Accounts What can you learn about a company by analyzing its balance sheet, income statement, statement of cash flow and common size financial statement?  What are the general factors that...

Accounts

What can you learn about a company by analyzing its balance sheet, income statement, statement of cash flow and common size financial statement?  What are the general factors that influence the quality of a company's reported earnings and balance sheet?

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kipling2448 | (Level 3) Educator Emeritus

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You can learn quite a bit by studying a company’s balance sheet and other financial data.  In fact, assuming these financial records are accurate and there has been no attempt to defraud investors or the government, a detailed balance sheet provides pretty much everything one would need to know to grasp the company’s financial health.  Balance sheets, by definition, represent, sometimes in minute detail, both the assets and liabilities or debts a particular business holds or is carrying.  By examining the data on these forms, one can ascertain the degree of imbalance that may exist with respect to the amount of debt a company is carrying on its books relative to the value of its assets.  The goal, obviously, is to have these sheets either in balance – in effect, the company is breaking even between assets and debts – or, preferably, to have a balance sheet that reflects assets that exceed in value the amount of debt or obligation represented on the financial statements.  Depending upon the level of detail, one can glean from such information precisely where the company’s business is healthy and where it is showing signs of potential problems in the future.  Assets that may be ephemeral and prone to fluctuation weighed against concrete debts to suppliers or to others may indicate that the business has become a veritable “house of cards,” likely to default on its obligations at any moment.

Similarly, financial data that reflect a corporation’s cash flow can reveal a company with a healthy level of liquidity, or one with its minimal cash flow because its assets are not conducive to exchange arrangements in a timely manner.  Cash flow involves the inward and outward movement of cash.  The objective, once again, is to have financial statements that reflect more incoming cash than what is outgoing.  That only makes sense, but in practice may present difficulties.  A business that has an excessive file of “accounts receivable,” in effect, money owed it by its customers, probably has a cash flow problem and needs its customers to pay their bills so that the business can, in turn, pay its bills, including employee salaries. 

“Common size financial statements” are financial statements that show data in terms of percentages, for example, the percentage of a company’s assets that are cash, equipment, and so on.  Common size financial statements are generally used for comparative purposes, such as in analyzing multiple companies within a specific industry or when analyzing the same company over periods of time.

The common factors that influence the quality of a company’s reported earnings and balance sheet are, as mentioned, the types of both assets and liabilities.  An asset that depreciates, such as manufacturing equipment that is old or on the verge of obsolescence, or commodities like petroleum that fluctuate in value with relative rapidity have to be examined on that basis, and may weigh against perceptions of a company’s real value.  Similarly, debt that will likely diminish with relative ease on account of price fluctuations or expected changes in the value of the underlying good or commodity may appear to show a balance sheet that is more favorable than it appears at first glance.  In short, while the concepts of balance sheets and the other types of financial statements discussed are relatively simple, understanding those records may require considerable training in corporate accounting.

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