Ernesto Hontoria L.
Cartoon taken from Internet:
Time to time I receive emails from students who want to know how to analyze financial statements. They ask me if I can provide them with a template to calculate the different ratios they used to learn in business schools. I have had to confess to those students, that I do not keep any template to analyze financial statements, and don´t follow a recipe to analyze them, but I let myself be led by the curiosity of what I discover in them.
Generally, when we evaluate the financial statements of a corporation, we have a reason for doing it, a purpose in mind for analyzing the data. That purpose may be to invest in the company we are evaluating (buying shares in the stock market, for example). Perhaps our intention is to acquire or to sell an entire business in a private negotiation. May be our interest in evaluating the financial statements is to know how a company that belongs to us is performing. Also, as seems to be the case for some of my readers, people analyze financial statements for the pleasure of learning finance or for fulfilling some academic request. Whatever the purpose is, if we want to evaluate how a company performs through its financial statements, it is advisable to obtain the financial statements (income statements, balance sheets and statements of cash flow) of the business we are interested in, for at least the last three consecutive years; but if we can get more, even better.
I would recommend starting the analysis by the income statement also known as profit and loss statement (P&L) and try to discover the answer to what I consider, should be the first question: Is the company gaining or losing money? Then come all other questions, among which I would include –mentioned only as examples- the following:
· What could be concluded about the trend observed when comparing results year by year? Do profits or losses increase with the time? Does it seem like the company is doing better or worse year after year?
· What explanations can be obtained from the results? What is the trend in income or sales: increase or decrease? What happens to the costs in the same period, grow faster than sales, maintain their proportion with respect to them, remain constant or decrease?
· Could we easily split fixed and variable costs from the income statement? If so, what is the ratio of fixed costs to income? How does that ratio change in different years?
· Are there any extraordinary items of expenditure that affect financial statements, such as the disposal of an asset before the end of its useful life, because it was sold, burned, or stolen?
· What happen to the results of the company if we exclude the depreciation of the assets?
· Have the financial statements been adjusted for inflation? Can we isolate the inflationary effect of the operations, to determine what portion of the sales growth is driven by the inflation and what portion is the result of selling more products, for example? What can be concluded from costs, have they grown more than inflation?
The analysis is oriented in one way or another, depending on the answers (to those questions) we can obtain from the income statement. However, a company's income statement does not tell us the complete history. One company can make a profit and go bankrupt because it does not have the money to honor its commitments. Also, it could be a case in which companies record losses, but generate enough cash to meet their temporary commitments. The analysis of the balance sheet of the company and of its cash flow statements allows to complete the picture.
From the cash flow of the company we can understand, for example, if the business is generating money or living from its savings. When we analyze several consecutive years, we can also infer if a particular situation is something punctual of one year, or if it is a continuous trend. We can find out, for example, whether the excess or the deficit of cash is produced by the operating profits of the company, or, on the contrary, it is due to an extraordinary event such as the sale of an asset, or the acquisition of some equipment necessary for future operations.
The balance sheets of the company usually give us additional information about its financial health. From the balance sheets we can infer things such as if the company is cashing on time their sales, or, on the contrary, the accounts receivable are piling up, preventing part of the money to enter in the company's bank account. In a similar way, we can find out if the company is paying on time its commitments with its vendors and suppliers or if it's becoming more and more indebted with them. We can also infer from the balance sheet, how the inventory is moving and the cash situation of the company.
Some additional questions might include:
· What is the cash situation of the company? How many months of operations could the company pay if it don't get any additional penny because an unexpected problem arise interrupting the sales? Do the firm has enough cash to pay off its short-term liabilities in such cases?
· What trend can be observed in the inventory, is it growing, shrinking, or maintains its proportion to the sales?
When looking for answers to those kind of questions, you can get an idea of how things are going for the company. But I don't want to say that the questions above are part of a recipe for analyzing financial statements. As I mentioned, it is more about been curious and let curiosity guide your search, while trying to understand and to make sense of the numbers and trends you are finding in the financial statements. So, you can add to the list whatever questions you think are relevant to understand the statements you are reviewing.
It may be helpful to bring up at this point, that a single financial statement says very little about a company. Generally, it is necessary to compare the financial statements of several years and to observe the trends, to be able to deduct what is happening to the business, and in many cases also it is convenient to compare the financial statements with those of some other company in the same industry. Comparing the financial statements of one company to another, or one fiscal year to another, allows us to put things into perspective. In this way, it can be inferred whether the company is doing better or worse than in the past, or better or worse than its peers.
Perhaps it is obvious, but nonetheless allow me to clarify that the financial statements of an oil company could be substantially different from those of a bank, so if we are to compare the financial statements of two companies it is appropriate that they belong to the same industry.
Now, how do we get answers to the questions that arise through the revision of the financial statements?
Depending on the question and what we are looking for, there will be a specific place in the financial statements to look for the answer. If we want to know, for example, if the company is gaining or losing money, we should look for the answer in the income statement, usually in the bottom line called net income (also net profit or net earnings).
The net income of the company represents the money that is left to the business after all the costs, expenses, taxes, etc., have been deducted. That line tells us if the business generates enough revenue to pay all its costs, and therefore if the company is profitable or not. If the net profit is positive the company generates money, if it is negative, it is losing money.
Let me stress that the point isn't whether the company generated profits or losses in a fiscal year, but rather whether the company is generating profits on a continuous basis and the trend of those profits over several years. Generating profits does not guarantee the survival of the company, but not generating them means that the company is not profitable, and, unless it is a non-profit organization, it will almost certainly determine its closure.
When the net income is negative, it means that the costs are greater than the income, which is not sustainable over time. However, there may be years in which the company has losses, and this not necessarily means that is going to close its doors. Keep in mind that a firm may face bankruptcy even if their books show profits. Net income only gives an idea of the sustainability of the business over time, and losses (negative net income), although not per se determinants of the closing, ignite the alarms of whoever analyzes the financial statements.
It is a common practice to show operating profits separated from those items that, by their nature, are not part of the core activity of the business. Therefore, in a company that manufactures light bulbs, the revenues and costs related to the sale of bulbs and their production, including the cost of the raw material, the payroll that works at the plant, or the utilities, are part of operating profits. While items such as interest, equipment depreciation and taxes are usually placed below in a separated section of the Income Statement.
This separation of financial statements allows us to get a first glance of the kind of situations a company is facing. Losses at the operational level often indicate core problems. It could be, just to name an example, higher production costs than its competitors, preventing the company to translate its cost to the price of the final products. Understanding where business profits or losses are generated enables better decision making.
If our questions are related to the cash situation of the company, its liquidity, its capacity to honor commitments, or its debts, we should look for answers in the balance sheet. The balance sheet shows the equity situation of the company, which is nothing more than the difference between its assets and its liabilities.
The assets are, as an esteemed finance professor said, the blocks and bricks of the company, its irons, its machinery and equipment, the tools the company has to produce something to sell. Also part of the assets, is the money in the bank, the inventory of raw materials and finished products and the accounts receivable from customers.
Liabilities are the debts of the company. Some are short-term, such as accounts payable to suppliers, others are long-term, such as bank loans with a maturity of more than one year. While the assets represent what the company has, liabilities shows what the company owes. The difference between liabilities and assets is what belongs to the owners of the company (shareholders). That is, if at any given time it is decided to liquidate the company, the shareholders would have what remains after paying off all debts.
If, when analyzing the income statement, we seek to know whether the company is profitable or not, when analyzing the balance sheets we discover to whom it really belongs the business, to its shareholders or to their creditors. Finally, the cash flow statement tells us what part of the profits generated by the company goes to the pockets of its shareholders, after having served the debt with the creditors.
If our question are related to how are we going to recover the investment in the company, we should understand its cash flow very well.
Just for conclude, I would like to say that, in my opinion, the analysis of financial statements is a matter of formulating the right questions, understanding the business model that we are analyzing, and to a large extent a question of curiosity and common sense.