Financial Statement Analysis-The basis of Fundamental Analysis.

How do investors do it? Not everyone is a technical analyst, especially those who buy and hold, investors. The basis of fundamental analysis will be discussed today by going through statement analysis.

Investors and other interested persons such as shareholders often perform financial statement analysis on a company to determine its health and operations, in order to attempt to predict its future earnings and health. The reason? To find a good investment in terms of a companies stock, among many other reasons.

Financial statement analysis is a great tool for investors, as they allow endless comparison between statement types and different years. This is done with the help of the comparison of different ratios.

There are two main ways to read and analyze a financial statement. Vertically and horizontally. The vertical method represents the categories in the accounts of the balance sheet as a percentage of the total account. For example cash as a percentage of the total assets held. Along with ratio analysis, this can help determine the relationship between the data in the statements. The horizontal method is used to compare multiple years of the companies financial statements in a percentage and dollar amount to see what has happened over the years in an attempt to predict what is to come.

Financial Statement Analysis-The statements.

There are three main types of financial statements a public company publishes, which allow investors to measure a company’s profitability, liquidity, cash flow and more.

The balance sheet encompasses the company’s assets, liabilities and shareholder’s equity for a specific period. The total assets are equal to the combined total of liabilities and shareholder’s equity. This statement assesses trends in assets and debts held by the company.

The income statement goes through the company’s revenue, deducting expenses to arrive to the net income for a specific period; providing investors with the company’s gross profit, and operating profit.

Finally, the cash flow statement gives investors a very in-depth look into the company’s cash flow from three main activities. Operating, investing and financing.

Financial Statement Analysis-Balance Sheet

Its only fair to divide the three statements and analyze them individually, what ratios are within, how investors use them and what it all means.

The balance sheet is used to calculate rates of return and analyze the company’s capital structure, what does the company in question own and what does it owe? How much is invested by its shareholders?

The basic formula everyone should be aware of: Asset= Liabilities + Shareholder’s Equity.

There are three main sections in the balance sheet, as illustrated below in Apple’s balance sheet.

Assets, with current and long-term assets, combined to make total assets. Current being the most liquid assets, such as cash, cash equivalents, marketable securities, accounts receivable, inventory and prepaid expenses. Long-term assets encompass long-term investments, fixed assets and intangible assets.

Next is liabilities, current, and long-term, outlining different debt taken on by a company. In current liability, there is the current portion of long-term debt, bank debt, interest payable, rent, wages payable, tax, utilities, etc. In long-term liabilities, one might find long-term debt and deferred tax liability such as depreciation.

The shareholder’s equity contains retained earnings and preferred or common stock.

The balance sheet is one of the three tools outlined in financial statement analysis and should be used in conjunction with previous years of operation to get an overall idea of the company’s current health. The balance sheet should also be compared to that of other companies in the same industry. This helps investors see if a company is lagging compared to industry counterparts or is it leading?

There are several ratios one can pull from the balance sheet, inclusive of debt to equity ratios, solvency ratios, turnover ratios, activity ratios and capital structure ratios.

An example is a quick ratio, a solvency ratio which interprets how much cash or liquid assets compared to debt that a company has in order to continue their operations without running into financial turmoil.

Quick ratio=(current assets-inventory)/ current liabilities.

Using Apple as our example the 2018 quick ratio is 1.09, or 109%. ({131,339,000-3,956,000}/{116,866,000}).

Meaning that Apple has many liquid assets, and will have no issues in continuing their operations. A ratio greater than 1.0 suggests this.

Financial Statement Analysis- Income Statement

The income statement can be described as the profit and loss statement because by the end of the statement you will know if a company incurred a loss for the given period or profit. This statement outlines the company’s financial performance.

The income statement layouts a company’s revenue and expenses for a given period, as is in the income statement below for Apple. In subtracting expenses from revenue, you will arrive at the company’s net profit, hopefull, a positive number.

Its a little more complicated than that though. The general construct of an income statement goes as follows:

Revenue, which encompasses operating revenue, and on occasion non-operating revenue. Which can include interest earned, or royalty payments? There is also the cost of revenue, or cost of goods sold. Substracted from the revenue will tell you what the company’s gross profit is for the period.

The statement then outlines expenses linked to primary activities, which will give you operating income. Along with expenses linked to secondary activities such as interest paid, etc.

Subtracting the expenses from gross profit you will arrive at the net income of the company.

These step outline what is present in the income statement below.

The income statement measure a company’s profitability and the business activities to shareholders.

The statement is useful when comparing previous years to see fluctuations in revenue, expenses, and net income. All which can be turned into a percentage to better visualize the change from year to year.

The ratios are also very useful when comparing similar companies within an industry.

The income statement is useful for investors, as well as the management of the company. Many internal decisions can be made from the income statement such as expanding operations, shutting down departments and more. For example, if net profit is suffering because of an increase in expenses and drop in revenue, a push in sales may be a strong solution for management.

Financial Statement Analysis-Cash Flow Statement

The final statement we’ve described is the cash flow statement which is divided into three main sections that display the cash inflows and outflows of a company.

The cash flow statement is divided into three main sections, the cash from operating activities, investing activities and financing activities. under the GAAP method, you may see a fourth category. A disclosure of non-cash activities.

A cash flow statement is a useful tool for investors in that it outlines where money is coming from and going to within the company’s operations. It is used by creditors as well when assessing a company’s ability to pay off debt.

Cash flow from operating activities

The cash flow from operating activities reflects the cash from business activities. This portion displays cash generated from a company’s business activities, meaning their products or services.

This portion of the cash flow statement usually includes accounts receivable, depreciation inventory and accounts payable.

Cash flow from investing activities

The cash flow from investing activities simply outlines the use or source of cash in a company’s investments. This outlines any sales or purchases of assets, loans, or payments.

The main categories are changes in assets, investments, and equipment. For example, when a company uses cash to buy new equipment or marketable securities the transaction is considered “cash out”.

This is important for investors to see how a company is investing in its future growth.

Cash flow from financing activities

This portion of the cash flow statement outlines a company’s cash from investors or banks, and cash used to pay shareholders. Such as paying out dividends or repurchasing shares. The repayment of debt principal is also included.

Raised capital for a company is a “cash in” transaction. When cash it paid out such as in the case of dividends, it is considered “cash out”.

Using bond issuance as an example. When the bond is issued to the public, raising capital is considered “cash in”. However, when interest is paid to bondholders, the activity is considered “cash out”.

Final thoughts

Financial statement analysis is an important tool all investors have in their arsenal. However, it is not enough just to know how to read one, an investor must be able to interpret all three statements to be able to come to a solid conclusion about a company’s future and potential.

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