Ernesto Hontoria L.
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Cartoon taken from Internet:
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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.
Good article.
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