Key Financial Statements

There are three key financial statements that are important to investors, security analysts, management, and lenders. These are the INCOME STATEMENT, BALANCE SHEET, and STATEMENT OF CASH FLOWS.

• INCOME STATEMENT -- The income statement provides information on the company's revenues and expenses over a specific time period (usually annually or quarterly). These revenues and expenses are accounting-based and not necessarily reflective of cash flows generated. For example, when a long-term asset is purchased the cash is spent at that time. However, its expenses are recognized over time as depreciation instead of at the point of purchase. Also, the method chosen to account for inventory can cause discrepancies between net income and cash flows from operations. The cost of our inventory is recognized when it is sold not when it is paid for. While the income statement is not cash based, that does not mean it is meaningless. It still provides a good picture of how well the company is doing, but we must recognize that net income is not cash.
• BALANCE SHEET -- The balance sheet provides a snapshot of the company's assets, liabilities, and owners equity at a specific point in time. The companies assets must be financed by either debt (liabilities) or ownership interest (equity). Therefore, assets will always equal liabilities plus owners equity (A = L + OE). It is important to remember that the values reported on the balance sheet are "book values" and do not necessarily represent the market value of the asset or ownership interest. For instance, the value of brand names, patents and other intellectual property which are often quite valuable to a corporation are not typically recorded on the balance sheet. Also, remember that the balance sheet represents a point in time and may not be the same throughout the year. For example, a company like Toy's R US may have relatively high inventory and low cash at the end of the 3rd quarter (start of Christmas shopping season) and relatively low inventory at the end of the fourth quarter (end of Christmas shopping season).
• STATEMENT OF CASH FLOWS -- The statement of cash flows attempts to reconcile the differences between net income according to Generally Accepted Accounting Principles (GAAP) and cash flows. Cash flows are broken down into three primary areas -- Cash Flow from Operating Activities, Cash Flow from Investing Activities, and Cash Flow from Financing Activities.
• SAMPLE FINANCIAL STATEMENTS -- Exxon's Annual Report (the financial statements start on page 38).

Financial Statements Analysis

Financial Statements provide a wealth of information to many different users. There are many ways to analyze financial statements. These include Ratio Analysis and Common Size Statements both of which can be analyzed through Trend Analysis or Comparative Analysis. While ratio analysis and common size statements provide an excellent way to analyze the information in the income statement and balance sheet, the statement of cash flows is best analyzed by breaking it down into its three primary components.

RATIOS

• Liquidity Ratios
  • Current Ratio = (Current Assets/Current Liabilities)
  • Quick Ratio (sometimes called Acid Test) = (Current Assets - Inventory)/Current Liabilities
• Asset Management Ratios
  • Inventory Turnover = (Sales/Inventory)
  • Days Sales Outstanding (sometimes called Average Collection Period) = (Accounts Receivable)/(Sales/360)
  • Fixed Assets Turnover = (Sales/Net Fixed Assets)
  • Total Assets Turnover = (Sales/Total Assets)
• Debt Management Ratios
  • Total Debt to Total Assets (sometimes called Debt Ratio) = (Liabilities/Assets)
  • Times Interest Earned = (EBIT/Interest)
  • Cash Coverage Ratio = (EBIT + Depreciation)/Interest
• Profitability Ratios
  • Profit Margin (sometimes called Return on Sales) = (Net Income/Sales)
  • Return on Assets = (Net Income/Total Assets)
  • Return on Equity = (Net Income/Common Equity)
• Market Values
  • Price/Earnings Ratio = (Market Price per Share)/(EPS)
  • Market/Book Ratio = (Market Price per Share)/(Book Value per Share)

Note that this is a list of a few primary ratios and not a complete list. There are probably 100+ different ratios, however we want to keep the list manageable so will only focus on these. The reason for so many ratios is that some (such as sales per square foot) make sense for some industries (such as brick-and-mortar retail chains) but not others (sales per square foot would have no meaning for a firm like Google). Also, some analysts have their own favorite ratios. Interpreting ratios is as much of an art form as a science as there are always exceptions. However, there is a class handout (also available on ANGEL) that will go through interpreting these ratios.

Video Tutorial

Using the Coca-Cola 2006 Financial Statements (included in the Ch. 2 Guided Tutorial), I have created 3 videos illustrating the solution to each of these ratios. These videos are available on Google Video (Note: Due to the size of the videos, it will be helpful to have the Coca-Cola Financial Statements in front of you as you are watching...some of the numbers may be hard to read on the video alone.)

• Liquidity and Asset Management Ratios
• Debt Management and Profitability Ratios
• Market Value Ratios

Common Size Statements
In addition to ratios, we can also glean information from financial statements by comparing them from year to year or from firm to firm. However, we need to be careful. If our sales go up from year to year when performing trend analysis, most likely so will our costs. What becomes important then is not did costs go up, but how did they change relative to sales. Alternatively our inventory may be down, but if all of our other assets our down as well, we may be starting to carry too much inventory. Finally, our selling and administrative expenses (or accounts receivable) may appear relatively low to our competitors. However, if their firm is three times the size of ours, these expenses and receivables may still be too high. To fix these problems, we can develop common size income statements and common size balance sheets. To get these common size statements is relatively easy. A common size income statement just takes each category in the income statement and divides by sales (expressing the item as a percentage of sales). A common size balance sheet just divides each component of the balance sheet by total assets (expressing each item as a percentage of assets). This makes it easier to compare items from year to year (or across different size firms) and see how well the company is doing in each component.

Trend Analysis
The ratios presented above are close to meaningless by themselves. Also, Common Size statements offer little value without context. In order for them to become valuable for analysis, we must have something to compare them to. One technique is to view how these ratios and Common Size statements change over time. For example, is our ROA rising or falling from year to year? If it is rising that indicates we are doing a better job of generating profits from our assets. Alternatively, if our DSO ratio is rising that indicates it is taking us longer to collect our credit sales. This may be a sign of a problem. While we can do trend analysis with two years, it is better to have 3 to 5 years of ratios to analyze to truly spot trends. Too few years makes it hard to identify real trends as opposed to just normal year-to-year fluctuations. Alternatively, too many years may present a misleading picture as the company, industry, and economy has likely changed too much over the period to make comparisons meaningful.

Potential Problems with Trend Analysis

• Seasonality -- Due to seasonality in quarterly financial statements (and annual balance sheets), seasonality concerns may lead to distortions in trends. We must be aware of how seasonality can impact or ratios and CS statements before we can properly analyze trends.
• Trend Changes -- Trend analysis is designed to help us identify weaknesses and forecast future performance. The problem is trends can change suddenly. Often we can not identify changes in trends until after they have happened which can hinder our ability to use trends for predictions.
• Fundamental Changes -- Significant changes in firm strategy or industry dynamics may make comparisons to previous years less meaningful.

Comparative Analysis
Another way to make the ratios and Common Size statements meaningful is to compare them to industry averages. For example, labor intensive industries may have high return on assets numbers while companies in capital (asset) intensive industries may have relatively low return on assets. Also, grocery stores are likely to have higher cost of goods sold values than software developers. If you are analyzing a software developer, it is important to compare it to others in the industry to determine if the numbers are "good" or "bad". If our numbers compare favorably to the industry average that is a good sign, and numbers that compare unfavorably to the industry average indicate potential weaknesses. However, we must be careful here. Our goal is not to be average. If we are better than the industry average in an area, that does not mean we have no room for improvement and management should ignore that area.

Potential Problems with Comparative Analysis

• Conglomerates -- Some companies (such as General Electric) defy industry classification. When a firm is involved in many different industries, comparative analysis can be misleading or extremely difficult to implement.
• Concentrated Industry -- Some companies (such as Microsoft) dominant an industry to such a large extent that it can be misleading to compare them to the industry norm.

ANALYZING THE STATEMENT OF CASH FLOWS

• Cash Flow from Operating Activities -- This represents the cash flows the firm is generating from its normal business operations. It is calculated by starting with Net Income and then adjusting back to a cash basis. For a healthy firm, Cash Flow from Operating Activities should be positive and growing over time. If this is not the case, it may represent a significant problem and should be examined further. If there is a reasonable explanation for negative or declining cash flows from operating activities AND we can expect them to turn positive and/or start increasing again in the near future we are less concerned. For instance, many young firms may experience negative cash flows early in their corporate life. Also, cash flows will typically decline in a recession. While these are still a cause for concern, if we are confident that it is a short-term issue it is likely not a significant problem. However, if a firm has negative cash flow from operating activities or steadily declining cash flows from operating activities over a long period with no real plan for turning things around, they are likely not going to be able to remain a solvent business in the long-term.
• Cash Flow from Investing Activities -- This represents the cash flows the firm is using to purchase new property, plant and equipment or new businesses. It also reflects cash flows generated by selling existing property, plant, and equipment or existing businesses. The Cash Flow from Investing Activities will typically be negative. While it seems like negative cash flows would be a problem, in this situation it is normal (and often indicates good things). In order for firms to grow, they need to expand their property, plant and equipment. Opening new stores, factories, distribution centers, etc are a sign of growth (which is good) but cost money (resulting in negative cash flow from investing activities). The main issue to look at here is whether the cash flows being used here are expected to generate increased cash flows from operating activities in the future.
• Cash Flow from Financing Activities -- This represents cash flows raised by issuing new debt or new shares of stock and cash flows spent retiring existing debt, buying back existing shares of stock, and paying dividends. It is hard to interpret positive or negative cash flows from financing activities as good or bad. Instead it primarily represents where the company is in its life cycle. Typically, firms that are younger and/or growing rapidly are more likely to have positive cash flows from financing activities as they need to issue new debt or new shares of stock to finance their growth. Older, more established firms often have negative cash flow from financing activity as they typically generate enough cash flow from operations to fund their investing activities and have a little left over to pay off previously issued debt, buy back shares of stock, or pay cash dividends.

Putting it All Together

Another problem is identifying what a significant change is. For example, let's say that our Return on Equity is 14.3% and the industry average is 14.5%. We are below the industry average, but only by a very small amount. Obviously we'd like it to be higher, but is this a weak spot or is it an average spot? How much below the industry average do we need to be before we get concerned. Or, let's say that last year our Return on Equity was 14.0% and industry average last year was still 14.5%. Now we have increased our ROE (marginally), but it is still slightly below the industry average. Is it a strength (because it is improving), a weakness (because it is below the industry average), or neutral (because there was little change and we are close to the average). Again, how much different do the numbers need to be before we are concerned? These are judgment calls.

Finally, the thing to remember is that when we go through our financial statement analysis, we are typically not identifying problems/strengths, but POTENTIAL problems/strengths. Think of the process as flagging areas for further investigation. When you visit a doctor, she checks your vital stats and asks you about symptoms. This is where the doctor generates an initial diagnosis, but then usually a series of tests are done to confirm what is wrong. Financial statement analysis is the initial diagnosis stage. Once you identify areas of concern, then you need to dig deeper to see what is going on and why. Once you have this additional information, then you can decide if it needs fixed and if so, how to proceed.