Question

Please write a summary of the usefulness of financial statements in making investment decisions. The summary should include information about analyzing and interpreting a company’s financial condition and performance, its liquidity, solvency, and profitability.

Answer 1

Financial statement analysis is critical in making effective stock investment decisions. If you do not research your stock investments, you essentially engage in glorified gambling. The balance sheet, income statement, cash flow statement and statement of owners' equity each offers unique insights. Combined, they can give you a good sense of a company's overall financial picture.

Balance Sheet

Some investors consider the balance sheet the best statement to get a good overall view of a company's financial position. The balance sheet follows the basic accounting equation assets equal liabilities plus owners' equity. The difference between what a company has and what it owes equals equity, or net worth. A high net worth may indicate that a company is relatively debt free, particularly if its owners' equity is higher, expressed as a percentage of assets, than other companies in its industry.

Income Statement

The income statement shows how much profit a company has earned during a given period. The format includes a gross profit calculation, followed by an operating income section. This produces operating income. Non-operating income or losses, including one-time or special sources of revenue or expense, are then added to derive net income. Gross profit is based on revenue minus the cost of producing the goods or services that a company sells, called the cost of goods sold. This shows how efficiently the company generates income from its production. Operating income considers many other costs along with the cost of goods sold, including overhead and depreciation on equipment. This is important in determining the company's basic profitability, especially when compared to prior periods or to other companies in its field. Growing operating income is a good sign. Special items may positively or negatively affect a period's net income, but they are less likely to affect long-term concerns.

Cash Flow Statement

The statement of cash flows also reveals useful information when making investment decisions. It shows the net change in the company's cash position during a given period. In general, stable or growing cash flow means the company can cover its short-term debt payments and expenses, while also keeping up with any long-term debt obligations. You can also look over the structure of the cash flow to see how much cash is generated from operating activities versus financing and investing. It is a good sign when a company's cash from operating income routinely exceeds its net income. This shows income is turning into cash. Typically, an effective cash position is favorable in an investment because it shows less risk of loan defaults or bankruptcy.

Statement of Owners' Equity

The statement of owners' equity isolates the equity section of the balance sheet. Its primary purpose is to show the trend in retained earnings for the company. Retained earnings are accumulated profits not paid out in dividends. This is useful in investment decisions because higher retained earnings relative to dividends means you get less dividend income. However, this often means the company is looking to grow and is holding onto income for reinvestment versus paying it out in the near term.

EVALUATION

Performance

The Current Ratio

The current ratio—which is total current assets divided by total current liabilities—is commonly used by analysts to assess the ability of a company to meet its short-term obligations. An acceptable current ratio varies across industries, but should not be so low that it suggests impending insolvency, or so high that it indicates an unnecessary build-up in cash, receivables or inventory. Like any form of ratio analysis, the evaluation of a company's current ratio should take place in relation to the past.

Financial Position: Book Value

If we subtract total liabilities from assets, we are left with shareholder equity. Essentially, this is the book value, or accounting value, of the shareholders' stake in the company. It is principally made up of the capital contributed by shareholders over time and profits earned and retained by the company, including that portion of any profit not paid to shareholders as a dividend.

Solvency

Solvency is the ability of a company to meet its long-term financial obligations. When analysts wish to know more about the solvency of a company, they look at the total value of its assets compared to the total liabilities held.

Assessing the Solvency of a Business

The solvency of a business is assessed by looking at its balance sheet and cash flow statement.

The balance sheet of the company provides a summary of all the assets and liabilities held. A company is considered solvent if the realizable value of its assets is greater than its liabilities. It is insolvent if the realizable value is lower than the total amount of liabilities.

The cash flow statement also provides a good indication of solvency, as it focuses on the business’ ability to meet its short-term obligations and demands. It analyzes the company’s ability to pay its debts when they fall due, having cash readily available to cover the obligations.

The cash flow also offers insight into the company’s history of paying debt. It shows if there is a lot of debt outstanding or if payments are made regularly to reduce debt liability. The cash flow statement measures not only the ability of a company to pay its debt payable on the relevant date but also its ability to meet debts that fall in the near future.

A solvency analysis can help raise any red flags that indicate insolvency. It can uncover a history of financial losses, the inability to raise proper funding, bad company management, or non-payment of fees and taxes.

Other Ratios

Several different ratios can help assess the solvency of a business, including the following:

1. Current debts to inventory ratio

The ability of a company to rely on current inventory to meet debt obligations.

2. Current debt to net worth ratio

The total amount of money owed to shareholders in a year’s time, expressed as a percentage of the shareholder’s investment.

3. Total liabilities to net worth ratio

The relationship between the total debts and the owner’s equity in a company. The higher the ratio, the lower the protection for the business’ creditors.

PROFITABILITY

Profit Margin

1.Find the annual sales of your business along with its net income. Net income is equal to your company's earnings less any costs of doing business. These costs can include taxes, interest, costs of goods sold and depreciation.

2.Divide net income by the annual sales and then multiply by 100. This is the profit margin of your business stated as a percentage. A higher number indicates greater efficiency in creating profits.

3.Compare the profit margin of your business with others in your industry and the industry as a whole. If a particular company is publicly traded, this knowledge is available to the general public.

Return on Assets

1.Find your company's total assets to compare to the already established net income. Assets are anything that a business owns that has value. These can be tangible or intangible and can include any equipment, cash, investments or land that a business possesses.

2.Divide net income by total assets and multiply by 100. This will be the ROA of your company. The higher the number, the more effective your firm is in generating profits.

3.Compare the ROA of your company with your competitors. Make sure you compare only your business with others in your industry, as the ROA of different industries varies greatly and wouldn't make for an accurate profitability assessment.

Liquidity

Definition of Liquidity

Liquidity is a company's ability to convert its assets to cash in order to pay its liabilities when they are due.

Current Assets

Generally, the assets that are expected to turn to cash within one year are reported on the balance sheet in the section with the heading current assets. Current assets are listed in the order in which they are expected to turn to cash. This is known as the order of liquidity. Since cash is the most liquid asset, it is listed first. After cash, the order is: temporary investments, accounts receivable, inventory, supplies, and prepaid expenses.

Evaluating Liquidity

Liquidity depends on 1) the speed at which the assets should be turning to cash, or 2) the assets' nearness to cash. For example, some temporary investments are marketable and can be converted to cash very quickly. Accounts receivable may be converted to cash in 10 to 40 days. However, inventory may require several months to be sold and the money collected. Hence, inventory is not considered to be a "quick asset."

To assist in evaluating a company's liquidity, the financial ratio known as the quick ratio or acid-test ratio is calculated by dividing the amount of the company's quick assets (cash, temporary investments, and accounts receivable) by the amount of the company's current liabilities. [An alternate calculation of the quick ratio is to begin with the amount of the current assets and subtract the amount of inventory. The remainder is then divided by the amount of current liabilities.]