Having a basic understanding of financial statements is key for anyone who wants to invest in shares.
All sorts of people analyse financial statements. From small time investors, to Chief Financial Officers (CFO’s) of big businesses.
For investors, a company’s financial statements help determine whether it’s a good or bad investment.
For business owners and CFO’s, financial statements drive their business decisions by showing them where their businesses are succeeding or failing.
Why do companies need financial statements?
All companies listed on a stock market produce financial statements each year so that:
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 exist today.
What are the three basic types of financial statements?
The three main types of financial statements are the:
Let’s go over each one separately.
The BS shows the value of a business at a point in time; usually the year end. The balance sheet shows a company’s:
Quick points about assets
Quick points about liabilities
Quick points about equity
The IS 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.
A company can record income on the IS 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 percent 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:
Fund Managers usually have teams of analysts pouring over financial statements to pick stocks for their funds.