If you have trouble the first few times you try to understand financial statements, don’t worry – that’s normal. The more you read financial statements, the more comfortable you will become with the presentation, and the better able you will be to interpret what the statements are telling you. Most of the numbers in the financial statements don’t stand alone.
Each integrated report will have numerous footnotes that amplify on the numbers – make sure you read these carefully. It’s also important to remember that to get a good feel for the company, you should look at it within a much larger framework.
Some of the things you need to consider before you even approach the financial statements or integrated report include:
- CONTEXT: Put the company into a context that includes its industry, the economy, interest rates, the business cycle, etc. For example, the financial statements and ratios of utilities such as Eskom are vastly different from those of retailers such as Edcon.
- TRENDS: Look at the company’s own trends or how it has performed over the past three, five or 10 years. You might find that this year’s performance is much better, or worse, than the performance over the past few years. If so, look for reasons – it may be that a company that supplies animal feed suffered a downturn during the drought.
When you are reading a company’s financial statements, remember that public companies produce two types of numbers: unaudited and audited.
- UNAUDITED: Unaudited numbers are sometimes called management figures. They are produced for executives and managers for specific purposes, such as inventory control and cash flow projections.
- AUDITED: This is where an independent auditing firm has reviewed the numbers to provide assurance that certain procedures have been followed so that the numbers conform to accounting principles. Note that not all numbers that companies release to the public have been reviewed by outside auditors.
The three financial statements you are going to encounter are the income statement, the balance sheet and the cash flow statement. Here’s what you need to look for in each:
1. THE INCOME STATEMENT shows what the company generates in profits or losses during the reporting period, such as a quarter or year. Key information in the income statement includes:
- Revenues, gross revenues, net operating revenues or sales: The company’s total sales or revenues during the period. This is often referred to as the “top line”.
- Headline earnings: These are a measurement of a company’s earnings based solely on operational and capital investment activities. It specifically excludes any income that may relate to staff reductions, sales of assets, or accounting write-downs.
- Cost of goods sold: For a manufacturer, this typically includes the cost of inventory (raw materials and supplies to make the company’s products), as well as the expenses of turning raw materials into finished products, such as labour and direct overheads. For a retailer, this category is what the company pays for the products it sells on its shelves. It is only the cost of the merchandise purchased for resale, not the cost of providing the service to customers. For a service company, this category is typically small.
- Gross profit: Revenues minus cost of goods sold results in gross profit. Most companies pay special attention to managing the gross profit margin or the gross margin.
- Operating expenses: Most companies present operating expenses in a general category called “selling, general and administrative expenses”. Operating expenses typically include rent, salaries and wages paid, payroll taxes, property taxes, telephone, insurance, research and development, depreciation and amortisation, and bad debts.
- Other revenues or expenses: This includes items such as discontinued operations, the sale of an investment, unusual or extraordinary items, changes in accounting principles and minority interest.
- Income taxes: The amount of income tax the company paid that year.
- Net income: Net income is what’s left after all expenses have been deducted. This is often referred to as the bottom line.
- Earnings per share: This tells you how much of a company’s profit is allocated to each share of common stock. It is determined by dividing net income minus preferred dividends by the average number of common shares outstanding for the period.
2. THE BALANCE SHEET is a snapshot of the company’s assets, liabilities and shareholders’ equity on the last day of the reporting period. The left side of the balance sheet lists the assets, or what the company owns. The right side lists the liabilities, or what the company owes, and the shareholders’ equity, or the funds invested in the company and retained earnings. The two sides must balance, so the balance sheet format is assets equal liabilities plus shareholders’ equity (A = L + E).
The balance sheet shows data from the two most recent years, which allows you to calculate changes from one year to another. Significant changes in any account must be examined and could be worth following up. Items on the balance sheet include:
- Current assets: Assets that could be expected to be turned into cash or sold or consumed within a year or within the normal operating cycle of the company, if it is longer than a year.
- Cash and cash equivalents: Cash and short-term, highly liquid investments. Examples include money market funds.
- Accounts receivable: Amounts due from customers to the company for goods and services provided in the normal course of business. The receivables category often shows an entry called “less allowance for doubtful accounts”, which presents an estimate of what the company expects will not be paid. It is essentially a bad debt estimate. Amounts are based on past experience and/or industry averages.
- Inventories: Goods on hand available for sale or materials on hand for producing those goods. Inventory is usually identified as being in one of three categories: raw materials; work-in-process; or finished goods. The rand amount allocated to each category is usually shown on the balance sheet or in the footnotes to the financial statements.
- Accounts payable: Accounts payable are obligations that result from the acquisition of goods and services. Payables include purchases of raw materials – supplies, services, etc – on credit.
- Accrued expenses or accrued liabilities: These are amounts owed for goods or services whose benefits have been received but will be paid for in the future. Typical accrued expenses are payroll, payroll taxes, property taxes, rent, royalties, interest, commissions, etc.
- Preference shares: Some companies sell preference shares, which differ significantly from common stock. Preference shareholders are entitled to receive a fixed dividend before common holders, and have a priority in case the company is liquidated.
- Retained earnings or reinvested earnings: When a company makes profits, it can reinvest the funds or return them to the owners (stockholders) as dividends. Retained earnings (sometimes called accumulated undistributed net income) are profits that have been reinvested since the company was founded. If the company experiences a loss for a quarter or year, it dips into retained earnings to cover the difference.
The balance sheet and income statement reflect the company’s performance under the accrual method (think of it as a way of keeping score.) But to get an accurate picture of the company, you need to know how it is handling its cash.
3. THE CASH FLOW STATEMENT shows how cash moved through the company over the year and lets you see if the company’s cash position increased or decreased. It presents data for the past three years.
Key components of the cash flow statement are:
- Operating activities: This category focuses on what the company does as a business, and excludes investing and financing activities.
The primary entry for operating activities is net income.
- Investing activities: This reflects payments for acquiring and disposing of long-term productive assets or businesses, and securities that are not considered cash equivalents.
- Financing activities: This reflects the issuing or repurchasing of stock and debt, and paying of dividends.
- Net change in cash and equivalents: Shows the increase or decrease in cash for the year.
- Balance at beginning of the year: Cash balance at the start of the year.
- Balance at the end of the year: Cash balance at the end of the year.
- Free cash: This is one of the most important numbers for executives and analysts, yet you will see it on very few cash flow statements. You will find it in the glossy pages of the annual report for a few companies.
Free cash refers to the cash that is left after a company maintains its productive capacity by doing things such as modernising plants by purchasing new equipment or buying another business.
Free cash is obviously essential for a company’s ability to expand activities, pay down debt, etc. There is no one way to calculate free cash, although a common format involves subtracting capital expenditures from cash from operations.