Why Do Investors and Creditors Look at Financial Statements?

Financial statements are formal records that convey a company’s financial activities and position. These documents provide a structured overview, allowing various stakeholders to make informed decisions. They are prepared following specific accounting rules, such as Generally Accepted Accounting Principles (GAAP) for U.S. companies. The reports offer insights into a company’s revenue, expenses, profitability, and cash flow.

What Financial Statements Reveal

The three core financial statements are the Income Statement, the Balance Sheet, and the Cash Flow Statement. Each offers a distinct view of a company’s financial situation. Publicly traded companies are required to issue these statements on a quarterly and annual basis by regulatory bodies like the U.S. Securities and Exchange Commission (SEC).

The Income Statement, also known as the Profit and Loss (P&L) statement, summarizes a company’s financial performance over a specific period, such as a quarter or a year. It details revenues earned from sales or services, subtracts expenses incurred, and ultimately shows the net income or loss. This statement provides insights into how efficiently a company generates profit from its operations.

The Balance Sheet provides a snapshot of a company’s financial position at a specific point in time. It lists what the company owns (assets), what it owes (liabilities), and the owners’ stake (equity). Assets are categorized as current or fixed, while liabilities are divided into current and long-term.

The Cash Flow Statement tracks the actual cash coming into and going out of a business over a period, categorized into operating, investing, and financing activities. This statement highlights a company’s liquidity and its ability to generate cash to sustain operations, invest in growth, and meet financial obligations. It provides a clearer picture of cash movements than the income statement, which can include non-cash transactions.

Why Investors Examine Statements

Investors examine financial statements to assess a company’s investment potential and overall financial standing. They use this information to determine whether to invest, hold, or divest their shares.

Investors scrutinize the Income Statement to assess profitability and growth potential. They analyze revenue trends, net income, and profit margins to understand how effectively a company is generating earnings. Profitability ratios like net profit margin indicate the percentage of revenue remaining after all expenses are deducted.

The Balance Sheet helps investors evaluate a company’s financial health and stability by examining asset quality, debt levels, and equity. A strong balance sheet suggests financial flexibility and potential for expansion. Investors also use the Balance Sheet to calculate ratios such as return on equity (ROE), which measures how much profit a company generates for each dollar of shareholders’ equity.

The Cash Flow Statement is reviewed by investors to understand a company’s cash-generating ability and sustainability. They analyze operating cash flow to see if the core business generates sufficient cash, and examine investment and financing activities to understand how cash is being used for growth or returned to shareholders through dividends.

Financial statements also provide data points for valuing the company. Investors use various valuation ratios, such as the price-to-earnings (P/E) ratio, derived from the income statement and market price, to determine if a stock is fairly valued, overvalued, or undervalued. They may also apply income approaches, like discounted cash flow (DCF) analysis, which relies on projected cash flows from the cash flow statement to estimate a company’s present value.

Why Creditors Examine Statements

Creditors, such as banks, bondholders, and suppliers extending credit, examine financial statements with a focus on a company’s ability to repay its debts. They aim to minimize the risk of default. Financial statements help them evaluate creditworthiness and determine lending terms, including interest rates and collateral requirements.

Creditors assess a company’s ability to repay long-term debt, known as solvency, by reviewing the Balance Sheet. They analyze debt-to-equity ratios to understand the proportion of debt financing compared to owner’s equity. A higher debt-to-equity ratio might indicate higher financial risk, potentially leading to stricter lending terms or higher interest rates.

Liquidity, or short-term solvency, is evaluated by examining current assets versus current liabilities on the Balance Sheet and short-term cash generation from the Cash Flow Statement. Creditors use ratios such as the current ratio (current assets divided by current liabilities) and the quick ratio (liquid current assets divided by current liabilities) to determine if a company can meet its obligations due within approximately 12 months. A healthy current ratio suggests a company has sufficient liquid assets to cover short-term debts.

The risk of default is a concern for creditors. They assess overall financial stability and the consistency of cash flows. Lenders often examine the interest coverage ratio, which compares earnings before interest and taxes (EBIT) from the income statement to interest expense, to see if a company generates enough income to cover its interest payments. A low or declining interest coverage ratio can signal an increased risk of default.

Creditors also consider the nature and value of assets on the Balance Sheet, especially if collateral is involved. For example, a bank lending to a manufacturing company might assess the value of its property, plant, and equipment as potential collateral for a loan. This evaluation helps secure the creditor’s position in case the borrower cannot meet their repayment obligations.