What are financial statements? Why are they important?
These should always be the first two questions that we look at when we start a new subject. It is the nature of a subject that we study and learn how to utilize. It is what a subject represents that tells us how it can benefit us.
So, what are financial statements, and why are they important?
Financial statements are official records of the financial activities, transactional, like capital purchases or employee payrolls, or investable, like lending and borrowing money, of a company over a marked period or a certain point in time. Financial statements usually consist of five components: a balance sheet, an income statement, an equity statement, a statement of cash flows, and a set of explanatory footnotes.
In this post, we are going to focus on one of its components: balance sheet, and discuss its significance with only the context of common knowledge.
A balance sheet records what a company owns, owes, and how much its shareholders own at a certain point in time. The above example is the balance sheet of Kodak on December 31st in 2006 and December 31st 2007. (Sometimes one balance sheet hold the balance information of a company at different times for comparison purposes.)
The assets category represents what a company owns. Under the asset category the entries are laid in such a pattern as the assets with most liquidity are on top and assets with least liquidity are on the bottom. (To find out what liquidity means, click here.) Cash assets with the highest liquidity is on top. Assets such as long term investments, facilities (property&plant), or intellectual property (intangibles) stay at the bottom. At the very bottom of the category is total asset, the sum of all previous entries. Kodak had a total asset value of 14,320 million dollars at the end of 2006 and 13,659 million dollars at the end of 2007.
The liabilities category represents what a company owes. The entries with the most “urgency” (debts with the closest payday) are listed on top. While entries with farther paydays are listed on the bottom. At the very bottom of the list is total liabilities, the sum of all previous entries under “liabilities.” Kodak had a total liability value of 12,932 million dollars at the end of 2006, and 10,630 million dollars at the end of 2007.
As we can see from the example above, comparing the balance records of Kodak between 2006 and 2007, its assets decreased by 661 million dollars worth. However, at the same time, its liabilities decreased by 2,302 million dollars worth. Even though what Kodak owns decreased, what it owes decreased by a greater extent. Therefore, we can conclude that over the year of 2007, Kodak paid off at least 2,302 million dollars worth of liabilities, and gained at least 1,641 million dollars worth of assets. (Note: Kodak could have taken some short-term liabilities and paid them off within the year of 2007, and those transactions won’t be recorded on a balance sheet. Hence the usage of “at least.”)
The stockholder’s equity category represents the assets that the company (stockholders) owns with no liabilities. Its total value is simply the difference between assets and liabilities. (Assets – Liabilities = Equity) Each entry under stockholder’s equity records how these equities are used. The sum of common stock and treasury stock is contributed capital. (Not shown as an entry above.) It represents the difference of cash a company earned from selling its stocks and spent on repurchasing its stocks. Retained earnings represent the amount of earnings that are reinvested back into the running of a company.
Kodak’s total stockholder’s equity was 1,388 million dollars worth at the end of 2006. It was 3,029 million dollars worth at the end of 2007. The difference of two years equity is congruent to 1,641 million dollars that we just calculated above. It means that Kodak earned 1,641 million dollars in the year of 2007.
Now, why is learning all the information we discussed important?
For investors, the ratio of equity versus liabilities tells us how much risk we bear in holding a company’s stock. The size of common stocks can help us determine what dividends we will receive if we choose to hold the stock. The size of retained earnings tells us how much a company is spending on itself for growth and expansion, which is particularly important for value-stockholders. The size of cash asset tells us how well a company can react to unexpected, or difficult situations. (Such as natural disasters, or legal scandals.) For business partners, they can use these information to strategize their partnership. For customers, who seek long-term services or product purchases, they can use these information to determine whether they will get high-quality service or product continuously.
The balance sheet is the only component of a company’s financial statements that is a “snapshot” and a “portrait.” It is a snapshot because it presents the company in one exact point in time. It is a portrait because it gives a complete anatomy of the financial structure of a company. It is often the first thing looked at by a new investor because it gives a most direct introduction to the company.
(P1 – http://mayrsom.com/2013/12/02/eastman-kodak-balance-sheet-analysis/)