The financial statements that
are important in analyzing a company and are used by internal as well as
external users are: the balance sheet, the income statement, cash flow, and
Income. Internal users are those within the company, like employees or the chief
operating officer, and as for the external users, are analysts, investors, and
auditors.
Understanding the
fundamentals of the financial statements is essential in making careful
decisions but also in understanding the financial health of a company. If we
look at the balance sheet of a company, it is comprised of assets, liabilities and
equity. In fact the fundamental accounting equation and one that must balance
at any point in time, is Assets = Liabilities + Owners’ Equity. This equation
must balance in that all accounts at the end of the accounting period must be
credited or debited so as to make the accounting equation balance.
If we visualize a T account
assets are on the left side, and liabilities, and equity are on the right.
There is a reason for this and when the records are prepared (trial balance), before
each account is balanced, each is placed according to whether it increases or
decreases an asset, a liability or an equity. So if a company had sales, they
would be classified as an increase in asset, if the company had revenues, it
would also be an increase in an asset (cash). If a company was granted a bank
loan, it would be an increase in a liability.
Assets represent things of
value, like cash, land, inventory, or even when it will receive in the future,
like selling on credit. Liabilities are what a company owes to suppliers,
creditors, bank loans, interest payments, taxes payable, and employee compensation.
Equity is what the owners have put into the business. If the company pays taxes
and keeps the rest into the business, that is retained earnings.
Certain accounts like
accounts payables, debt liabilities reveal the financial health of a company
and the way that company is being financed. This will also depend on the line
of business, industry characteristics and the mix of liabilities to equity. For
example, businesses sell on credit so one would expect that the asset account
accounts receivables will increase. But if the company’s credit policy extends
beyond say 90 days this may not be good as the company is not converting those
assets into cash quick enough.
The financial health of a
company is determined by the ratio of debt to equity. If the company’s debt
obligations are higher than its equity then it could signal, combined with
other indicators, that the company has a high debt burden it is unable to
service.
If one looks at the assets
side of the balance sheet, the account presentation is listed in descending
order. That is, the assets are listed in the order by which they can be
converted to cash (liquidity). Also they are classified as current and non-current
assets. Those that are current have a life span of one year, before they are
converted to cash. Examples are cash, and cash equivalents, inventory, and
accounts receivables. Inventory is another asset, and depending on the type of
company the makeup of the inventory will differ. For example, for a manufacturing
company, we will see raw materials, goods in progress, finished goods.
Non- current assets are
assets that last more than a year before being converted to cash. For example, machinery,
computers, land, buildings. They are also classified as tangible and non-
tangible. A tangible asset is something that one can touch. A non- tangible
asset is a patent, goodwill or a copyright. They are non-physical, but they are
important in a company’s valuation. They are also depreciated over their life,
like buildings, and deducted from their original cost over its useful life.
On the liabilities side of
the balance sheet they are also classified as short term and long term. Long
term liabilities are debt which are due for more than a year. Current
liabilities are those liabilities due within a year, like accounts payables,
interest payments. On the shareholders’ equity account, shows the initial
capital put up by the owners of the company. Also at the end of year, and the
company pays its taxes, the amount left, retained earnings, can be reinvested
in the company. It will show in the equity section of the balance sheet, by
being transferred from the income statement.
To analyze a company and
having an understanding of the balance sheet, one can use financial ratios to
analyze the financial condition of a company. For example, the debt / equity
ratio. The D/E is a financial ratio used to find the financial leverage of the
company. This is also referred to in the Miller – Modigliani theorem to analyze
the capital structure of the company. It compares the total liabilities to
total equity.
Another ratio is the working capital (WC). It
is defined as current assets – current liabilities, and indicates whether the
company has enough short term assets to cover its short term debt. If WC is
below 1, it indicates negative working capital.
