In performing equity or credit analysis, in addition to external data about a company obtained from economic statistics, industry reports, trade publications, and databases, analysts rely on financial reports prepared periodically by the company which contains their audited financial statements along with supplementary disclosures.
A complete set of financial statements includes a statement of financial position (also called balance sheet), a statement of comprehensive income, a statement of changes in equity, and a statement of cash flows, together with associated notes and disclosures. In addition to the financial statements, companies provide additional information, such as management discussion and analysis (MDA)—also called management commentary, a letter from the chairman, a report from directors, a governance report, a corporate responsibility report, etc.
A balance sheet (also called the statement of financial position) presents a company’s financial position, i.e. its assets, and how they are financed, i.e. liabilities and equity at a specific point in time. Assets are resources controlled by the entity, liabilities are obligations to lenders and other creditors, and owner’s equity is the difference between assets and liabilities, and it represents the residual interest of the owners in the company.
A balance sheet is an expansion of the accounting equation, which is as follows:\[ Assets = Liabilities + Equity \]
This is why a balance sheet has two sides and they always balance, hence the name. It typically presents information about the prior year, such that the most recent year appears to the left (but the order may be different). Accounting standards, such as IFRS, require companies to classify assets and liabilities into current (short-term) and non-current (long-term). Further, there is often some order based on liquidity, non-current assets/liabilities before current assets/liabilities, or vice versa.
Statement of comprehensive income
Companies present either a single statement of comprehensive income or and income statement and a statement of comprehensive income which carries forward profit and loss figures from the income statement. Comprehensive income represents all items that affect owners’ equity other than transactions with the owners.
An income statement (also called profit and loss statement or statement of operations) presents information about the financial performance of a company. Revenue less operating expenses plus other operating income equals operating profit (also referred to as earnings before interest and taxes). Net income equals the difference between revenue and all expenses. Net income is also referred to as the bottom line because it appears at the bottom of the income statement.
A consolidated income statement also reflects the performance of the subsidiary companies. If the subsidiaries are less than 100% owned, an income statement shows the profit that is attributable to the non-controlling (minority) interest.
An income statement shows basic and diluted earnings per share (EPS). Basic EPS is calculated by dividing the income attributable to common shareholders by the weighted average number of common shares. Diluted EPS adjusts for the potential dilutive effect of stock options, etc.
Other comprehensive income (OCI) represents comprehensive income not reflected in net income.\[ Comprehensive\ Income = Net\ Income + Other\ Comprehensive\ Income \]
Statement of changes in equity
A statement of changes in equity reconciles the opening balances of shareholders’ equity with closing balances. Its components include paid-in capital, the investment of the owners, and retained earnings, the cumulative profits retained by the company. It also shows non-controlling interest and reserves resulting from other comprehensive income (either separately or part of retained earnings).
Paid-in capital increases with issuance of new shares and decreases with repurchase of stock already issued. Retained earnings increase with net income and decrease with dividends.
Statement of cash flows
A statement of cash flows presents a company’s cash flows from operating activities (transactions that affect net income), investing activities (acquisitions and disposal of long-term assets), and financing activities (obtaining and repayment of capital).
There are two methods of presentation of cash flow statement:
- indirect method, which starts with net income and adjusts its for non-cash income and expenses, and changes in working capital, and
- direct method, which shows major categories of operating cash inflows and outflows.
The indirect method reconciles net income with operating cash flows. It helps the analyst see whether the company’s primary source of cash flows from operating activities.