A Basic Overview Of Financial Statements

Why do companies need financial statements?

All companies listed on a stock market produce financial statements each year so that:

1. Current and potential investors know how the company is doing.
2. The Taxman can make sure the company is paying the right amount of tax.

The statements need to be correct, so companies pay auditing firms like PWC, KPMG and Deloitte to go over them in extreme detail.

Auditing is a long process, which is governed by a set of accountancy standards. For example, in the UK, financial statements adhere to the Generally Accepted Accounting Practice standards, which is abbreviated as UK GAAP.

Standards like UK GAAP make sure that different companies follow the same financial reporting rules. This way, investors compare apples with apples when researching different businesses.

If its financial statements are wrong or fraudulent, things can get messy for the company. That’s what happened to Enron in 2001, when markets discovered it was hiding billions of dollars in debt in its financial reports.

Neither Enron, nor its auditing firm exists today.

What are the three basic types of financial statements?

The three main types of financial statements are the:

1. Balance Sheet (BS)
2. Income Statement (IS)
3. Cashflow Statement (CS)

Let’s go over each one separately.

Balance Sheet

The balance sheet shows the value of a business at a point in time; usually the year end. The balance sheet shows a company’s:

1. Assets: things it owns that generate revenue.
2. Liabilities: what it owes in debt.
3. Equity: its assets minus its liabilities.

Quick points about assets:

1. Assets don’t need to be ‘things.’ They can also be intangible assets like the brand names of Coca-cola or Heineken. Intangible assets are hard to value.
2. Assets are split into current assets (like products for sale and cash in the bank) and non-current assets (like brand names, property and office equipment).

Quick points about liabilities:

1. Most companies need to borrow money from investors to grow their businesses. They do this by issuing bonds to investors.
2. Liabilities are split into current liabilities (debt that needs to be paid back within a year) and non-current liabilities (the rest).

Quick points about equity:

1. Equity is equal to all the assets minus all the debt.
2. The more equity the better.

Income Statement

The Income Statement lists all the income and expenses of a company over a period of time, usually a year. Profit equals income minus expenses. The more profit the better.

Cashflow Statement

A company can record income on the Income Statement once they make a sale, even though they haven’t yet received the cash. This is called accrual accounting.

Accrual accounting also applies to liabilities. CFO’s can use accrual accounting to ‘big up’ their financial statements. For instance, they could record sale when they aren’t 100% sure they’ll get the cash.

As the name suggests, the CF shows a company’s cash inflows and outflows over a period of time. Cash doesn’t lie so it’s hard to manipulate.

Here’s a table to summarise the three types of financial statements…

What do good financial statements look like?

It sounds obvious, but good financial statements should show that a company is in good financial health.

This means the company:

• Has more assets than liabilities (BS).
• Gradually increases its profit each year (IS).
• Has positive cash flow (CF).
• Isn’t drowning in debt (BS).
• Keeps its expenses under control (IS)
• Makes sales (IS)
• Makes a good return on assets (IS & BS)
• Makes a good return on equity (IS & BS)

Fund Managers usually have teams of analysts pouring over financial statements to pick stocks for their funds.