Understanding Financial Statements for Investing & Life
Whilst audit is not my thing (as explained in my last week’s post here), financial statements are the core of showcasing any companies’ performance and state.
It is like the health screening report of a person or the year end performance review of an employee. We can glean a lot of information about the company from the financial statements if we know where to look.
Else, they are just papers with a lot of numbers. Confused just like BTMar is in my cover pic.
The Triplets: Financial Statements
For those who don’t know, financial statements commonly refer to the 3 inseparable reports that a company releases:
- Income Statement (Statement of Comprehensive Income)
- Cash Flow Statement (Statement of Cash Flows)
- Balance Sheet (Statement of Financial Position)
*The one in brackets is currently the official name used in financial reports.
As with most things, there is an order. And it starts with:-
Income Statement
This famously reports the profit / loss of the company – also used to be called the “Profit & Loss Statement”.
It starts off by recording the income generated by the company for the year which is then reduced by the expenses incurred for the year. This will result in either profits or losses.
An important concept about this is the “Accrual Basis”. In other words, all transactions are recorded as long as they are confirmed even if there are no cash transactions yet.
A very similar concept can be drawn with credit card spending. When we spend using a credit card, we don’t need to pay in cash first (but at a later date) and the purchase is confirmed the moment we swipe the card. Hence, by “Accrual Basis”, it will be recorded in the income statement as an expense.
The follow up question, obviously, would be, “But I only need to pay up after 30 days in my credit card bill”.
Yes. And this is where we introduce the 2nd financial report:-
Cash Flow Statement
The Cash Flow Statement affects ONE thing primarily – the cash balance of the company. But within this statement, there is a lot to learn about.
This statement is separated into 3 segments.
Firstly, the Operating Cash Flow deals with the cash of running the day to day operations. It transforms the Income Statement from “Accrual Basis” into “Cash Basis”. Remember the credit card purchase? In this statement, it will only be recorded when we make the payment and not when we swipe the card.
Then, we have the Investing Cash Flow that deals with the usage of funds that relates to some of the assets of the company – be it an acquisition or disposal. This includes its fixed assets (properties, plant, equipment), mergers & acquisitions, investments in securities. This shows where the company is investing its cash.
Lastly, the Financing Cash Flow handles all the transactions that has to do with the funding of the company – in short things that affect shareholders (injection of new money, dividend payouts, etc) and loan-related transactions (bank or other loans, etc).
With these 3 segments, it shows us how the company gets and spends its money resulting in the cash balance that we see in the next report.
Balance Sheet
Ask any accountant / auditor and they will tell you that their nightmare is when “THE BALANCE SHEET CANNOT BALANCE”. #insidejoke
The balance sheet is the master financial statement of all financial statements because the others ultimately feed into the balance sheet. On top of that, the equation must balance at the end.
What equation?
ASSETS – LIABILITIES = EQUITY
*To dear seasoned accountants: I know that this is not the way it’s shown in textbooks, but practically, this makes more logical sense when we analyse the financials as I’ll explain below
We can draw a very important inference from this equation: Any change in the net asset of the company can only be affected by the changes in the equity of the company.
And the equity of the company can only be affected by 2 things:
- Share capital = The funds that shareholders put into / withdraw from the company.
- Retained earnings = The accumulated profits / losses of the company since day 1, which includes accounting for any dividend payouts as companies can pay dividends out of available retained profits.
Both the Income Statement and the Cash Flow Statement will eventually flow into the Balance Sheet to make it whole.
- The final profit / loss will be incorporated into the retained earnings.
- The final cash balance will be the input for the cash balance (usually the final piece of this balancing puzzle).
One BIG report, many SMALL parts
One for all, all for one
The Three Musketeers
The 3 financial statements are inseparable in that they each represent different things about the company, and yet, they are reliant on one another to tell the full story – gears that operate one big machine.
So what are the things I look at?
There is a lot of methods and ways when it comes to analysing the financial statements. Let me share a quick list here on the first level information that I go through before digging further.
Income Statement
- Revenue growth
- Gross profit margin
- Earnings before Interest, Tax, Depreciation and Amortisation (otherwise known as EBITDA and is the closest to the operating earnings of the company after removing non-operation related items)
- Net profit margin
Cash Flow Statement
- Operating cash flows vs profit/loss in the income statement
- Capital expenditure spending / sale (this showcases if the company is expanding or getting rid of assets)
- Financing cash flows in relation to its Operating & Investing cash flows (more importantly: is the company getting additional funds for expansion or just to support its operations?)
Balance Sheet
- Net asset change from one year to another
- Growth of trade receivables vs revenue (Is the company maintaining a healthy credit line to its customers?)
- Growth of trade payables vs purchases (Is the company maintaining a healthy credit line with its suppliers?)
- Trade payables vs trade receivables changes yearly (Is the company maintaining a healthy ratio between both debtors and creditors to ensure it does not run into cash flow problems?)
- Share capital changes from one year to another
Generally, I will be able to get a decent grasp of the company with a quick look at the few items listed above. I will dive deeper into other metrices the moment any of these raise concerns.
Applying these to our Personal Finance
As the 3 financial statements help to represent the holistic view of a company’s financial health, we could do the same for our own personal capacity.
I highly recommend tracking both income and expenses on a daily basis in coming up with our income statement / cash flow statement. This will ensure that we are profitable (i.e. wealth accumulation) or find ways to fix it if we are at losses every month.
It is also important to do up a balance sheet at intervals (I do once every 6 months) so that we know our financial health. This entails tracking all our investments (assets) and our outstanding loans (liabilities). It will also enable us to get a grasp on a few things:
- What is our current net worth?
- Is our net worth increasing or decreasing between each period?
- Where are our assets focused at?
- How much are we in debt?
- Can we afford to take one more debt?
I have created templates for these and you may download them for free via my Templates page.
- Expense Tracker: Predominantly cash flow statement and incorporated “accrual basis” recording for credit cards / e-wallets
- Financial Position: The Balance Sheet
Closing Thoughts
The 3 financial statements are one of the best creations of the financial world, but it is far from perfect. It takes a lot of experience to know what to look at and where to find things.
I believe it is important to keep things simple so that we avoid paralysis by over-analysis. Hence, unless it’s a work requirement to dive deep into my analysis, I generally keep to those few items I mentioned above when I look into a company’s financial statements. Especially when evaluating for investments.
Hope this post gives you some insights to this 3 commonly found financial statements and also guidance on where to start.
Have fun analysing and happy investing!
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