Chapter 2. Financial Statements, Cash Flow, and Taxes

Chapter 3. Analysis of Financial Statements

Finance – Week 2 Lecture

Financial Statement Analysis

This week the focus will be on financial statements and how to use them to assess the performance of an organization. Before we can use them successfully, we need to know the basics. While we certainly do not need to be accounting experts, we do need to have baseline knowledge of what we are looking at. There are four basic financial statements: the income statement, balance sheet, statement of stockholder’s equity, and the cash flow statement. All four provide important information about the organization. While some financial statement users tend to prefer one statement over the other, all four are necessary in order to get a full picture of an organization’s health.

Let’s begin our exploration with the income statement. Though every income statement may look slightly different than the next, they will all still have the same basic elements: revenues and expenses. Income statements show us how much a company had for the period in sales and how much they spent in order to achieve those sales. Hopefully there are some funds left over, resulting in a profit. If we spend more on expenses than we bring in for sales, we end up with a net loss rather than a profit. It’s important to note that the income statement shows us performance over time. The most common time periods for income statements or any financial statement, is a month, quarter, or year. There are lots of ways that we can use the income statement to analyze an organization. We can look at several years of income statements to identify trends (trend analysis) to see if performance is improving or declining. We can translate the dollar figures on the income statement into percentages of sales and compare the organization to competitors, other organizations in the industry, or to industry averages. We can also calculate a wide range of profitability ratios to see how well the organization is performance in terms of profits. Ratios are a handy analysis tool as well. They allow us to easily compare the organization to others, history, and industry benchmarks.

Unlike the income statement, the balance sheet shows us only a snapshot in time. It does not show performance over a period of time. It does show us what the organization has for assets, liabilities, and equity on a given date. The balance sheet earns its name by doing just that: balancing. The balance sheet supports the accounting equation: assets = liabilities plus equity. I like to think of the equation as everything we have (assets) and where we got it from (liabilities or equity) = borrow money or someone invested money in us. Just as we are able to use the income statement for analysis, the balance sheet is just as helpful. We can also look at several periods of data for the balance sheet to identify trends. We can also translate our balance sheet dollar figures into percentages of assets to make comparisons to other organizations more meaningful. There are also many ratios we can use to analyze items on the balance sheet. For example, we might look at the debt-to-equity ratio to see how heavily the firm is financed by debt. Since debt is more risky than equity, knowing how heavily the firm relies on debt is a helpful ratio in measuring performance. We can also put the income statement and balance sheet data together to calculate several additional ratios such as return on assets which measures how profitably we are using the assets we own.

The statement of stockholder’s equity helps us see how what has happened in the equity section of the balance sheet in more detail. In this helpful statement we can see the beginning balance of stockholder equity, any dividends issued, stocks issued or retired, and income earned, and the ending balance for stockholder equity.

Finally, we have the statement of cash flows. This financial statement is often overlooked but holds crucial information about an organization. There is a common misconception that if an organization is profitable, they must have cash and if they are not making a profit then they will not have any cash. This actually isn’t true! An organization can be highly profitable but if they do not track and manage their cash flow properly, they can be profit rich and cash poor. The statement of cash flows shows where the organization’s cash came from and where it went. It allows investors to see the difference between profit (or loss) and cash flows of the organization. The statement is broken down into three categories: operating, investing, and financing. This allows anyone reviewing the statement of cash flows to easily see what type of business activities are providing or using the organization’s cash. A new creditor, for example, would be interested in the organization’s cash from operations which can provide an indication of the sustainability of the organization’s short term cash flow.

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