Introduction To Financial Statements

Financial analysis is the process of evaluating a company's current and expected future financial performance in order to arrive at an investment decision or recommendation, using historical data from the company's financial statements. It is standard practice for publicly listed companies to present audited financial statements that adhere to a set of financial reporting standards, mainly the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS), in order to ensure consistency. The three main financial statements used by investors are the balance sheet, income statement and the cash flow statement, all of which provide a foundation for a better understanding of a company's financial performance. Along with the required financial statements, investors may also encounter other additional information in a company's annual report, such as the chairman's statement, discussion of the company's performance by the management team, and any other supplementary disclosures required by regulatory authorities.

Balance Sheet

The balance sheet (also known as the 'statement of financial position') is a snapshot of a company's financial position on a given day. It provides a summary of the assets, liabilities and shareholders' equity of a company. Assets refer to the economic resources that a company controls, including cash, accounts receivables, inventories, as well as property and equipment, and are expected to produce economic benefits to the company. Liabilities are the amounts that a company owes to its creditors for past transactions, or can also refer to amounts received in advance from customers for future services that has not been delivered yet. Shareholders' equity is the excess of assets over liabilities, and represents the amount of residual assets attributable to a company's owners after all of its obligations have been met. It is important for investors to know how to read and understand balance sheets because it gives them a grasp on the financial standing of a company. The relationship between assets, liabilities and shareholders' equity can be expressed in the equation (also known as the 'accounting equation') below – a company must pay for the things it owns (assets) with either borrowings (liabilities) or capital from owners (shareholders' equity).

Assets = Liabilities + Shareholders' Equity

Income Statement

The income statement (also known as the statement of comprehensive income) gives investors an overview of the revenues generated by a company over a period of time, and the expenses it incurred to generate the revenues. Revenue (sometimes known as 'income' or 'sales') typically refers to the amounts received by a company when goods are shipped or when services are delivered to customers. If the revenues derived are from regular business operations, they are considered to be operating revenues. On the other hand, if the revenues derived are not directly linked to regular business operations, they are considered to be non-operating revenues. An expense can refer either to a cost incurred in the process of using up an asset (e.g. cost of goods sold and depreciation expense) to generate revenue, or the incurrence of a liability that leads to a cash outflow (e.g. interest expense). The net income of an income statement is calculated by subtracting expenses from total revenues, and is often referred to as the 'bottom line' due to its proximity to the bottom of the income statement. If expenses exceed revenues, the result is referred to as a 'net loss'.

The accrual basis of accounting is the standard approach for recording revenues and expenses in the preparation of income statements, advocated by the GAAP and IFRS standards. Under the accrual basis of accounting, revenues are recorded at the time of delivering the goods or service, even if cash is not received at the time of delivery, such as the case of a sale of goods on credit. Similarly, expenses are recognised in the period in which they are incurred. The accrual basis of accounting is in stark contrast to the cash basis of accounting, revenues and expenses are recorded only when there are cash inflows (when cash is received from customers) and cash outflows (when cash is paid out). As all transactions are accounted for when they occur, the accrual basis of accounting provides a more accurate picture of a company's current financial conditions, and allows investors to have a better gauge of its future earning potential.

Cash Flow Statement

While income statements and cash flow statements are similar in that they measure the performance of a company over a period of time, they present different but related sets of information. Analysing one statement without the other is likely to give an incomplete picture of a company's current financial standing. It is entirely possible for a profitable company with a healthy net income (as shown on its income statement) to not have enough cash to pay its liabilities, or in worse cases, go out of business, if it fails to manage its cash flow adequately. As such, besides having an understanding of a company's financial performance, investors should also have a firm grasp of its cash position by examining the cash flow statement, which is a financial statement that describes the sources of cash generated by a company and how the cash was spent over a specified period of time.

The cash flow statement categorises cash flows into three different categories: cash flows from operating activities, cash flows from investing activities and cash flows from financing activities. Cash flows from operating activities refer to the cash collected or paid out from the day-to-day business operations of a company. There are two methods of preparing the operating section of the cash flow statement. The direct method starts with a summary of all cash receipts from different sources, excluding non-cash items such as depreciation, and then deducts all cash payments over a certain period to arrive at the net cash flows from operating activities. The indirect method, on the other hand, starts with net income (from income statement) and makes adjustments for non-cash revenues and expenses, to arrive at the cash flows provided by operating activities. Cash flows from investing activities are the cash received or paid for the purchase and sale of long-term investments and fixed assets. Cash flows from financing activities account for the inflows and outflows of cash arising from debt issuance and financing, issuance of new stocks, dividend payments, and the repurchase of existing stock.