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Financial Statements: Eight Things to Know

02 May 2019 by National Bank
Financial Statements

Understanding a company’s financial statements is an asset for any investor. It allows them to seize opportunities and avoid certain pitfalls. Here’s how to analyze them.

What are financial statements?

Financial statements are documents that a company must present at its annual meeting. Usually prepared by a certified public accountant (CPA) with assistance from management, they show different facets of a company’s financial health and must be approved by the board of directors. Financial statements help administrators and directors make the right decisions.

Here are the three main types of financial statements:

  • Balance sheet or statement of financial position: This presents the company’s assets and debts as well as capital as of the exact date of the end of the fiscal year.
  • Income statement: This indicates income, expenses and profits during the fiscal year.
  • Cash flow or statement of changes in financial position: This provides information about the company’s activities, financing from various lenders and investments. It reports the company’s cash flow.

As an investor, you can unearth valuable information from these statements. Here is some information you should examine closely.

1. Earnings per share

This ratio indicates the amount of net earnings compared to the number of company shares. In other words, it is the amount you would receive for each share if the company returned all its profits.

This data is generally already calculated in public companies’ financial statements. By comparing the information with that of previous years, you can evaluate the company’s growth rate and figure out the company’s position compared to its competitors.

2. Book value per share

The book value per share is an interesting ratio for a future investor. It can indicate whether the price of a company share is undervalued or overvalued. To calculate it, subtract the value of preferred shares from the shareholders’ equity. Then, divide the result by the number of shares in circulation.

If the share price is lower than its book value, the security may be undervalued. It would therefore have good growth prospects, which would reflect a potentially interesting purchase.

3. Accounts receivable collection

In financial statements, revenue should grow faster than accounts receivable. To evaluate this ratio, you have to divide the accounts receivable by the daily revenue.

A high ratio is reason to be cautious—a company could eventually experience problems getting paid.

4. Liquidity

The relative liquidity ratio indicates whether the company can meet its immediate obligations without selling inventory and without including its prepaid expenses. To calculate it, first add up cash, accounts receivable and short-term investments. Then you need to divide the result by current liabilities.

The result will indicate whether or not the company has difficulties meeting its commitments.

5. Inventory

Other interesting financial statement data? The company’s inventory. To calculate their ratio, divide the cost of goods sold by average inventory or the current period.

Is the inventory climbing at a rate faster than sales? This is a bad sign! In some sectors, such as perishable goods, a slow inventory turnover rate is abnormal. It could mean losses ahead. Conversely, a company that sells product quickly will generate more money.

6. Taxation

If a company benefits from tax cuts, this will inflate its net earnings. However, this is probably a non-recurring event.

Because it is very unlikely that a company can reduce its taxes year after year, it’s better to evaluate growth before taxes, which can be attributed to the managers’ performance. You will therefore get a better picture of the situation.

7. Internally generated funds

Internally generated funds are net earnings plus depreciation expenses (non-cash outflows), after investments in working capital (the sum intended to cover current expenses).

Ideally, these should exceed the net profits. Otherwise, this may be a symptom of a future slowdown.

8. Amortization

The purpose of amortization is to include in the accounts the wear and tear on certain equipment. An increased amortization expense can generate weaker profits, and vice versa.

A company may be tempted to underestimate amortizations, which is difficult for an investor to detect. To get a clear picture, compare the company’s approach with that of other companies in the same sector. To help you, information in the notes to the financial statements of public companies in the same sector is available on the SEDAR website.

Familiarizing yourself with this information will help you better understand and analyze financial statements, an undertaking that can be very complicated for non-specialists. Your advisor can also help you get a clear picture so you can better choose your investments.

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