Financial Statements

Studying a company’s financial statements provides an investor with vital information about a company’s performance and – more importantly – pointers to its prospects.

Analysing that information using financial ratios, such as the oft-quoted price-earnings ratio, allows comparisons to be made with the past, with other companies in the industry, and with the market as a whole.

What are Financial Statements?

Financial statements provide specific information about a company’s financial position and performance. They are found in the annual report and consist of a:

• Statement of financial performance
• Statement of financial position
• Statement of cash flows

Each year, public companies must provide shareholders with an annual report – a document that summarises the results of operations and the company’s financial status in the past year.

Reading the annual report – which must be independently audited – is a chance for investors to examine the company’s financial strength and performance over the past year and to consider what opportunities there are for future growth.

In Australia, the financial year officially runs from July 1 to June 30, but companies may register another 12-month period as their reporting period.

Companies must lodge an annual report with ASIC within four months of the end of their financial year.

That report will be formally presented to shareholders at the annual general meeting (AGM), which must be held within five months of the end of the financial year.

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Reporting Requirements

Six main bodies formulate and/or or enforce accounting regulations in Australia:

• The Australian Securities and Investments Commission (ASIC)
• The Australian Accounting Standards Board (AASB)
• The Financial Reporting Council (FRC)
• The Australian Stock Exchange (ASX)
• The Urgent Issues Group (UIG)
• The Australian Accounting Research Foundation (AARF)

Australian companies have four main financial reporting requirements to consider.

First, they must comply with accounting standards. These standards have the aim of ensuring that companies produce financial statements that can be readily compared.

Second, they must provide ‘true and fair’ financial statements. This is commonly interpreted to mean that the financial statements comply with accounting standards.

The company must also provide a directors’ declaration – a signed opinion by company directors attesting that the financial report is true and fair, complies with accounting standards and that the company can meet its debts.

And the annual report must include a report from the company directors providing a general outline of the business for the year and making certain statutory disclosures

Companies will more often than not report their financial results from the perspective of the ‘consolidated’ entity, not just that of the ‘parent’ company.

The objective of consolidated financial reports is to provide a complete picture of the financial performance, position and cash flows of a group of entities that are under common control.

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Accounting standards

On January 1, 2005, Australia completed the phasing out of Australian accounting standards and adopted international financial reporting standards (IFRS).

The new standards resulted in changes in the valuation and recording of items in companies’ financial statements, and in some cases companies had to write off assets from their balance sheets entirely (or more rapidly) under the new rules.

As part of the transition, annual reports issued since the change have included a section detailing the impact of the move to IFRS.

On the plus side, IFRS is expected to improve investors’ ability to compare companies’ financial statements, they are expected to reduce reporting costs for companies – especially those with international operations – and a spin-off is that international capital flow is likely to improve.

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Statement of Financial Performance

The statement of financial performance (the profit and loss statement) reports the revenue, expenses and profit (or loss) that have been made over a given period.

The statement shows how an entity’s revenue was obtained and how the expenses were incurred. This report allows investors to evaluate the past performance of an enterprise and assess its prospects for the future.

Here’s an example:

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The key elements of the statement of financial performance are revenue, expenses and the various measures of profit: gross profit, net profit, EBIT, EBITDA and NOPAT.

Revenue represents cash, or claims to cash, generated through the provision of goods or services.

Expenses are are the costs incurred in the process of earning that revenue – measured by the cost of goods and services consumed in the operation of the business.

Gross profit is is total revenue minus the ‘cost of goods sold’ (COGS). It identifies the amount available to cover other operating expenses.

Net profits is the net increase in the earned resources of the entity.

EBIT (earnings before interest and tax) is a measure of net cash inflow from operating activities – that is, revenue less expenses apart from interest and tax. It is intended to be a more accurate measure of operational profit than if these expenses were included.

EBITDA (earnings before interest, tax, depreciation and amortisation) is a measure of net cash inflow from operating activities, before working capital movements. Some argue that depreciation and amortisation are inherent expenses to any business and so stripping these out gives a better indication of profit.

NOPAT (net operating profit after tax) measures the amount of profit a company makes after all of its income and expenses. It also represents the total dollar figure that may be distributed to shareholders.

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Extraordinary Items

The statement of financial performance typically identifies the major sources of revenue and expenses as either ‘operating’ or ‘extraordinary’ items.

Extraordinary items are unusual or nonrecurring events that must be explained to shareholders – for example, write-offs of bad debt, adjustments due to revaluation of intangible assets, or the sale of large assets such as buildings.

Extraordinary items are a separate line item on the statement of financial performance and are separately disclosed in the notes to the financial statements.

Be aware of the impact of the way such items are reported. For example, if land is sold and the proceeds included as ‘other income’, on the face of it profit is positively affected. Investors would have to read the notes carefully to understand that this impact on profit is unlikely to recur.

Still, it may be argued that the separate disclosure and discussion of such events reveals much about the performance of the entity that would otherwise not be shown.

Statement of Financial Position

The statement of financial position (balance sheet) is a statement of the book value of a business at a particular point in time.

This statement lists the assets or resources controlled by the enterprise, its debts, and the owner’s claim on the equity.

Here’s a sample statement:

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And here is another example:

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The key elements in the statement of financial position are assets, liabilities, net assets, shareholders’ equity, and retained earnings.

Assets are are the economic resources controlled by the entity for the purpose of providing future benefits to that entity. They are divided into two groups: current assets are those intended to be converted into cash or consumed in the next financial year; while non-current assets are those that cannot be easily converted into cash.

Liabilities are the financial obligations of an entity. They are also divided into two groups: current liabilities are those that must be discharged within 12 months; while non-current liabilities are those that will mature beyond the next 12 months, including long-term borrowings, debentures and mortgages.

Net assets are the excess of assets over liabilities.

Shareholders’ equity represents the owners’ interest in the entity or the owners’ claim to the entity.

Retained earnings/profits represent the amount of earnings not distributed to shareholders. This can be regarded as money set aside by the company for future investment.

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Statement of Cash Flows

The statement of cash flows reports the effects of all transactions involving a flow of cash into or out of the entity – whether those transactions are operational, financial or investment in nature.

People who would be interested in the cash flow statement include potential lenders or creditors, who would want a clear picture of a company’s ability to repay, and potential investors, who need to judge whether the company is financially sound.

A statement of cash flows reports movements in cash, over a specified accounting period, under three headings:

Operating activities involve receipts and payments for the production, sale and delivery of goods and services.

Investing activities relate to the acquisition and disposal of non-current assets.

Financing activities relate relate to the size and composition of the financial structure of the entity.

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Here’s a sample statement:

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And here is another example:

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Interpreting Financial Statements

The analysis of financial statements should include all publicly available information, not just the statements themselves. Why? When analysing a company, we need to understand what’s driving the figures that appear on the financial statements.

The analysis needs to be placed in some context: Is the company meeting its corporate goals (which can be found on websites and in annual reports)? And there are broader factors that affect the company under scrutiny: How is the economic environment affecting its results? In a recession you’d expect a food producer to be doing better on the sales front than a maker of plasma television sets …

Accounting treatments are also important when scrutinising financial statements. Turn to the ‘notes’ accompanying the financial statements. Has there been a change in the accounting method used, and, if so, why? If there has, be careful when using figures from the statements in ratio analysis and forecasting (more on this later), as the results will be distorted.

Look beyond the figures. What’s important is where the numbers come from and which way they will head (up or down) in coming quarters and years.

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Ratios

Ratios are an important tool in seeking to understand current performance and form a basis for your forecasting.

There are hundreds of ratios – it’s important to be selective and know specifically what aspects of performance are important to your analysis.

Interpret your calculations. For example, a 15 per cent return on equity (ROE) result is the same as saying that shareholders are receiving a 15 per cent return for every dollar of capital invested; a 10 per cent return on assets (ROA) would be interpreted as a 10 per cent return for every dollar of sales generated.

Look at past ratios for a company as a starting point for forecasting important line items such as sales.

Liquidity Ratios

Liquidity ratios relate to the ability of a firm to service future short-term financial obligations.

Calculation of these ratios matches current assets with current liabilities such as accounts payable and notes payable.

The most basic liquidity ratio is the current ratio, which simply examines the relationship between current assets and current liabilities.

A very high current ratio indicates that too many assets are tied up in less than optimal investments (earning lower rates of return), while a low current ratio indicates potential problems in meeting short-term obligations (and a possible need for additional short-term borrowing).

An alternative measure that excludes less liquid assets (such as inventory) is the quick ratio.

The most conservative liquidity ratio is the cash ratio as it only considers cash and marketable securities.

The interpretation of both the quick ratio and the cash ratio is similar to the current ratio – too high or too low is not desirable.

A final, commonly used ratio for liquidity is the operating cash flow ratio, which concentrates on a company’s ability to generate sufficient funds from operations to meet current liabilities.

A higher operating cash flow ratio generally indicates higher management efficiency in the day-to-day operations of a firm.

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Capital Structure Ratios

Capital structure ratios give some indication of the extent to which a firm relies on debt (and thus equity) to finance its operations.

As a firm increases its debt finance, it increases its financial risk, together with the probability of default and bankruptcy.

The debt-to-equity ratio measures the proportion of capital raised from debt compared to other sources such as common stock.

The debt-to-equity ratio is generally compared over time to gauge how a company’s reliance on debt varies. An increase in debt is often considered undesirable.

For businesses that derive a significant amount of capital from short-term borrowing, the total debt ratio is often more appropriate.

The total debt ratio is interpreted in a similar way to the debt-to-equity ratio, except that a much lower ratio is expected (about 50 per cent lower than the debt-to-equity ratio).

Then there’s the interest coverage ratio. In addition to understanding the proportion of debt on the statement of financial performance, this ratio relates the flow of earnings available to meet interest obligations.

The interest coverage ratio indicates how many times interest expenses are covered by normal earnings.

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Profitability Ratios

Profitability ratios allow an evaluation of how profitable a company’s operations were (profit margins), and how effectively it used its assets (capital).

The gross profit margin (where gross profit equals net sales less COGS) indicates the basic cost structure of the firm.

The gross profit margin is best compared over time –a falling margin generally indicates that selling prices are not keeping track with operating expenses.

The operating profit margin (where operating profit equals gross profit less selling, general and administrative expenses) is a prime indicator of business risk.

As the operating profit margin reflects all operating policies (while eliminating debt policy), a falling margin generally indicates an increase in business risk.

Net profit margin simply relates net income to sales.

The net profit margin should be based on earnings from continuing operations to give some indication of future profitability.

Finally, the return on total capital ratio measures how effective the firm was in using resources.

As the return on total capital ratio is effectively the company’s return on all capital employed, it should be compared to that of other companies and the economy as a whole.

If the ratio is less than expected, given the risk of the firm, the question arises whether the business should exist at all or the capital be invested in other, more productive projects.

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Turnover Ratios

Turnover ratios give some indication of how well management is using assets and capital (in terms of dollar sales) in running the business.

The total asset turnover ratio indicates how effectively the firm is using its total asset base.

As there is significant variation across industries, the total asset turnover ratio should be compared across companies within an industry sector. A very high (greater than 10) or low (less than 1) result is undesirable.

The equity turnover ratio indicates how effective the firm was in using its alternative capital.

The equity turnover ratio needs to be interpreted in conjunction with capital structure ratios, as an increase in debt capital will lead to an increase in this ratio.

In addition to measuring how effective management is in using resources, it’s important to know how efficient management is in turning inventory into profit.

The average inventory processing period is a measure of processing time.

A lower inventory processing period indicates that inventory is being turned over more frequently, but it is essential that this ratio is compared to industry averages.

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Cash Flow Ratios

In addition to using information from the statement of financial performance, it’s common to calculate a series of ratios based on a business’s cash flows.

A company’s cash flow is often compared to its financial obligations, with the view of predicting future financial difficulty.

The cash flow to interest expense ratio simply relates the company’s cash flow to interest repayment obligations.

The cash flow/interest expense ratio gives an indication of how many times the cash flow generated from operations is able to cover the interest expense. A declining ratio could indicate impending financial difficulty.

The cash flow coverage ratio is similar to the above ratio except that interest payments are added back to the cash flow. The ratio is interpreted in a similar fashion.

Finally, the cash flow to long-term debt ratio relates cash flow to outstanding debt. It is generally considered one of the best predictors of future bankruptcy.

A falling cash flow/long-term debt ratio – especially if below industry averages – is a sign of potential financial difficulty.

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Owners’ Equity Ratios

Owners’ equity ratios are very important to the real owners (the common shareholders) of the company.

These ratios indicate the rate of return that management has earned on capital supplied by the owners, after incorporating all payments to other sources of capital (that is, interest repayments).

The return on total equity ratio includes all equity in the company (common stock plus preferred stock).

The return on owner’s equity ratio is based on common shareholders’ equity only.

Both the return on total equity and return on owners’ equity ratios should be in line with the risk of the business. They should also be compared to industry and economy-wide averages to determine how successful management has been in running the firm.

As the return on owners’ equity (ROE) is one of the most important performance indicators, it is commonly broken down into several components.

The above breakdown effectively consists of three separate ratios:

• profit margin
• total asset turnover
• financial leverage

While analysis of the overall ROE figure is important, the break-down allows a more thorough analysis of how changes in ROE are attributable to profit margins, asset turnover and changes in capital structure.

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Industry Benchmarking

While it’s necessary to look at ratios for a company both as stand-alone figures and across time, it’s also essential that ratios are compared with those of other companies.

The problem with straight comparisons across companies is that different industry sectors have very different patterns of liquidity, cash flow, capital structure and profitability, and these vary systematically – and quite often predictably – over time.

These systematic variations across industries generally can be attributed to five main forces:

• Threat of new entrants
• Threat of substitute products
• Bargaining power of buyers
• Bargaining power of suppliers

As each of these forces varies over time, the expected profitability of each industry sector will also vary – hence the need for industry benchmarking.

When completing an analysis of the financial statements of a company, it’s essential that appropriate industry averages are available for comparison.

The comparisons need to account for current-year standings (for example, is this year’s ratio significantly different to the industry average for the year?), as well as how the industry has changed over time (has a particular ratio increased or decreased over the past three to five years for both the company and the industry?).

It’s important to note that even within the same industry, companies can vary significantly in terms of strategy and future growth opportunities. And quite often the operations of one company can fall into various industry classifications, making single-industry analysis difficult.

When situations like this arise it’s important to select companies that share the most similar operating and financial characteristics and calculate ‘industry’ averages using just these companies.