Analyzing Financial Statements

From the few people I have been able to interact with outside my work environment regarding financial statements, it is quite clear that a ‘lay-man’ may liken Financial Statements to rocket science to some extent. This is due to the perceived complexity of the calculations and jargon used. As such, I feel obliged to play my role as the diligent analyst I am to shed light on how to demystify the sorcery that is financial statements.

First and foremost, financial statements can be defined as the written records that highlight the performance of the company by describing in detail the business activities that have been undertaken. In simple terms, it is how the business has spent money and the returns they have received in return.

To be able to account for different types of businesses with ease, scholars over the years have come to accept specific standards when it comes to financial reporting. Organizations are expected to adhere to global accounting standards known as International Financial Reporting Standards (IFRS) which are guidelines set aside to ensure best practice when it comes to financial reporting. A basic financial statement can be divided into four main parts; a balance sheet (gives a detailed information of a company’s assets, liabilities and shareholder’s equity), an Income statement (gives detailed information on how much revenue a company has generated over a specific period, coupled with the relevant expenses to show the profit for the period), a Cash flow statement (highlights a company’s cash inflows and outflows) and Statement of Shareholder’s equity (gives a summary of the ownership structure of the company).

In essence, a balance sheet in simple terms can be seen as a register where everything owned by a company is listed either as an asset, a liability, or shareholder’s equity. Assets are the things that a company owns that have value, meaning they can either be sold or used by the company to make products or provide a service. Liabilities are the funds owed to others by the company, it can be in the form of a bank loan, rent for an office, or money owed to suppliers. Shareholder’s equity represents the capital invested by the owners or the net worth of the business. This gives a rough picture of the size of the business having considered the size of the balance sheet. The income statement, on the other hand, shows how the business has generated revenue and the expenses it has incurred doing so. This can be through selling a product or offering a service. Here, the focus is normally the core business and how sales translate to profits at the end of the year. These two are the more important parts of the financials since they show the value of the company. When it comes to the Cash flow statement and the Statement of shareholder’s equity, the former describes how funds in the company have been used during the period in question (i.e. how much was spent on investment activities, financing activities, etc.), while the latter usually highlights the changes in equity value over the period of reporting.  The above four elements combined help to draw a picture of the current financial situation of a company. Normally, to accompany the above notes to the financial statements are appended to the end of the financial statements as informative disclosures or additional information to the various items in the financial statements.

Further to the above, these are some of the important steps to cover when analyzing financial statements:

• First, it is important to identify the economic characteristics of the industry the company is in. This is where one looks at what drives the business. For example, in a manufacturing company, raw materials are an important input in the business and as such changes in their prices ultimately affect the profitability of the company,
• Know the company strategy. Due to the unique nature of every business, identifying the company’s strategy goes a long way in helping one understand the nature of the business, how profits are generated through the products offered by the business and from a broader perspective; understand the growth strategy for business continuity,
• Determine the quality of the figures provided. This can be as simple as finding out more about the company’s auditors and their track-record. One can also go through the auditor’s report which is normally included with the financials.
• Familiarize yourself with important analysis tools used by professionals to determine the profitability and the risks for various companies. This includes key financial ratios that help inform the profitability, liquidity, debt management, and other aspects of the business. This can be done by going through reports released by professional analysts on the financials of the various organizations in an industry

Finally, when it comes to analyzing financial statements, like all other skills, practice deepens your understanding of the subject at hand and will help you make that informed decision when you decide to invest in that company you’ve always been thinking of.