A Primer on Financial Statements
One of the major challenges facing corporate communicators is understanding the financial statements of public companies. First, there is the math. Then, there is the matter of all that unfamiliar jargon. What exactly is “free” cash, for example? No cash is “free.”
The purpose of this column and its next few installments is to give you an overview of the primary financial statements—the balance sheet, the income statement and the statement of cash flows—and how they are generated, so that you can make sense of a public company’s financial documents.
If you have trouble the first few times you try to understand financial statements, don’t worry: That’s normal. The more you read financial statements, the more comfortable you will become with the presentation, and the better able you will be to interpret them.
When getting started, it’s important to get a feel for the company and how its numbers are generated; this is the focus of this month’s column. Future columns will describe each financial statement in some detail and what you can learn from them.
First, when looking at your company or any other, you should think about it within a much larger framework. Some factors to consider are:
- Context. Look at the company in a context that includes industry trends, the economy, interest rates, the business cycle, etc. For example, the financial statements and ratios of retailers are vastly different from those of utilities. Also, financial statements in uncertain economic times, such as today, will probably be less impressive than when the economy is more robust.
- Trends. Look at the company in terms of how it has performed over the past three, five or 10 years. You might find that this year’s performance is much better, or worse, than the performance over the past few years. If so, find out why.
- Documents—especially those filed with the Securities and Exchange Commission. The 10-K, which is the SEC version of a company’s annual report, gives the definitive picture of the firm and is a must-read. You’ll find a wealth of information there.
- Outsiders. This includes suppliers, customers, competitors, analysts, bankers, unions, regulators, etc. What do they say and write about your company? This provides a largely unbiased perspective.
- Insiders. Insiders include current and former executives, board members, managers and employees. Individuals who are no longer with the company will probably be more forthcoming than individuals still with the company. Reporters love to talk with former officers and board members.
Public companies produce two types of numbers: unaudited and audited.
Unaudited numbers may be called management figures. They are produced for executives and managers for specific purposes, such as inventory control and cash flow projections.
The numbers in a 10-K are audited. That means an outside auditing firm reviews the numbers to assure that certain procedures have been followed so that the numbers conform with Generally Accepted Accounting Principles. It’s important to note that not all numbers that companies release to the public have been certified by outside auditors. The most important exception is the 10-Q, or quarterly statement, which contains unaudited numbers.
In general, the accounting rules public companies follow depend on the stock exchange they are listed on. Companies listed in the U.S. follow rules mainly promulgated by the Financial Accounting Standards Board (FASB), while companies listed in countries outside of the U.S. primarily follow rules promulgated by the International Accounting Standards Board (IASB). For the past several years, FASB and IASB have been working to develop “compatible accounting standards that could be used for both domestic and cross-border financial reporting.”
In addition, two main positions are involved in producing the numbers: accountants and Certified Public Accountants (CPAs).
- Accountants perform accounting and bookkeeping functions. They may or may not have a degree in accounting.
- CPAs meet specified educational and experience criteria, and pass a rigorous examination.
Most of the numbers in financial statements don’t stand alone. Each 10-K or annual report has numerous footnotes that expand on the numbers. Many stories go unwritten because reporters ignore the footnotes. By contrast, investors such as the legendary Warren Buffet and top analysts burrow deep into the footnotes to learn the company’s real story.
Oversight of public companies
The Securities and Exchange Commission is the primary regulator of public companies in the U.S. The SEC, which was created in the wake of the stock market crash of 1929, sees its role as:
- Protecting investors by requiring companies to make public certain information through various filings.
- Maintaining a fair and orderly trading market.
- Maintaining investor confidence in the market.
The SEC requires filings by companies with more than US$10 million in assets whose securities are held by more than 500 owners. Many private companies with more than 500 shareholders or with public debt offerings also have to file.
As a result of corporate fiascos such as Enron and WorldCom, the Sarbanes-Oxley Act was enacted in 2002. SOX, as it is frequently called, is the most far-reaching change of U.S. securities laws since the New Deal era. The law radically redesigned federal regulations of public company governance and reporting obligations. It also significantly tightened accountability standards for directors, officers, securities analysts and legal counsel.
Another outgrowth of SOX was the creation of the Public Company Accounting Oversight Board (PCAOB) as an independent board to oversee the practice of accounting and the reporting of corporate financial data.
Public companies prepare their numbers to conform with Generally Accepted Accounting Procedures (GAAP). These rules have evolved over time, and can be vague and ambiguous.
Words of caution
Now that you have some general ideas about a company’s numbers, it is time for some important words of caution. First, the numbers in an annual report or 10-K, though certified by an auditor and presented in accordance with GAAP, are a function of the accounting assumptions used in their preparation. The use of different assumptions will produce different results. You should read the footnotes to learn about the various assumptions.
Developing the ability to understand financial statements takes time and practice. Statement formats and terminology can vary by company. The more statements you read and analyze, the more comfortable you will become.