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Understanding Financial Statements: Importance, Limitations, and Key Components

Financial statements are essential for assessing a company's financial health, providing insights into management performance, and facilitating comparisons across businesses. They include crucial components such as the income statement, balance sheet, and statement of cash flows, each offering unique insights into operations and liquidity. However, financial statements have limitations, as they often reflect historical data and can contain subjective interpretations. Understanding these documents is vital for accurate financial analysis and making informed investment decisions in today's financial landscape.

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Understanding Financial Statements: Importance, Limitations, and Key Components

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  1. Financial Accounting Greg Gleeson, CPA, CFA Chief Operating Officer- GROW Partners, LLC ggleeson@growpartnersllc.com

  2. Why are Financial Statements Important? • Financial Health of Company • Track Record of Management • Independently Audited & Objective • Ease of Comparison Across Companies • Valuation of Company • Starting point for all Financial Analysis

  3. Why are Financial Statements Limited? • Backward Looking • Highly Summarized • Accrual Basis • Non Cash Items (“Stock Options”) • Subjective “One-Time” Charges • Accounting Elections can Make Comparisons Difficult

  4. Do you need CPA to Review and Understand Financial Statements? • Financial Data Providers have Distilled (Bloomberg, Factset, Reuters) many important facts • Financial Ratios provide important information and details, without having to read financials themselves • There are many analysts out there who review info for you …however… • Strong fundamental research requires in-depth review/knowledge of accounting • Ability to review/examine/digest financial statements is a growing area of need in money management (e.g., forensic accounting research, fraud specialization)

  5. Financial Statement Components • Auditors Report • Must read, if other than unqualified, look out! • Balance Sheet • The net worth of the company at a point in time • Income Statement • The results of operations for a period of time (accrual basis) • Statement of Cash Flows • Operations on a cash basis, plus other changes in cash • Statement of Changes in Equity & Retained Earnings • Did company issue equity/debt, at what price? • Footnotes • Must read, the only color in the report (which is audited)

  6. Auditors Report • Was an Audit Even Done? • Audit is different from an compilation, examination/attestation, agreed upon procedures, or other reports • Who are the Auditors? • Are they national/reputable? PCAOB? • Was it Prepared in Accordance with GAAP? • Is the Report Unqualified (i.e., Clean) • Is the report Qualified • Why? Read very carefully! • Has the Firm Changed Audit Firms in Recent Years?

  7. Balance Sheet • Assets • Is it a company spinning of cash or burning cash? • Is it a company that is capitally intensive? • Is it a company that holds inventory? How old is inventory? Accounting? • Is it a company that holds intangibles? • Liabilities • Can the company pay their bills? • Does the company have long term debt? Interest rate sensitive? • Does the company have unionize labor? Long term liabilities? • Are their contingencies on the books? Why? • Equity • Who bought equity at what price? • Are the senior equity or debt holders ahead of you? • Why is company raising capital? • Can the company pay a dividend?

  8. Income Statement • Revenues • What is the revenue recognition policy? • How do they collect their revenues? • Does the company offer terms “Accounts Receivable”? • How does company account for “Cost-of-Goods Sold”? LIFO/FIFO? • Expenses • What is in G&A? Is it tight-ship? • What are cash versus non-cash expenses (such as depreciation, stock options)? • How levered is the business model? • Other (One-time) • Why does the company have one-time charges? • Are “one-time” charges routine at this company?

  9. Statement of Cash Flows • Cash Flow From Operations • Translates Accrual Basis to Cash Basis • Eliminates “Non Cash” items such as depreciation, unrealized gains or losses • Gives a better estimate of what the company is generating on operating basis • Cash Flow from Investing Activities • Accounts for “big ticket” items that are typically capitalized • Shows you what the company is really spending on equipment and long lived items • Gives you an idea of how successful the company is at selling equipment • Cash From Financing Activities • Shows the sources of capital raising activities during the period • Shows distributions to shareholders

  10. Statement of Changes in Equity & Retained Earnings: • Drills Down the Equity Section of the Balance Sheet • Shows the net income that made it to shareholders • Show new issuances of stock, amounts, and price • Shows retirement of stock, amounts, and price • Shows distribution of earnings to shareholders • Shows conversions of debt to equity

  11. Footnotes: Devil’s in the Details… • “Minimum” Color Required by GAAP • Audited • Provides Critical Information to Understand Financial Statements Such As: • Earnings-per-share • Details of taxes provisions • Details of pension obligations • Valuation of Investments such as derivatives • Off balance sheet items, contingencies

  12. Ratios: Accounting Shorthand • Reader’s Digest of Financial Statements • Derived from Financial Statements but Audited • Objective view. However, Subjective to Accounting Distortions • Allows for Quick Comparisons against Prior Periods and Peers • Allows Stock Pickers to Screen Companies Quickly • Widely Used Ratios can Measure Many Dimensions of Financial Reporting: • Valuation: P/E, P/S, P/B • Profitability: Margin %, ROA, ROE • Efficiency: Rev/Employee; A/R Turnover • Liquidity: Current Ratio, Quick Ratio • Credit: Debt/Equity; Debt/Earnings

  13. Other Information: MD&A • Additional Color Provided by Management • Can be Forward Looking • Unaudited • Can Highlight Items Not in the Financial Statements

  14. Case Study: Cisco (CSCO)

  15. Case Study: Cisco - Balance Sheet Almost $49B in Cash and Growing Low A/R (falling) Leases (increasing) Purchased Companies in Past Took Cash, Haven’t Booked Revs 25% of Company Leveraged Cumulatively, Have Been Profitable Has Healthy Equity

  16. Case Study: Cisco – Income Statement Grew 12% over past 3 years Grew 24% over past 3 years Grew 10% over past 3 years Grew 10% over past 3 years Grew 3.5% over past 3 years Grew 10% over past 3 years Starting Paying Dividend

  17. Case Study: Cisco – Stmt of Cash Flow Collecting Faster than in Past Extending more Credit (leases) More Profitable than P&L Shows Stopped Buying Companies Slowed down Purchasing Own Stock Increasing Dividend

  18. Case Study: Cisco – Footnotes (40 pages worth) Leases grew by 9.5% in 1 year, Faster than revenues…. Past Due Increased by 43% in 1 year

  19. Case Study: Cisco – MD&A (Un-Audited) Provides warning about When Revenues Booked

  20. Case Study: Cisco – Ratios (Un-Audited)

  21. Cisco- Accounting Observations • Generally…Low Valuation in Relation to Other Large Companies • Cash Cow …However… • Earnings Not Growing Very Fast • Net Margins are Not Terrific • Their Cash Flow May decline it they Continue to Lease • Don’t seem to know what to do with their Cash

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