Financial statements are often referred to as a company’s report card. They provide regular information on the company’s performance, financial position, and cash flow situation. Publicly traded (or listed) companies are required to publish their quarterly and annual financial statements.
Understanding the information contained in financial statements and MD&As is important in making informed investment decisions. That’s especially true if you are investing on your own.
Contents of the MD&A and financial statements
Generally, the MD&A and financial statements consist of:
- a detailed discussion and analysis by management of its perspective on the company’s financial statements, financial position, and outlook. The MD&A complements the financial statements, but does not form part of them.
- a statement of financial position (balance sheet)
- a statement of profit or loss (income) and other comprehensive income
- a statement of cash flows
- a statement of changes in equity
- Notes, including significant accounting policies and other explanatory information
- an independent auditor’s report
Read the section entitled “Management’s discussion and analysis” for a discussion by management of the company’s latest results and outlook. Review the reasons given for any changes that occurred. For example, a company may have lower-than-expected earnings because some customers postponed their orders. However, if the company is about to lose a major customer to a competitor, this could indicate a potential decrease in revenues and earnings in the near future.
In this analysis by management, several ratios and measurements presented in the financial statements are adjusted in order to exclude the effect on the financial results of certain unusual, one-off, or rare events. Management’s goal is to help investors better understand the effect of these events on the company’s normal operating results. However, remain critical of those adjustments:
However, remain critical of those adjustments if:
- some of them end up recurring over more than two or three years.
- multiple events are deemed “rare,” resulting in special costs regularly cutting into the company’s income.
Read between the lines: Those special costs may also be the consequence of a decision by management.
Statement of financial position
The statement of financial position (commonly called the “balance sheet”) provides a comprehensive snapshot, as at a specified date, of a company’s financial condition.
The statement of financial position includes:
Assets: Everything that belongs to the company.
They can be cash assets (cash and cash equivalents), accounts receivable, merchandise inventory, investments or tangible (fixed) assets (e.g., buildings, machinery) or intangible assets (e.g., patents, trademarks). Assets are used to operate the company or help it make money.
Liabilities: Everything the company owes.
Current liabilities refers to debt that must be paid back in a relatively short period of time, whereas non-current liabilities refers to debt that is repaid over a longer period of time.
Equity comprises share capital and retained earnings.
Equity (net worth or book value) can be determined by subtracting a company’s liabilities from its assets. It is what belongs to the company’s shareholders once all debts have been deducted.
The book value of each share is calculated by dividing total equity by the number of shares outstanding. Another way of calculating book value is to include shares awarded but not issued, particularly stock options awarded to company executives. These options are often tied to management compensation. This is called “dilution”: the allocation of the company’s equity among all outstanding shares, including the potential dilutive effect of stock options awarded to executives.
Pay particular attention to the following:
- Does the company maintain or renew its assets in order to preserve its growth potential?
- Many assets and liabilities must be regularly remeasured in accordance with the accounting standards. Are you able to assess the various techniques used by the company to estimate the value of some of its assets and liabilities?
- Has the company increased or reduced its debt? A high debt-to-asset ratio can harm a company’s growth and viability.
- Will the company be able to meet its current debts? Are there enough liquid current assets, such as cash and accounts receivable, to cover current liabilities, including accounts payable and current loans?
Statement of income and other comprehensive income
The income statement (also called “profit and loss statement”) shows a company’s profitability over a specified period (usually one quarter, a six-month period, a nine-month period and, in all cases, one year). The income statement can provide valuable information on the company’s financial performance, such as whether it is making a profit and its sources of profit (for example, increased revenue, reduced expenses, one-time revenue gains).
The income statement includes:
- Revenue: What the company has earned.
- Expenses: What it costs to generate revenue and run the company.
- Net income or loss: the resulting profit or loss.
The income statement summarizes revenues and expenses resulting from operating activities and non-operating activities.
Operating activities are all the things a company does to bring its products and services to market on an ongoing basis. Operating activities include manufacturing and marketing.
Non-operating activities are one-time events that may affect revenues, expenses or cash flows but fall outside of the company’s routine, core business. Examples include selling capital assets and relocating the business. Many analysts, like management in its MD&A, exclude non-operating activities from any assessment of a company’s financial performance, as they can generate non-recurring gains and losses.
Pay particular attention to the following:
- Is the company making a profit? If not, what indications are there that the company has the potential to become profitable?
- Do the results seem encouraging? For example, are revenues and earnings rising? Has the company increased its sales? Has it gained new clients or contracts?
- Do the results seem disappointing? For example, are revenues and earnings declining and expenses increasing? Has the company lost clients or partnerships? Has there been a product recall?
- Are the gains or losses likely to recur in the future? Take the time to read the notes to the financial statements in order to complete your analysis.
- Are revenues generated from a handful of large customers? If a large customer ends its business relationship, will the company be able to easily replace the customer and continue as a going concern?
Statement of cash flows
Cash flows are the amounts of money entering and exiting a company’s bank account. Cash flows are analyzed to determine a company liquidity requirements.
The statement of income and other comprehensive income indicates whether a company has earned a profit based on the accounting standards. The statement of cash flows indicates whether the company has actually generated cash, i.e. whether the company is taking in more cash than it is paying out.
The statement shows cash flows:
- from operating activities, which are the company’s principal revenue-producing activities.
- from investing activities resulting from the acquisition and disposal of long-term assets and other investments.
- from financing activities resulting from amounts received from or paid to providers of capital to the company, such as lenders and shareholders.
Pay particular attention to the following:
- Does the company have sufficient liquidity to pay its various stakeholders, including employees, suppliers, and creditors, for a subsequent period?
- Is the company likely to generate positive cash flows?
- Could past sources and uses of cash flows from operating activities recur in the future? Non-sustainable cash flow sources and uses should not be used to project future cash flows.
- Did the company have to cover investing and operating cash flows by borrowing or issuing shares? Will the company have to do so again in the future? If so, why? Is the company planning to enter new markets, build new plants or invest in research and marketing?
Statement of changes in equity
The statement of changes in equity summarizes the changes in a company’s equity (i.e., net worth).
Among other things, this statement can provide useful information on the types of transactions and events that caused an increase or decrease in equity.
Notes to financial statements
The notes to financial statements contain information on the accounting policies applied in the financial statements, the judgments and estimates used by management in preparing the notes, as well as other information essential to your understanding.
In applying accounting standards, the company’s management may exercise judgment, make estimates and, when possible, choose the standards it wishes to adopt. Therefore, the choice of accounting policies a company applies can make a significant difference. Earnings per share vary based on which accounting standards are applied and what the income tax rates are in the countries and jurisdictions in which the company and its subsidiaries operate.
The external auditors’ report
The external auditor’s report also contains useful information. For example, if a company is facing major difficulties, the external auditor’s report must state that there is a material risk that the company may not be able to continue as a going concern. The auditor’s report also describes other important information related to the audit. Will you be able interpret all of it?
Other published information
Most company websites have an “Investor relations” section and a “Newsroom” section containing the press releases they have issued.
Some companies also use social media platforms like Facebook and LinkedIn to publish material information. Others may even actively participate in forums or blogs to drum up excitement in their products and services, management decisions or good performance.
All of these sources represent a wealth of information: Before you invest, you should analyze it all to determine whether the company is doing well or not.