Deciphering financial statements for non-financial professionals - Part 4

September 05, 2014

Frozen in Time

This fourth post in my Deciphering Financial Statements for Non-financial Professionals series addresses how you, as a financial statement reader, can use the statement of financial position to understand a company’s assets and liabilities and how you can apply that information in assessing its financial health. In this series of posts, I provide insight into financial reporting and related topics geared toward non-financial professionals who need to understand financial statements as part of their professional roles. I encourage you to also read the other installments in the series, past and future, particularly the introduction published on July 25, 2014 as that post sets the scene for the series and includes a number of resources you may find useful as you go along.

Some may find it useful to have a statement of financial position available while reading this post, which can be found at page 3 of the sample financial statement available at this link.

What’s a financial position?

The statement of financial position, also commonly referred to as the balance sheet, summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time, generally the last day of the company’s fiscal year. Unless it’s the first year of operations, you’ll find a column presenting the figures from the company’s previous fiscal year end next to the current fiscal year end figures. Observing two points in time side by side in this manner allows you to draw conclusions about the company’s operations during the year by observing where it started and where it wound up. Did cash go up or down? How about liabilities? All right there for easy viewing.

Assets? I like assets!

Most of us are familiar with assets because we have them ourselves – things like cash, computers, buildings and such. The assets section is divided into two categories: current and non-current. Assets are current if they can be realized (ie: sold, cashed in, collected, etc.) within the coming operating cycle. For most companies, the operating cycle is equal to its fiscal year but not always. Non-current assets are everything else and are often assets that the company uses on an on-going basis to produce revenues. Things like factories or long-term investments in other companies. An item called goodwill is sometimes seen in non-current assets, which is a balance arising when a company purchases another company for an amount exceeding its apparent value, representing hidden synergies that arose upon the combination of the two entities. The total of the assets section will equal the combined totals of liabilities and shareholders’ equity, reflecting where the resources came from to gain those assets.

Completeness of liabilities

Most of us are also familiar with liabilities as we often have some ourselves, such as a mortgage or car loan. Similar to assets, liabilities are divided between current and non-current for the same reasons as assets. Current liabilities are expected to be paid out within the current operating cycle and non-current will be paid further on down the line. Some individual liabilities will be divided between current and non-current, such as the payments for a long-term loan that are due within the coming year. Other seemingly long-term assets may be classified as short term if circumstances cause them to be due sooner than originally planned, such as in the case of a loan where the debt covenants have been breached. As an auditor, I’m primarily concerned about whether all potential assets have been accrued and sufficiently disclosed - this is an issue that you may also consider when reading financial statements.

Shareholders’ net ownership in the company

The third section, shareholders’ equity, is a little more foreign to us than the assets and liabilities because we don’t usually deal with these types of things in our own lives. This section has no current/non-current classification and, at a minimum, contains two sections: share capital and retained earnings (or deficit, as the case may be). In simple terms, share capital represents the amount of consideration that the company has received in exchange for issuing shares. This consideration is usually cash, but could also be for property or services provided to the company. Retained earnings simply represents the accumulation of the company’s earnings and losses since inception. You may see other categories within shareholders’ equity referred to as ‘reserves’. These reserves will have specific purposes, such as representing the aggregate value of stock options issued by the company. In the notes to the financial statements, you will find a definition of the reserves and the purpose of each. Overall, shareholders’ equity represents the shareholders’ net ownership in the company, being the equity remaining for distribution to those shareholders if all assets and liabilities were to be settled.

The details of a company’s shareholders’ equity transactions during the fiscal year are often summarized in a separate statement called the statement of changes in shareholders’ equity, which is useful in understanding the activity in this area of the company’s operations.

Estimates and other squishy things

The figures presented in the statement of financial position often require adjustments or estimates to be applied in order to present the most realistic figure. Simple examples include adjusting the year end bank balance for cheques and deposits in transit or estimating the amount of certain payables that are due at year end. Complex examples include fair value adjustments to derivatives or accretion of loans. In cases of such complex issues, you’ll need to look to the financial statement notes to understand the judgments and estimates management may have applied in order to determine the most realistic figure. In many cases, there will be specific note references accompanying the figures in the statement of financial position that will point you to the note disclosing the details of the figure and any critical estimates applied to determine the amount. It’s important to understand these subjective determinations applied by management as they can have a material impact on the operating results of the company, in some cases flipping a nice tidy profit into a disappointing loss, should the estimate prove to be in error.

What does it all mean?

Now for the fun part – how does one evaluate the health of a company through examination of its statement of financial position? It’s important to remember that you’ll need to consider a company’s financial statement as a whole and perhaps compare it to its peer companies when performing such an evaluation, but here are a couple handy ratios that can be useful when trying to separate the dogs from the stars.

Current ratio = current assets / current liabilities

This ratio reveals how much working capital a company has available to carry on operations in the short term. A ratio of 1:1 means there is essentially no working capital since all of the company’s current assets will be required simply to pay down its current liabilities. That being the case, a higher ratio such as 2:1 or 3:1 will better provide you with that warm, fuzzy feeling. A lower ratio such as 0.5:1 may predict trouble in the company’s immediate future.

Debt to equity = total liabilities / total shareholders’ equity

This ratio tells you how much of the company’s assets are financed through debt versus through the company’s own historical operations or cash infusions by its shareholders. There are many strategies to fund a company’s growth affecting this ratio’s results, but generally you want to see a lower ratio (ie: 1:2 instead of 2:1) as debt can be a costly method of financing.

These are simple ratios specific to the statement of financial position and there are many others that span the financial statements to provide deeper insight into a company’s health. I’ll cover such ratios in a later post once we’ve walked through further aspects of the financial statements.

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