WHAT ARE FINANCIAL STATEMENTS, WHY ARE THEY IMPORTANT, AND WHY DO FINANCIAL ANALYSTS USE THEM?
Financial statements are formal records of the financial activities of a business. For a corporation with publicly traded securities, there are three primary financial statements that must be reported quarterly (4 times per year):
>Income Statement: Reports a snapshot of a company’s business performance over a period of time. This statement indicates how much revenue (sales) is generated by a business, and also accounts for direct product costs, general expenses, Interest on Debt, Taxes, and other expense items. The purpose of this statement is to show the company’s level of profitability, which is equal to a company’s Revenue net of its expenses.
>Balance Sheet Statement: Reports a snapshot of a company’s outstanding balances in various accounts at a specific point in time. The purpose of this statement is to demonstrate a business’s financial heath at any given time, by enumerating it assets as well as the claims against them (liabilities and equity).
>Statement of Cash Flows: Reports on all of the company’s activities that affect its cash position over a period of time. These activities are broken down into three primary categories: Operating, Investing, and Financing. The purpose of this statement is to give a detailed reconciliation of how the company’s Cash is being used (and how much Cash is being generated).
These financial statements all aim to provide an overview of a business’s performance and position, either over time, or at a given point in time. They are highly interrelated and must tie together perfectly. For example, in the Statement of Cash Flows, a detailed account of the change in a company’s Cash balances is given. This change must exactly match the change in Cash balances listed on the beginning and ending Balance Sheets for the Company. Similarly, many items in the Income Statement directly reflect changes in Balance Sheet accounts over time, and must match the changes there. More discussion of this concept can be found at the end of this chapter.
Financial statements are issued by companies and reviewed by the Securities & Exchange Commission (SEC). The SEC requires publicly-traded companies to file quarterly and annual results of operations. These are the summarized financial results of the company, and they are the backbone of financial modeling, company profiles and pitch book presentations. Without financial statements, most valuation work would be difficult or nearly impossible.
LOCATING FINANCIAL STATEMENTS
All publicly-traded companies are required by the SEC to file quarterly and annual reports. Private companies are not required to file financial reports, although some may have to if they have publicly traded debt. Company filings are found on the SEC’s EDGAR website.
PRIMARY INFORMATION FOUND IN FINANCIAL STATEMENTS (FORMS 10-K & 10-Q)
> Management Discussion & Analysis
> Income Statement
> Balance Sheet Statement
> Statement of Cash Flows
> Notes and Exhibits to Financial Statements
Annual reports are filed as 10-Ks with the SEC and must be filed within 60 days of the company’s fiscal year end. 10-Ks are much more detailed than quarterly reports (10-Qs, discussed below), and contain information such as the company’s Business Overview, Risk Factors, Financial Data (Income Statement, Balance Sheet, and Statement of Cash Flows), Management Discussion & Analysis, and other important disclosures.
Quarterly reports are filed as 10-Qs with the SEC and have to be filed within 40 days of the end of the fiscal quarter. 10-Qs are less detailed than annual form 10-Ks but do provide helpful detail around the quarterly Financial Data (Income Statement, Balance Sheet, and Cash Flow), Management Discussion & Analysis, and other Company disclosures.
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The Income Statement shows how much Revenue (i.e., sales) is being generated by a business, and also accounts for Costs, Expenses, Interest, Taxes and other items. The main purpose of this statement is to show the company’s level of profitability. The Income Statement represents items over a period of time, usually over a quarter (3 months) or a year. This statement is also referred to as the Profit and Loss Statement (P&L).
INCOME STATEMENT: KEY LINE ITEMS
>Revenue represents the sales brought in from selling a product or performing a service.
>Cost of Goods Sold (COGS) represents direct costs of producing goods and services that the business has sold, such as material costs and direct labor.
>Selling, General, & Administrative Expense (SG&A) represents expenses associated with selling products and managing the business. This will include salaries, shipping, insurance, utilities, rent, compensation for executives, etc.
>Depreciation & Amortization (D&A) represents the expenses associated with fixed assets and intangible assets that have been capitalized on the Balance Sheet. D&A that is directly related to production will generally be included in COGS and will be separated out on the Statement of Cash Flows (more on this later).
>Net Interest Expense represents the total Interest paid on Debt liabilities, net of the total Interest received on Cash assets.
>Tax Expense represents the amount of taxes paid.
>Net Income represents the company’s profit, which is Revenue minus all of the aforementioned costs and expenses.
CALCULATING EARNINGS PER SHARE (EPS)
EPS equals Net Income (after dividends on preferred stock) divided by the company’s Weighted Average Shares Outstanding. Shares Outstanding will typically be found either on the Income Statement, below Net Income, or on the first page of the most recent 10-Q or 10-K. It can also be calculated as the average of the number of common shares outstanding at the beginning of the period and end of the period (from the company’s Balance Sheet).
EPS is an extremely important metric of a company’s value: it represents the profit generated by the company for each shareholder. It will be used extensively when working through valuation techniques such as Comparable Company Analysis and Precedent Transaction Analysis.
Attached is an example of an Income Statement, showing all of the discussed line items, from Amazon at the end of 2010 (Ticker AMZN).
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