When it comes to evaluating a company's financial health as well as its earning potential, market analysts, investors and creditors will always look to a company's financial statements. Financial statements for any company should form part of the annual report.
The 3 major financial statement reports:
Balance sheets give a 'snapshot in time' overview of a company's assets, liabilities, and shareholders' equity. The date at the top of the balance sheet will tell when the snapshot was taken - generally the end of the reporting period. Here’s a breakdown of the items found in a balance sheet:
Cash and cash equivalents: These are liquid assets, including things like Treasury bills and certificates of deposit.
Accounts receivables: the amount of money owed to the company by its customers for the sale of its product and service.
Inventory: This includes the goods a company has on hand that it intends to sell as part of its business. Inventory may include finished goods, work in progress (unfinished work), or raw materials that you’ve already bought that still have to be worked.
Prepaid expenses: These are costs that have been paid in advance of when they are due. These expenses are recorded as an asset because their value hasn’t been recognized yet (if it’s not recognised, the company would theoretically be due a refund).
Property, plant, and equipment: These are capital assets owned by a company for its long-term benefit. This includes buildings used for manufacturing or heavy machinery used for processing raw materials.
Investments: These are assets held for speculative future growth. They are not used in operations; they are simply held for capital appreciation.
Trademarks, patents, goodwill, and other intangible assets: These aren’t physical assets but have future economic (and often long-term benefits) for the company.
Accounts payable: These are bills due as part of the normal course of operations of a business. This includes utility bills, rent invoices, and obligations to buy raw materials.
Wages payable: These are payments due to staff for time worked.
Notes payable: These are recorded debt instruments that record official debt agreements, including the payment schedule and amount.
Dividends payable: These are dividends that have been declared to be awarded to shareholders but have not yet been paid. (A dividend is a reward paid to a shareholder/shareholders for their investment in a company’s equity.
Long-term debt: This can include a variety of obligations, including sinking bond funds, mortgages, or other loans that are due in more than one year’s time. Note that the short-term portion of this debt is recorded as a current liability.
Shareholders' (or, stockholder's) equity is a company's total assets minus its total liabilities. It represents the amount of money that would be returned to shareholders if all of the assets were liquidated and all company debt was paid off.
Retained earnings are part of shareholders' equity and are the amount of net earnings that were not paid to shareholders as dividends.
A company’s income statement provides a summary of a its revenues, expenses, and profits over a specific period of time.
3. Statement of cash flows
This presents a record of a company's incoming and outgoing cash over a specified period. It provides insights into how much money a company generates from its operations, how much it invests in its assets and how much it finances through debt or equity.
The statement of cash flows includes three sections: operating activities, investing activities, and financing activities.
Operating activities include cash inflow (money coming in) and outflow (money going out) resulting from the production and delivery of a company's products or services. It reflects the day-to-day business activities of the company.
Investing activities refer to the purchase or sale of long-term assets like property, plant, and equipment. It also includes investments in other companies or securities.
Financing activities include the inflow and outflow of cash resulting from the issuance or repurchase of a company's equity and debt. It reflects the company's financial structure, how it is financed, and how it uses its financing activities to create value for shareholders.
Interpreting Financial Statements
Interpreting financial statements requires a thorough understanding of the accounting principles and the underlying business model of the company. The ratios and metrics used to analyse financial statements may vary depending on the industry and the type of company.
Investors use financial ratios to assess the financial health of a company, compare it to its peers, and make investment decisions. Some of the most commonly used financial ratios include:
Price-to-earnings ratio (P/E ratio) - this is the ratio of the company's stock price to its earnings per share (EPS)
Return on equity (ROE) - the amount of net income returned as a percentage of shareholders' equity
Debt-to-equity ratio - the ratio of total debt to total equity
Current ratio - the ratio of a company's current assets to its current liabilities
The interpretation of financial statements also involves analysing the trends and changes over time. For example, a declining profitability ratio may indicate a shift in the company's competitive position or the emergence of new industry trends.
Understanding financial statements is a critical skill for investors and analysts. The financial statements provide a wealth of information about a company's financial health, earnings potential, and future prospects. The three primary financial statements - the balance sheet, income statement, and statement of cash flows - offer different perspectives on a company's financial performance. By analyzing these statements, investors can make informed investment decisions and predict future stock prices.
When it comes to managing your business finances, it can be quite easy to get bogged down in terminology. We hope this article has made some of that a bit clearer. For small business owners especially it can feel intimidating to tackle every aspect of your finances on your own. But it's easier to do now than ever with all the tools and services available today. And of course anything is easier when you have a clear understanding of what's required.
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