…Accounting is the language of practical business life – Charlie Munger
Whether you are an investor deciding which company’s shares to buy, a small business owner trying to understand your businesses financial position and performance or a philanthropist deciding on which charity to donate to, the ability to read financial statements is an invaluable skill to have.
The skill of financial statement analysis is at the heart of accounting. This module serves as a guide for it, with Part One being a basic overview, and Parts Two and Three going through Balance Sheet Analysis and Income Statement Analysis, respectively.
Business Analysis and Financial Statement
The statements reveal:
1. how a company obtains its resources (financing)
2. where and how those resources are deployed (investing); and
3. how effectively those resources are deployed (operating profitability).
Uses of Financial Statements
Boards of directors, as investor representatives, use them to monitor managers’ decisions and actions.
Employees and unions use financial statements in labour negotiations.
Suppliers use financial statements in setting credit terms.
Investment advisors and information intermediaries use financial statements in making buy-sell recommendations and in credit rating.
Four Key Financial Statements
1. The Balance Sheet (Statement of Financial Position)
2. The Income Statement (Statement of Financial Performance)
3. The Statement of Cash Flows
4. The Statement of Shareholders’ Equity
1. The Balance Sheet
Assets = Liabilities + Equity
Assets relate to resources controlled by a company. These resources are investments that are expected to generate future earnings through operating activities.
A company needs financing to fund their operating activities. Liabilities + Equity identify the funding sources. Liabilities are funding from creditors and represent obligations of a company or alternatively, claims of creditors on assets.
Equity is the total of:
(1) funding invested or contributed by owners; and
(2) accumulated earnings in excess of distributions to owners since the inception of the company.
The right side represents source of funds and left side represents use of funds.B. Current vs. Non-current
Assets and liabilities are separated into current and non-current amounts.
Current Assets are expected to be converted into cash or used in operations within one year or the operating cycle (whichever is longer).
Current Liabilities are obligations of the company expected to settle within one year or the operating cycle (whichever is longer).
The difference between current assets and current liabilities is known as working capital. In other words:
Current assets – Current Liabilities = Working Capital
Non-current assets and liabilities are those which do not fit into the maturity periods described above.
The accounting equation can also be considered in terms of business activities:
Total investing = creditor financing (other people’s money) + owner financing (your own money)Remember the accounting equation is a balance sheet identity reflecting a point in time. Operating activities arise over a period of time and are not reflected in this identity.
However, operating activities can affect both sides of this equation. That is, if a company is profitable, both investing and financing levels increase.