When you are looking to invest in individual stocks, it makes sense to look at the company’s financial statements (or at least the company profiles on Yahoo! Finance and Morningstar). This series “Looking at Company Financial Statements and Ratios” tries to break down some of the things you should look at to help understand how the company is doing and whether the company stock price is fair. Last week, we covered liquidity ratios, looking at how easily a company can cover its current liabilities. This week, we’re going to go back to the beginning, and cover financial statement basics. What are the parts of a financial statement? What do each of them do? Then we’ll go through what you can learn from the accountant’s report.
Financial Statement Basics
Financial statements are reports that cover a company’s current financial position, how it got there, and how it changed. All companies generate financial statements, even if they don’t realize it. For that matter, your personal income tax return is basically a financial statement. It is a very specialized income statement that you prepare for the government each year. When the term financial statement is applied to publicly traded companies, it usually refers to the annual or quarterly statements that the company prepares for investors and the SEC. You can find all these statements on the SEC Edgar Search site, or on the Investor pages on the company’s website.
The main parts of the financial statement are:
- The Accountant’s Report: This shows who prepared the statement, and how confident the auditing accountant is of the information presented in the statement.
- The Balance Sheet: A listing of all of a company’s assets, liabilities and equity at one period of time. For an annual statement, that period will be on the last day of the company’s fiscal year.
- The Income Statement: A list of all of the company’s income and expenses for one period (usually one year or one quarter).
- The Statement of Cash Flows: A list of adjustments showing changes to a company’s beginning and ending cash balance.
- The Statement of Shareholders Equity: A list of all factors that affect balances within the equity section of the balance sheet, including stock sales and repurchases and dividends.
- Accompanying Statements: A list of disclosures and additional information, complementing the statements.
Why You Should Care about Financial Statements
If you want to invest in an individual stock, you need to understand the company’s health. While financial statements present past rather than future information, most of the information presented in them does have impact on future performance. Knowing how to read the statements gives you a good idea of what the company does, how effectively its management team has performed and what concerns you should have about the company. If you know what financial statements do, you can look for ways the data might have been manipulated.
The Accountant’s Report
The Accountant’s Report, or Auditor’s Report, is short but important. The accountant’s report will give the reader the name of the auditor. It will state that the financial statement has been prepared under the Generally Accepted Accounting Principles (GAAP). Most importantly, it will state how sure the auditor is that the information in the statements is accurate. Most of the time, the auditor’s opinion is that the statement presents fairly, in all material respects, the financial position of the company. This is an unqualified opinion, and you can think of it as the accountant’s seal of approval on the preparation of the statements.
If you are reading the report and see a statement that gives some area where the statement does not conform to GAAP, this is called a qualified opinion. This is usually for one issue that affects part of the statement without compromising the entire picture the statement presents. A qualified statement may indicate a big problem or it may just indicate a minor deviation from standard procedure. It is important when looking at a qualified opinion to determine where and how much of an impact is being made.
An adverse opinion is presented when the auditor says that the statements do not fairly represent the financial condition of the company. An adverse opinion is always a symptom of a big problem. It essentially means that you cannot trust the information provided in the statements to give you an accurate picture. Another problematic opinion the auditor may raise is that the company may have difficulty continuing as a going concern. Either of these should be a red flag for any investor.
Additionally, sometimes the accountant’s letter will disclose that the previous statements were prepared with a difference in methodology or presentation. Sometimes these changes are due to changes in GAAP. Sometimes they are due to the fact that previous statements were audited by a different company. It is important to understand these differences so that you can make good comparisons of the company’s performance in different years.
Finally, while annual reports are usually prepared by an independent auditor, quarterly reports may not be audited or may be prepared by an inside team. If the financial statement that you are looking at is not prepared by an independent auditor, you want to know and adjust your expectations of its reliability accordingly.
Why You Should Care about the Accountant’s Report
If you are going to go through the trouble of looking at a financial statement, you need to at least look at the report to make sure that there are no red flags to turn you off right away. An adverse opinion or going concern opinion, while rare, are not easily ignored. And, since you probably want to look at more than the two years presented in most financial statements, an accountant’s report disclosure of a change from previous years can help you figure out what information is truly comparable.
References and Further Reading
Auditor’s Report-from Wikipedia
The Four Basic Financial Statements-from Accounting Tools