going such as the purchase of assets big and small, such as new computers for office staff or for large delivery vehicles for a transportation company. These physical assets are classified as fixed assets on the Statement of Financial Position, but the costs are not recognized in full at the time. An asset is given a reasonable shelf life (a computer may be 3 years, a vehicle may be 10 years) and its expense is drawn down over that period of time. Companies with lots of expensive fixed assets may therefore see quite a big difference between cash flow and net income.

Also included in cash flow from investing activities are the purchase and sale of securities. A company with excess cash may choose to invest a portion of it in short-term securities to earn a little bit more than just having it sit in a bank account - sort of like how we may operate. When analyzing cash flow from investing activities, try and distinguish how much is considered normal investing activities and growth investing activities. A site like Reuters classifies normal investing activities simply as Capital Expenditures, while non-normal investing activities are classified as Other.

A company which is growing their asset base by investing more is usually a good sign that they feel comfortable with their future prospects. A stagnant asset base (along with consistent or decreasing investing cash flows) is perhaps a warning sign that the company is doing its best to conserve cash for the wrong reasons. Putting off new investments in technology due to poor operating cash flows or even the lack of opportunities within the industry is a clue that maybe the company has reached its growth potential.

—  CASH FROM FINANCING ACTIVITIES —

The third and final section of the Statement of Cash Flows describes cash generated from financing activities. This primarily includes transactions involving the issuance and retirement of debt and equity. In other words, it helps answer the question: how is this business being financed?

In a perfect world, a company could meet all of its investing requirements from its normal business operations (i.e. operating cash flows) and maybe even have enough money leftover to pay a dividend to shareholders. But this isn’t realistic, so companies must make decisions as to how they raise capital. Generally speaking, they can either take out a loan (i.e. issue debt) or issue new shares to the open market for us shareholders to purchase (i.e. issue equity). By raising capital quickly, it jumpstarts a business and gives it the capital it needs to accomplish its objectives.

This section can help you easily identify if the company is continuously needing to raise more capital. If the company’s goals are being met and they are raising more to capitalize on their growth prospects, that’s usually a good sign. However, if they are raising more capital just to keep the business from going bankrupt, or just to ensure they do not have any uninterrupted dividend payments, that’s usually a bad sign. The key is understanding which one it is. Unfortunately there isn’t a financial metric or ratio out there that is going to give you the answer - you have to dig a little deeper and understand why a management team is doing what they’re doing.