Investing For Dummies: Introduction To Financial Statement Analysis
Not Everybody has the background to Invest, I’ll teach you
In this article I will introduce you to financial statement analysis — more specifically we will start discussing the balance sheet. We will look into different terms of it, so you can start understanding the numbers and the structure of a company.
They are accounting reports issued by a firm periodically (often quarterly or annually) that show the past performance of a given company and a snapshot of the same company’s assets and the financing of those assets.
Types Of Financial Statements
A public company is required to produce four financial statements. These are:
- The Balance Sheet
- The Income Statement
- The Statement of Cash Flows
- The Statement of Stockholders’ equity
Notice how the balance sheet is divided into two sides. On the left side, you see the assets, and on the right side, you see the liabilities.
1. The assets list the company’s inventory, cash, plant & equipment, property, and any other investment the company may have made.
2. The liabilities simply show a firm’s obligations to its creditors.
3. In the liabilities section, you will also find stockholders’ equity, which is also called shareholder’s equity. The stockholder’s equity (the difference between the firm’s assets and liabilities), is an accounting measure of the firm’s net worth. The stockholder’s equity has two parts: 1. common stock, which is equal to the amount the shareholders/stockholders have directly invested in the firm by purchasing stocks from the company. 2. retained earnings, which are the profits made by the firm, but retained in the company with the aim of reinvesting it into assets or to be held as cash.
So the assets on the left side show how the company has used its capital (money), and the liabilities summarize the sources of capital, or how those assets were financed.
I will not dive into why this is important, but be aware of the following:
Assets = liabilities + stockholder’s equity
As you can see there must be a balance on the balance sheet. I guess you figured out why it’s called the balance sheet.
It is a complex world we live in, so we are not done talking about assets, since there is more to it.
A company’s assets can be divided into current and long-term assets. I will discuss both of them separately.
These kinds of assets are either cash or assets that can be converted into cash within a year. It included assets like:
- Cash and other marketable securities are short-term, low-risk investments that can be sold without much effort, and then converted into cash. It could be money market investments such as government debt that mature in a year.
- Accounts receivable, which are amounts owed to the firm by customers who purchased any goods or services on credit from the company
- Inventories are composed of raw materials as well as work-in-progress and finished goods.
- Other current assets, which is a catch-all category. It includes items like prepaid expenses (could be rent or insurance)
These assets are real estate or machinery that produce tangible benefits for more than one year. Long-term assets will reduce in value, which is why you will see a reduction in the value of the long-term assets, also called depreciation, according to a depreciation schedule that depends on an asset’s life span.
Now let’s talk more about the liabilities. They can like assets to be divided into current, and long-term liabilities.
Liabilities that will be satisfied within one year are called current liabilities. They include:
- Accounts payable. This is the amount owed to suppliers for products or services purchased on credit
- Notes payable and short-term debt. Loans that must be paid back in the next year. If a company pays back a part of a long-term loan within the next year this will also be listed here as the current maturities of long-term debt.
- Accrual items, like salary or taxes, that are owed, but not yet paid, and deferred or unearned revenue, which is revenue that has been received for products or services, that haven’t been delivered to the customer yet.
Again, long-term liabilities are liabilities that extend beyond one year. When a company needs to raise capital to purchase an asset or make an investment, it may borrow that capital through long-term loans. That loan would appear on the balance sheet as long-term debt.
So the clever reader might already now have seen that the current liabilities and the long-term liabilities are equal to total liabilities. The difference between a firm’s assets and the total liabilities is equal to the stockholder’s equity. It is also called the book value of equity.
Ideally, the balance sheet would provide investors with an accurate assessment of the true value of a firm’s equity. Sadly, this is unlikely to be the case. First of all, you must be aware that the assets listed on the balance sheet are based on historical costs rather than their true current value.
For instance, a building is listed on the balance sheet as its historical cost less its accumulated depreciation. However, the real value might be very different from that amount. We all know how buildings can appreciate in value, which means that the building could be worth much more today.
Although the book value of a firm’s equity is not good for estimating its true value as an ongoing firm, it can sometimes be used for estimating the liquidation value — This is the value that would be left after a firm’s assets were sold and its liabilities were paid.
That was all I had for the first lesson. Next, I’ll dive into the income statement. I hope you found it valuable.
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