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Finanical Statement Analysis for Investors - Part 1
Course Section 3 - Lesson 4
Every company keeps records of its financial position and the results of operations. However, publicly traded companies are unique in that they must make these records available for anyone to review. Every quarter, all publicly traded companies release four major financial statements: Balance Sheet, Income Statement, Statement of Cash Flows, and a Statement of Changes in Shareholders Equity.
These documents provide investors with a very clear view of exactly how a business is performing at any point in time. A complete understanding of these documents can require a college degree in accounting and many years of experience. However, investors often don't need to understand every nuance of how transactions are reported in these statements to make informed decisions. In this lesson and the following two, I will walk through how we can use these documents to make better investment decisions.
But before we do that, I want to start with an explanation of each.
The Balance Sheet
The Balance Sheet provides you with a snapshot of a company's financial position at a point in time. The document provides you with a listing of all assets (things they own), liabilities (debts they owe), and equity (what's left for owners) at the end of a given period.
For Each section of the Balance Sheet, line items are listed from the most "Liquid" or the easiest to convert into cash to the least.
One nuance of the balance sheet that is important to understand is that items are listed at cost (what a company paid to acquire an asset), not at fair market value. At first, this may seem counter-intuitive. Suppose you're looking at this document to understand a company's financial position. In that case, you care much more about what the assets are currently worth than what the company paid for them. However, establishing a fair market value for something like 150 restaurant buildings is tricky. Because of this, regulators have settled on an at-cost requirement to prevent management from aggressively fudging the numbers to make their company look more attractive than it really is.
We will primarily use the balance sheet to determine whether companies are putting themselves in precarious financial situations.
The Income Statement
The income statement gives investors insight into how a business performed over a given period, typically a quarter or a year. The document begins with revenue and deducts various expenses as the reader moves down the schedule. At the bottom of the income statement, readers will see both a net income line item and net income on a per-share basis.
The income statement is useful because it helps us understand how a business makes money and where the major costs for a business lie.
We can use the income statement in a few different ways; by looking back at historical statements, we can:
evaluate how well the management team performed,
determine how volatile certain revenues and expenses are,
set baseline estimates for line items to use in forward-looking projects.
We will do all of these as we progress through our analysis of TXRH.
The Statement of Cash Flows
There's an important concept in accounting called accrual accounting. Accrual accounting refers to a methodology of preparing financial statements such that revenues and expenses are matched to the period in which they actually occurred. For instance, imagine you run a bakery. In January, someone prepays for a cake that is to be delivered in February. Under an accrual basis, you would not recognize that revenue until February - even though you actually received the cash in January. Public companies' income statements are prepared on an accrual basis.
While accrual accounting is excellent for providing an understandable breakdown of a company's operations - it does not provide clarity around when cash is actually changing hands.
The statement of cash flows provides this information and more. The document is split into three sections:
Cash Flows from Operations,
Cash Flows from Investing, and
Cash Flows from Financing
Cash flows from operations remove the effects of accrual accounting so that you, as an investor, can see precisely how money moved during the course of business.
Cash flows from investing show flows resulting from purchasing or selling long-term assets, such as a factory or a restaurant building.
Finally, cash flows from financing show transactions that occurred in association with debt and equity issuance.
Types of Analysis we will Perform
There are primarily two ways that we will be reviewing these documents: Vertically, Horizontally, and through Ratios.
Vertical analysis refers to the practice of analyzing a single year within a particular statement. When we do this, we will often convert a given statement to a "common size." This refers to taking every value in the statement and looking at it as a percentage of either total assets (in the case of a balance sheet) or revenue (in the case of an income statement).
Horizontal analysis refers to the practice of looking at the same line item over many periods (quarters or years) to see how that line item changes over time.
Ratio analysis is the practice of combining two or more related fields in a given statement to derive a figure that is comparable to itself over time and to other companies.
In upcoming lessons, we will be performing all three types of analysis on Texas Roadhouse and its competitors.
A Note on Aggregating Data
It used to be the case that all of this data had to be compiled by hand. As you can probably imagine, doing the necessary data alignment and calculations this way would be time-consuming. Today there are many tools available to help with the grunt work; one of my favorites is Tikr.com.
Tikr is a web application that makes the process of financial statement analysis easy by automatically aligning statements across periods and conducting ratio analysis calculations. I'd suggest heading over to Tikr to sign up for a free account so that you can do the same.