Chapter 3: Introducing financial statements

The bar is in full swing, and floating rounds of cocktails permeate the garden outside, until the air is alive with
chatter and laughter, and casual innuendo and introductions forgotten on the spot...
F. Scott Fitzgerald (from The Great Gatsby)
In this chapter you will be introduced to the financial statements of firms. It will be sort of like meeting
someone for the first time at a party, perhaps along the lines of Sarah, this is Chris; Chris, this is Sarah. Once
introduced, you know each others name and a bit about what each other looks like, but not a lot else. To really
get to know someone you need to do more than simply be introduced at a party. But once you are introduced
you have the opportunity to get to know each other better. You can talk to each other about where you are from,
what you do, what music you are interested in, what movies you may have seen recently; and then later, about
deeper and more personally meaningful things about each other. But at parties, many people do not necessarily
do this. It can be so easy to skate over the surface in our relationships and to not really be that interested in the
people we meet.
It is the same with being introduced to financial statements, maybe for the first time as you read this chapter.
You might feel a little bit shy, perhaps a bit overwhelmed or worried, even though you may try to maintain an
image of cool confidence in front of your friends. When Chris and Sarah are introduced at a party they are each
much more than simply their names; but for getting to know each other, it is a good place to start. It is the same
with financial statements. We will see there are four general purpose financial statements some businesses are
required to provide: the balance sheet, income statement, statement of changes in equity and cash flow
statement. But there is much more to a firms financial statements than simply their names.
Each of us are different and we will see that firms and their financial statements are each different as well. There
are no specific rules about how firms set out their financial statements, so different firms will set them out in
different ways though there will be some general patterns they will use. We will also see there are no rules
about what we call or name different items in the financial statements (or even the financial statements
themselves), so there can be different names used for the same or similar items. It is like how most people have
two eyes, a nose and a mouth, yet all of us have such different and unique faces which we use to communicate
with those around us.
As part of getting to know the ideas, concepts and facts about financial statements you will need to be able to
recall some things. Just like remembering someones name at a party. If Chris and Sarah were introduced to
each other at a party and then an hour later bumped into each other again and neither could remember each
others name, how far is their relationship developing? Not very far. They really know nothing about each other,
not even each others names. It is very difficult to remember anything unless we are interested in it and it means
something to us personally. Not remembering someones name probably means we are not very interested in the
other person.
But when we understand something, and what it means to us and how it is connected to our lives and to our
prior knowledge and previous understanding of the world, then we generally just remember it. We do not have
to try to, we just do; including remembering someones name who we are interested in. In this chapter you will
have the chance to be introduced to four financial statements, like being introduced to four people at a party.
You will then have the chance to think about how we can make sense of a firms financial statements, including
how they can help us to understand how firms add value in business. So, welcome to the party ... OK, OK ...
some parties we may look forward to more than others ... but we can always be surprised.
3.1 A view of business at rest
The financial highlights offered at the beginning of the report tend to focus on what they (the company) want you
to seebut thats just an appetizer. The second coursethe big plate of meat and potatoes is the financial
statements.
Richard Loth
Now what do financial statements look like? In the annual reports of your firm you will likely see lots of glossy
photos with happy people and sunny skies everywhere and often with optimistic comments from the Chairman
and Managing Director. You will see heaps of words and photos. If you think your firms annual report is not a
marketing document, think again. It is a marketing document. By this I mean the firms management is seeking
to tell you some stories about their firm. They want to communicate to you messages they want you to hear and
to influence your behaviour (particularly if you are an investor, but also, for example, to help their staff feel
good about the firm they work for). You will see at the back of your firms annual report that there are a lot of
numbers and some words in a few tables with headings like Balance Sheet (or perhaps Consolidated Statement
of Financial Position), Income Statement (or perhaps Consolidated Statement of Financial Performance),
Statement of Changes in Equity and Cash Flow Statement.
A firms annual report is the whole glossy document. The financial statements are part of the annual report that
usually comprise a balance sheet, income statement, statement of changes in equity and a cash flow statement.
They also include a statement of accounting policies, a great long list of footnotes and also usually a five year
summary of some key financial and non-financial information. In this section we will have a look at the balance
sheet. As we do this we will start thinking about how we could ever possibly use these financial statements to
engage with and connect to what is really going on in a firm. And just as I love to introduce my friends at
parties to new people, let me introduce you now to the balance sheet.
Balance sheet
A firms balance sheet shows its financial position on a particular day; that is right, on just one day. Have a look
at your firms financial statements and look at its balance sheet. You will see it says in the heading that its
balance sheet is as at a certain date. At the top of Ryman Healthcares balance sheet it says Consolidated
Balance Sheet as at 31 March 2013. A firms assets, liabilities and equity are shown in its balance sheet as at
a certain date, say 30 June, 31 March, or 31 December or whenever its balance date is. A firms balance date
can be any date. Many companies will use the same date as the end of the normal tax year in their country,
which is 30 June in Australia and 31 March in New Zealand. However, there are a range of balance dates used
by different companies.
As we saw in Section 2.3 in Chapter 2 above, we want to know what is happening to a firm at regular intervals
during its life. Now businesses have a life-span just like we do; some shorter than others, others longer (again,
just like us). But usually we are not prepared to wait for the firm to go through its entire life before we assess
how well it is going. We want to know how it is going along the way. You will see in your firms balance sheet
it includes assets, liabilities and equity. You may remember we talked about what assets, liabilities and equity
are in Section 1.4 in Chapter 1 above. They are three of the five elements of accounting. The balance sheet gives
us a picture of a firms assets, liabilities and equity on a given day. Balance sheets are usually produced at least
once a year. This gives us a chance to see these three elements of a firms accounts each year, rather than wait
until the end of a firms life.
Have a look at your firms balance sheet. There is no required format, so you will see different firms will set out
their balance sheets in different ways. There are also no standard terms to use for different items; so different
firms can tend to use a range of different words for the same item. But just as we each have a different face, so
our faces also have some similarities such as we usually have two eyes, a nose and a mouth. You will see a
number of similarities between the balance sheets of different firms. For instance, you will see next to some of
the items numbers referring to specific footnotes. In Ryman Healthcares balance sheet next to the item
Property, plant & equipment there is a reference to footnote 7. When we look at footnote 7 among the
footnotes there are three pages (yes, three pages) of further information about Ryman Healthcares property,
plant & equipment. Ryman Healthcares balance sheet fits on one page but the footnote for just one of the items
on its balance sheet (property, plant & equipment) takes all of three pages.
No need to worry about all this detail in the footnotes yet. You are just getting introduced to your balance sheet,
like Chris and Sarah being introduced at a party. There is much more to get to know about each other than
simply being introduced. But introductions are a good place to start. Going back to the balance sheet, you will
see there are lots of footnotes next to many of the items in your firms balance sheet. Have a quick look at some
of these footnotes. Do not get worried about trying to understand them; just have a quick look at them.
Your firms financial statements include the footnotes. So reading the footnotes is part of reading your firms
balance sheet. But we do not usually read through the footnotes in one go. Rather, as we look at a balance sheet
we can refer to the footnote that relates to a specific item to get further information about that item, as we wish.
The use of footnotes gives us an uncluttered balance sheet, providing an overview of a firms financial position
not just on a particular day but also just on one page, with a lot more of the details included in the footnotes
which are available to us as we need them.
Not just one company
In your firms financial statements you may see two sets of financial numbers; one may be headed group or
consolidated and another may be headed parent
1
. Ryman Healthcare has this. Almost all listed companies
will not just be one company but a group of companies. This means there is a parent company which is the
company you actually buy shares in, should you buy shares in your firm. This company controls a number of
subsidiary companies, which typically means the parent company owns between 51% and 100% of the shares in
these companies. Though the parent company of your firm controls its subsidiary companies (that is, the parent
companys management runs the group of companies as a single economic entity, calling the shots in the
subsidiary companies) it may not necessarily own all of the equity in its subsidiary companies.
You will be able to find a list of all your firms subsidiary companies along with the shareholding the parent has
in each of them in one of the footnotes in your firms financial statements. In the Ryman Healthcare balance
sheet one of its assets is called Investment in subsidiaries. Next to this item is footnote 23. When I turn to that
footnote, which is quite a lot pages from the balance sheet, I find a list of its subsidiary companies. In Ryman
Healthcares case there are 25 subsidiary companies and all are 100% owned by the parent company. Most
subsidiary companies are named after one of its retirement villages, such as Anthony Wilding Retirement
Village Limited.
By the way, only four of Ryman Healthcares 24 retirement villages are named after guys: Anthony Wilding,
Edmund Hillary, Ernest Rutherford and Bob Owens. Most people in the world have heard of Sir Edmund
Hillary who (with Tenzing Norgay) first climbed Mt Everest; and quite a few have heard of Sir Ernest
Rutherford (a Nobel Prize winner and father of nuclear physics). Ernest Rutherford is also on New Zealands
$100 note. One of Ernest Rutherfords friends at uni (at the University of Canterbury in Christchurch) was
Apirana Ngata. He is on the $50 note in New Zealand. Not bad; two friends at uni both later managed to get on
their own New Zealand bank notes.
Although Sir Apirana Ngata was acting Prime Minister of New Zealand for a few days (the only Maori to have
done this so far in New Zealand), he has not yet made it to the (possibly) higher accolade of having a Ryman
Healthcare retirement village named after him. Anthony Wilding won Wimbledon eight times in the early 20th
century (the only New Zealander to ever win Wimbledon) and Bob Owens founded Owens Group, a major
supply chain company in New Zealand. The fact most of Ryman Healthcares retirement villages are named
after women (and not men) is probably fitting as the overwhelming majority of people in retirement villages are
women; guys are literally a dying breed in the older age group that frequent the worlds retirement villages. As a
guy, I am determined to do my bit to reverse this worrying statistic in the future.
So the balance sheet is actually two sets of balance sheets: the balance sheet of a group of companies,
comprising the total economic entity controlled by the parent companys management team; and the balance
sheet of the parent company by itself. We are not interested in the parent accounts but rather in the group or
consolidated accounts. This applies to the balance sheet and to each of the other financial statements. The
reason for this is that we are interested in understanding what is going on in the group of companies that are
controlled by the management of the parent company; this is the economic entity we are interested in
understanding. The parent companys accounts are usually of little interest to us as they relate simply to that
part of the activities of the firm that happen to reside in the legal entity of the parent company and ignore all the
rest of its activities that happen to be held in corporate legal entities separate to the parent.
Whether certain assets or liabilities are held in a firms parent company or in a subsidiary company does not
really matter to us, except in one area. Your firm may have only 100%-owned subsidiaries. That is the case with
Ryman Healthcare. However, your firm may have some subsidiaries that are less than 100% owned, say 51%
owned by the parent company. In this case, the parent company does not own all the equity in these partly-
owned subsidiaries. Someone else owns some of this equity and they are the minority shareholders (called non-
controlling interests) in the partly-owned subsidiaries. You can quickly tell whether your firm has any partly-
owned subsidiaries by looking in the equity section of the balance sheet of your firm. If you see an item in your
firms equity called non-controlling interests or minority interests, you know it has some partly-owned
subsidiaries. An item called non-controlling interests or minority interests in the equity of your firms balance
sheet represents the equity in the subsidiary companies not owned by the parent company (and thus not owned
by the equity investors in the parent company). It is the bit of the subsidiary companies owned by someone else.
So you can see the consolidated balance sheet of your firm shows the assets, liabilities and equity of a group of
companies, not just the parent company. If there are some partly-owned subsidiary companies controlled by
your firm, the equity interests of the minority shareholders in those subsidiary companies will be shown as non-
controlling interests or minority interests. Ryman Healthcare owns 100% of all its subsidiary companies so it
has no non-controlling interests in its balance sheet. You will probably also see that your firm has two years of
numbers in its balance sheet, perhaps for 2013 and 2012. It is usual to include two years of numbers. If the
accounting policies of the company in both years are consistent, the amounts for each item can be easily
compared to see what has been changing and what has not. Setting it out this way makes comparing numbers
between the two years easier.
We have seen that a firms balance sheet shows the position of a firm at a particular date. But we know that
business is not static. It is on the move all the time. There are things happening to firms every day. Your firm
will be changing all the time; it is changing today as you read this book and as you look at its financial
statements. Let me now introduce you to three other financial statements that show the firm on the move over
a period of time, showing what is happening between each snapshot in a moment of time given by a firms
balance sheet.
3.2 Business on the move
To live in Australia permanently is rather like going to a party and dancing all night with ones mother.
Barry Humphries
A firm is forever dancing with others, exchanging value in markets as it seeks to add value to its equity
investors. Businesses are active, doing things all the time. For this reason firms are changing all the time and
can often be very fast-moving. One of the exciting things about running a business is facing all the challenges
that arise each day. It is true some businesses may move more slowly and be more boring than others, and may
feel a bit like Barry Humphries (a well-known Australian comedian) dancing with his mother all night. For
other firms, the ride can be more exciting. But whichever way it is, it is still a ride. Business is not about sitting
still on the sidelines.
It is difficult to see this changing world of business from a firms balance sheet. The changes in a firms balance
sheet from year to year give little information about the many steps involved in moving the business forward
from the end of last year to the end of this year. Three further financial statements tell us something about what
has been happening on the journey or movement of a business between the snapshots of two balance sheets.
The key one is the income statement which shows the revenue and expenses and thus the profit of our firm over
a period. The other two financial statements give us insights into how two key items in our balance sheet have
changed: equity and cash. First of all, let me introduce you to the income statement.
Income statement
...mega-corporations have a huge influence on our daily lives ... [and] are generally only concerned with one thing
... the bottom line. That is, maximizing profit, regardless of the social or environmental costs.
David Suzuki
A firms income statement shows how things are changing in a firm over a period of time, usually one year. We
saw in Chapter 1 that the view of business underlying accounting sees everything a firm does as affecting itself
and its equity investors and no-one else. So it should come as no surprise that the income statement shows how
the various activities of a firm during a period, usually one year, have affected the equity investors. The income
statement shows a firms revenue and expenses. Revenue less expenses equals a firms income for a period.
This is the bottom line of your firms income statement, which is the line at the bottom.
As you look at your firms financial statements and also compare them with the financial statements of other
firms, you will see how different firms can set out their financial statements in quite different ways. That is fine.
There are no fixed rules for how we set out our financial statements, or even what we call different items. So we
see lots of variety in how financial statements are presented to the world. But the concepts and ideas embedded
in the accounting numbers are all basically the same. In your firms income statement you will see various
revenue items and some expense items. You will see most expenses of your firm are probably not disclosed.
This is because there is no requirement on firms to disclose most of their expenses, so they usually do not.
You will also see that just like the balance sheet there are usually two columns showing the group or
consolidated numbers and the parent numbers. We are only interested in the group accounts. These numbers
include all of the revenue and expenses of a group of companies (and all of its income or profit, which equals
revenue less expenses). Where a parent company does not own 100% of the equity in all of its subsidiary
companies, not all of the profit of the group of companies will actually be for the benefit of the equity investors
in the parent company; some of it will be for the benefit of minority investors in the partly-owned subsidiary
companies.
In such a situation, you will see non-controlling interests or minority interests deducted from group profits in
a firms group income statement to arrive at the profit belonging to the equity investors in the parent company.
As with the balance sheet, you will also see various footnotes next to some items in the income statement. You
can have a look at these footnotes to get more detail on various items in the income statement. The balance
sheet and income statement set out all five elements of accounting: assets, liabilities, equity, revenue and
expenses. Indeed, we could check out whether the extended fundamental accounting equation works for our
firm by taking the numbers from our firms financial statements and put them into the equation:
Assets + Expenses = Equity + Revenue + Liabilities
To do this, we would only need to look at the balance sheet (for assets, equity and liabilities) and the income
statement (for revenue and expenses). So why do we need any more financial statements? After all, we found
out in Section 1.4 in Chapter 1 above that there are only five elements of accounting. There are not any more
elements, or aspects of business, that we look at in the business model underlying accounting. So surely we
have it all covered with just these two financial statements? Well, yes and no. There are a couple more things
about the changing nature of business that we are interested in finding out about. One of these is to do with what
changes in equity.
Statement of changes in equity
As you look at your firms financial statements you will see it will have another financial statement which may
be called statement of changes in equity. It can be called a range of different names and on first introduction at
a party may sometimes have a pretty confusing appearance to us. In some ways, the statement of changes in
equity can be the most nerdy or geeky of the financial statements to meet. Do not worry. It takes a range of
people to brighten and deepen the mix of our lives. Just go with it and over time you will get to know and
appreciate the part played by your firms statement of changes in equity.
This financial statement shows the various changes in shareholders equity over a period of time. Have a look at
it for your firm. Do not worry that you may not understand what some of the items are at this stage. Have a look
at the general format of your firms statement of changes in equity. Try to make some sense of it. It will show
opening equity; the profit (or loss) for the period (as also shown in the income statement); possibly various other
items (often called other comprehensive income); and various payments or transfers between your firm and its
equity investors, such as dividends or share issues. Sometimes, as in the case of Ryman Healthcare, it can have
a lot of columns for each of the different items of equity, showing how they each changed during the year. Do
not worry about all this detail. Just have a look at the total equity column. After all, we are only at the stage of
first introductions.
Other comprehensive income items are changes in the value of your firms equity that have occurred as a
result of your firms activities in the period (and not as the result of transfers between your firm and its equity
investors). They are often shown separately in the statement of changes in equity because they have not been
included in your firms income statement. In other words, these items, instead of being included in your firms
income statement and thus in your firms profit (or loss) for the period, have been put directly into your firms
equity account. So we cannot find these items in a firms income statement; we have to look at our firms
statement of changes in equity to find them. Other comprehensive income can also sometimes be shown in a
statement of comprehensive income, separate to the income statement (as is the case with Ryman Healthcare).
2

Cash flow statement
Never ever discount the idea of marriage. Sure, someone might tell you that marriage is just a piece of paper. Well,
so is money, and what is more life-affirming than cold, hard cash?
Dennis Mille
Finally, your firms fourth financial statement is its cash flow statement. The cash flow statement shows the
opening cash balance at the beginning of the period (which is mainly its bank balances on that date, although it
might hold some actual cash on that day as well), cash inflows and outflows during the period (usually a year)
and the closing cash balance. Now cash is an asset of a business just like any other asset. You will see it is one
of the assets in your firms balance sheet. The opening cash balance is your firms cash in its balance sheet one
year ago; the closing cash balance is your firms cash in its latest balance sheet.
You will see lots of other assets besides cash in your firms balance sheet. Why do we have a special financial
statement showing details about the changes in cash balances from one balance date to the next and not one for
the changes in each of the other assets of our firm as well? The reason for this is that there is only one way a
business (or individual) can go broke or go into liquidation; and that is to run out of just one of its assets: cash.
As long as we do not run out of cash, no matter how big the losses we may make in our business we will not go
broke and can keep on trading. However, the moment we run out of cash, no matter how many other assets we
might have or profts we might be making, we are in trouble; serious trouble.
If we run out of cash we cannot pay our suppliers or our employees. This usually upsets them a lot; and very,
very quickly. If we suggest to our employees we could pay their salaries by giving them an office chair or
perhaps a filing cabinet, they usually look at us like they want to strangle us with both hands firmly around our
neck. The reason for this is that cash is a widely accepted form of payment in our society. It is why people say
cash is king (a sort of Elvis Presley amongst all other assets); no other asset on our balance sheet has the
same negotiability as cash.
We also saw in Section 2.3 in Chapter 2 above that we use accrual accounting. This means our firm will record
in its accounts various transactions, such as revenue and expenses, when they are judged to actually occur which
may not necessarily be when cash is paid or received (it often is not). By contrast, the receipt and payment of
cash in and out of our firms bank account requires no judgements to be made by those preparing our firms
financial statements; all they need to do is look up the firms bank account.
Trust relationship in business
Your firms financial statements reflect the powerful idea that we can view a firm as separate to its owners. This
simple idea has greatly influenced modern business. As we view a firm as separate to its owners then everything
a firm does has two effects: one on its owners (equity) and the other on itself (assets and liabilities). This is what
our firms balance sheet shows at a single point of time. It shows the assets the firm has been debited with, as
the firm owes an obligation to its equity owners for all the assets it controls and which are the means by which
the firm can generate future value to meet that obligation or debit it owes to its owners. Your firms balance
sheet also shows the equity and liabilities it has been credited with, each recognising someone outside the firm
has believed, trusted, or credited it to repay them in the future.
In this way, your firms balance sheet expresses the trust relationship that exists between a firm and its owners
and also with its debt providers. Your firms balance sheet shows that others have entrusted the firm with
resources in exchange for IOUs (that is, I-Owe-yoU), being equity and liabilities. It also tells us what the
assets are that the firm controls and which are expected to generate future value to repay those IOUs, that is to
repay their trust in the firm. The equity or IOUs of the business to its equity owners change in value over time
as a firm either adds value or reduces value as a result of its activities. Receiving revenue from people outside
the firm increases value to equity investors; incurring expenses by paying people outside the firm reduces value
to equity investors. Revenue and expenses are the two temporary elements of accounting.
Instead of including revenue and expenses directly into equity as each transaction or activity of a firm occurs,
we keep these changes separate from equity for a period of time in temporary revenue and expense accounts. At
the end of each period (usually a year) we empty out each revenue and expense account and put the balance of
all these accounts into a profit and loss account. This will be a positive number if revenue is greater than
expenses for the period (this is called making a profit); or will be a negative number if revenue is less than
expenses for the period (this is called making a loss). We then start out the next year with zero balances in our
revenue and expense accounts.
The profit or loss for a period is transferred to equity at the end of a period, as shown in our statement of
changes in equity. Also usually included in the statement of changes in equity are other comprehensive
income items, which are transactions or activities of a firm that did not go into the temporary revenue or
expense accounts (and thus did not end up in the profit or loss figure in our income statement) but instead were
put straight into equity as they occurred. The statement of changes in equity also shows the transactions that
occur directly between a firm and its owners, for example payment of dividends. The statement of cash flow
shows some details of how cash changed between one balance sheet and the next, helping us to see where cash
came from and went to during the year. Now that you have been introduced, let us consider in the next section
how we can make sense of what financial statements might have to tell us about the economic and business
realities of firms.
3.3 Making sense of financial statements
the most striking aspect of the present state of ratio analysis is the absence of an explicit theoretical structure
the user of ratios is required to rely upon the authority of an authors experience. As a result, the subject of ratio
analysis is replete with untested assertions about which ratios should be used and what their proper levels should
be.
James Horrigan (1968)
With the growing availability of financial statements over the past 100 years or so, people have developed ways
to analyse or make sense of the information they contain. People have taken an old idea from the ancient Greeks
about ratios and used this to focus on the relationship between different items in a firms financial statements.
People have sought to use these relationships, or ratios, to predict whether a firm might be more or less likely to
fail in the future; or, perhaps more positively, what its earnings or other performance measures might be in the
future. The only problem with this was there was no clear reason why these ratios should be useful to predict
future outcomes of firms. There was no reason, no theory, no mental framework or reasoned connection (or in
other words, no understanding) for us to think that these ways of analysing a firms financial statements help us
to meaningfully engage with the future economic and business realities of firms. In this section we look at how
people have developed approaches to analyse or make sense of financial statements.
Ratios
As financial statements started to be provided more frequently to people outside of firms, they began to be more
systematically analysed and assessed. Ratios, an idea taken from the Greeks, were used as a key part of this
analysis. They help us focus on the relationship between different items in a firms financial statements. The
term ratio (the Greek word for ratio is logos) was first introduced by Euclid in the Elements. Euclids
Elements is the worlds second most widely translated and circulated book, second only to the Bible. Written in
about 300BC, it has had over 1,000 editions and is an amazing treatment of geometry and number theory. It
gathers together the concepts and theorems of Greek mathematics. It is not easy to read. It contains no examples
to illustrate the concepts, no clever comments, indeed not even an introduction. It contains nothing but theorems
and their proofs. Nevertheless, it is without doubt the best mathematics text ever written. Book V of the
Elements provides a thorough analysis of the properties of ratios.
The earliest use of the word ratio in the Oxford English Dictionary is from Barrows 1660 translation of
Euclids Elements, Ratio (or rate) is the mutual habitude or respect of two magnitudes of the same kind to each
other, according to quantity (Archibald, 1950). In his 1908 translation of Euclids Elements, Sir Thomas Little
Heath says A ratio is a sort of relation in respect of size between two magnitudes of the same kind (Heath,
1908). I quite like the idea of mutual habitude, which sounds a bit like two people living or flatting together
and focuses us on the idea of looking at the relation between two numbers or quantities. A lot of financial
statement analysis uses this mathematical idea of the Greeks to help us gain insights into the economic and
business realities of firms.
Just do what works
In the 1890s, when it started to become more common practice for bankers to request financial statements to
assess applications for credit in the US, probably most bankers requested a balance sheet, looked over it
carefully and filed it with no attempt to systematically analyse its contents. However, some bankers appear to
have started to increase the level of sophistication of their analysis. They began to separate current and non-
current assets and liabilities in the balance sheet and to calculate some ratios. They began to pay particular
attention to the current ratio which is the relationship between current assets and current liabilities of a business.
Analysing financial statements also started to become more popular for equity investors, although how they
went about doing this was usually quite unformulated and unclear.
In the first twenty years of the 20th century an increasing number of ratios were being calculated and used to
help assess businesses. Criteria to assess what were good or bad ratios began to be developed, including the then
well-known requirement of a 2:1 current ratio (twice as many current assets as current liabilities). Further, the
benefit of comparing a firms ratios with the ratios of other firms was starting to become apparent. However,
analysis of financial statements was still largely casual and informal with only some people calculating and
using ratios as part of their analysis. In 1919, Alexander Wall in his classic Study of Credit Barometrics (Wall,
1919) produced seven ratios for 981 firms in the US. A barometer measures changes in atmospheric pressure to
forecast the weather. Walls ratios were meant to be like a barometer, measuring changes in a firms past
performance from its financial statements to predict its future performance.
Walls study was influential and showed how financial statements could be analysed by calculating a number of
different ratios for a firm and then assessing the firm by comparing these ratios with the ratios of other firms.
Influenced by this study, there was a rapid growth in the 1920s in the US in the number and type of ratios that
analysts began to consider when assessing businesses. Ratios were also collected for industries and average
ratios calculated for comparison purposes. In the 1930s, Roy Foulke successfully promoted a particular group of
ratios as being the most useful largely because he was also able to supply industry data for these ratios. In 1933,
while working for Dun & Bradstreet, Foulke published his ratios and they quickly became a well-known and
widely used series of industry average ratios in the US (Foulke, 1968).
With the growing dominance of the US economy, over time the emerging practices in the US greatly influenced
the way financial statements were analysed in other parts of the world. Today, in the second decade of the 21st
century, analysts of financial statements still may often select the ratios and information they use, and the
criteria they use to judge this information, based on a pragmatic view of what works, drawing on the authority
of experienced investors and lenders. Typically, there may not be a clear framework, conceptual map or idea in
the analysts mind that clearly links information from the financial statements to the economic and business
realities of firms. In other words, they may be tending to just look at the numbers and not at how the numbers
are connected to a firms performance.
There is quite a lot of consensus amongst practitioners and others about the usefulness of financial statement
analysis to examine high level categories of profitability, long-term solvency and short-term solvency. Thus
profitability (how much a firm earns) and liquidity or solvency (how readily a firm can come up with cash, if
needed) are commonly thought of as useful aspects to examine of a firms financial statements. However, once
we seek to get more specific about which ratios and information from financial statements are useful, we find a
diversity of views rather than consensus. These views can be seen expressed in a range of popular textbooks and
other academic writings on financial statement analysis over the years. References to some of these are at the
end of this chapter.
However, I do not find this approach to financial statement analysis of relying on what practitioners do to be so
useful, since other than agreement on the value of looking at profitability and long-term and short-term solvency
in a general sense, there is surprisingly little agreement or consensus on the details. There is also no clear reason
why these various ratios should be useful to predict future economic and business outcomes of firms; and,
indeed, no clear evidence that they are. However, we can gain a lot of practical wisdom and good sense from
experienced practitioners, particularly if they combine their experience with the ability to explain and
communicate their insights well. In this respect, I would recommend the classic work Security Analysis by
Benjamin Graham and David Dodd (Graham and Dodd, 1940). This is a real favourite of mine. An easier to
read version of this book is The Intelligent Investor, by Benjamin Graham (Graham, 1949).
I would also recommend the writings of one of Benjamin Grahams most famous students, Warren Buffett (such
as Buffett, 1984). Warren Buffett is arguably the most successful investor in the world and is one of the worlds
richest individuals. Many of us around the world enjoy reading Warren Buffetts annual musings based on his
practical experience and sound good sense in his annual Chairmans Letter to the Shareholders of Berkshire
Hathaway Inc (Buffett, 2012). These come out in late February or early March each year. Indeed, when the
time comes for Warren Buffett to stop writing these annual letters, many of us will miss his valuable injection of
views based on extensive practical experience and good thinking. The key to the success of the ideas of
Benjamin Graham and David Dodd and of Warren Buffett is their ability to use financial statements and other
sources of information to gain insights into the economic and business realities of firms.
Use a structure
There have been some attempts to provide a framework or structure to support the practice of financial
statement analysis and in particular the usefulness of certain ratios. In about 1919, the du Pont Company in the
US applied the idea of analysing profit margins and turnovers to a major manufacturing enterprise. This idea
had been used for some time in retail businesses. The du Pont Company evaluated its operating performance by
focusing on return on assets, which is the relationship of profit to total assets. This was broken down into profit
margin (profit/sales) and turnover (sales/total assets). However, the du Pont Companys framework for the use
of ratios to analyse a firms financial statements had little immediate influence outside the du Pont Company
itself (although, as we will see later, it did belatedly catch on). There were other attempts to come up with
different structures. For example, in 1923 James Bliss attempted to provide a framework for the integrated use
of the growing number of ratios he was using; however his ideas generally were not taken up in practice (Bliss,
1923).
In the 1950s, there were a number of studies that looked at the usefulness of the du Pont approach of breaking
down return on assets into profit margin and turnover ratios to assist decisions by business managers. This held
some promise of being able to use measures of return on assets as a means of integrating a number of ratios into
a coherent system of analysing a firms performance. Since the 1950s, the du Pont approach started to gain a
degree of popularity. We will see in Section 4.4 in Chapter 4 below that we will draw on aspects of the now
well-known du Pont approach.
When we analyse our firms financial statements, we should not simply focus on a firms financial statements.
Instead, we should use a firms financial statements to help us engage with key aspects of our firms economic
and business realities. We need to use a firms financial statements to help us understand these realities and to
then quantify the dollar effects they may have on the value of a firm. A firms economic and business realities
are messy and qualitative in nature. For example, key aspects of the economic and business realities of Ryman
Healthcare might include the level of residential house prices in New Zealand and the proportion of the
population over 65 years that wish to live in retirement villages. We might be able to find various statistics (or
numbers) on these two aspects of Ryman Healthcares economic and business realities and make some
predictions about them. But how do we connect these insights into value for the equity investors in Ryman
Healthcare?
This is where financial statement analysis comes in. An analysis of a firms financial statements can help us
gain an understanding of the quantified dollar effects of Ryman Healthcares economic and business realities, if
we understand the connections between the key drivers of Ryman Healthcares economic and business realities
and the key drivers of its financial statements. What we need is a theory of financial statement analysis that will
help us do this: help us to connect a firms financial statements with its economic and business realities and thus
to its value. The focus of our analysis of our firms financial statements should be on understanding the
connections and relationships between key elements of the financial statements and the key drivers of the
economic and business realities of a firm. This leads us to focus on understanding the economic and business
drivers of a firm, which is at the heart of making sense of what our firms financial statements can tell us. Let us
now consider how we know what anything is worth to us in the world of business and how this might help
provide a framework or theory for us to analyse a firms financial statements.
3.4 The value of anything
Price is what you pay; value is what you get.
Warren Buffett
What is something worth to us? The only way we know how to value anything in business is to put a value on
the future cash flow we expect from it. We do this by calculating a present value of its expected future cash
flow. This is the value today of the cash flow we expect to get in the future. Here is $20. There is a picture of
John Flynn (of Royal Flying Doctor Service fame) on one side and a picture of Mary Reibey (of convict-
made-good fame) on the other. Would you like this $20 note now, or perhaps you would prefer I gave it to you
in five years time?
The fact most people would say, I would prefer the money now, please means that dollars today are generally
worth more to us than the same amount of money in the future. For this reason, we reduce or discount the value
of money we might expect to get in the future to its present value to us today. This is what present value (often
shortened to PV) means. In this section, we will see that dividends are what equity investors expect to receive
in the future from their investment in companies. It is in fact all they will ever receive from a firm by owning
shares in it. We will also see how the cash flow generated by a business is directly related to dividends, so when
analysing firms we can focus on a firms cash flow instead of on its dividends.
Dividends
The only way we know how to value any asset or business is to value it based on the cash flow we expect to
gain from it in the future. The more cash flow we expect to get in the future, the higher its value; the less cash
flow we expect the lower its value to us. What cash flow do we get from owning shares in a company? Well, the
only cash flow equity investors will get from their investment in the shares of a firm is a stream of future
dividends for the rest of the life of the firm. If the firm is liquidated or taken over at the end of its life, this
would include a final dividend representing the remaining assets after all liabilities of the firm have been
settled, or a payment to the equity investors from the party taking over the firm.
That is what an equity interest entitles you to; nothing more, and nothing less. If we sell our shares to someone
else (as we often do as equity investors, rather than hold them for the full life of a firm), someone will pay us
money for those shares. So we might make a capital gain or loss when we do this, which could be quite
significant. But what does the person buying the shares from us get from owning them into the future? Well, the
dividends they expect to get into the future. Dividends, and only dividends, are what a share actually gives us
regardless of how its share price may fluctuate over time.
This means the equity value of a firm is the present value (PV) of expected future dividends:
Equity value = PV of expected future dividends
This is called the discounted dividend (DD) model. It is the theoretical basis for us to value equity in a firm. We
forecast the dividends we expect to receive and discount them to the present by applying a suitable discount
rate. We discount or reduce future dividends to reflect the fact we generally prefer money in our pocket today
rather than money we might expect to receive in the future. This is the value to us today of owning equity in a
firm. If we could, in practice, value equity using this approach, equity investors would focus on using the
financial statements (and other sources of information) to predict a firms future dividends.
Though dividends are what equity investors in a firm will actually get, they are generally not able to be used in
practice to value equity in a firm. The key difficulty is that dividends are not the source of value for equity
investors. Rather, they are simply a transfer of value between a firm and its equity investors. To see what I
mean, let us look at the forecast dividends for two firms, King Enterprises and Marks Inc. Both companies have
a policy of distributing 10% of their profits each year.
Table 4-1: Forecast dividends
Year 1 Year 2 Year 3 Year 4
King Enterprises
Marks Inc.
1,000
1,000
1,100
1,100
1,200
1,200
1,300
1,300
Which company would you prefer to own shares in? Well, you might say you would not care; you would value
each company the same. After all, the expected dividends from each company are the same. Let us now say that
Marks Inc decides to increase its dividend payout ratio (the proportion of it earnings it pays as dividends to its
shareholders) from 10% to 90% of earnings. Assuming no change to earnings, this would result in dividends
from Marks Inc increasing by nine times, as follows:
Table 4-2: Forecast dividends (Marks Inc changes its dividend policy)
Year 1 Year 2 Year 3 Year 4
King Enterprises
Marks Inc.
1,000
9,000
1,100
9,900
1,200
10,800
1,300
11,700
Which company would you prefer to invest in now? Does it mean my equity in Marks Inc is now worth nine
times more than it was prior to the change in dividend policy? This does not seem to make much sense. Nothing
has necessarily changed concerning the economic and business realities Marks Inc is facing, such as the market
for its products and services, the actions of competitors, government regulations and taxation, and so forth.
Everything about its actual business is still exactly the same. The only thing that has changed is that the board of
directors of the firm has held a meeting and decided to increase the proportion of profits it pays to equity
investors as dividends. It is not obvious how this action by itself can change the value of a firm.
This is the key practical difficulty of valuing equity in a firm using a discounted dividend (DD) model: it is
difficult to forecast a firms future dividend policy to the end of a firms life as it is based on the discretion of a
firms management and board of directors. As well as the regular payment of cash dividends, a firm will
typically have other transactions between itself and its equity investors. These will include the issue of new
shares and also share buy-backs (the repurchase by a firm of its shares from equity investors). For convenience,
in this book we will use the term dividends to include all transactions between a firm and its equity investors.
To understand the value of the equity of a firm in practice we will need to look in behind the dividends a firm
pay its equity investors. One way to do this is to focus on the cash flow a firm generates from its operating
activities.
Cash flow
In the virtual world of our firm called accounting, dividends and cash flow are related. Their relationship can be
expressed like this:
Dividends (d) = Operating cash flow (C) Capital outlays (I) + Net cash flow from debt owners (F)
that is, d = C I + F
Remember, our idea of dividends is net dividends, which are the net payments to equity investors in a firm. It
includes all transactions between a firm and its equity investors. Operating cash flow (C) is the cash generated
by a firms operating activities, from selling goods and services less the expenses incurred in generating those
sales. For example, the operating cash flow (C) of Tanby Roses Florist in Yeppoon, could include cash received
from selling flowers and related items to customers, such as $50 for a bouquet of roses, less expenses such as
the cost of flowers and other items sold, rent, salaries of staff, advertising, electricity, insurance and maintaining
its website.
Capital outlays (I) is the cash invested into the operating assets of a firm (these are the assets that generate
products or services for sale) less the cash received from selling operating assets. For example, Tanby Roses
Florist may invest money into a new fancy fit out for its store with new signs, shelving and furniture and
perhaps also into increasing its inventory into new lines of gift and related items; it might also receive some
cash from selling some of its old shelving and furniture and perhaps from selling an old delivery van it no
longer needs. For other businesses capital outlays (I) might including investing in new factories, new retirement
villages (in the case of Ryman Healthcare), corporate jets, additional inventory or a new warehouse; less what
might be received from selling operating assets such as some surplus land or an old factory.
The operating cash flow (C) (for example, from selling flowers) less capital outlays (I) (for example, installing a
new shop fit out) is known as the free cash flow (FCF). This is the cash flow that is free of the operations of
the business; the cash being generated by the business after allowing for on-going capital investment into its
operations. So, FCF = C I. We use the letter I to represent capital outlays because it is the net cash investment
into a firms operating assets (and C is already taken, being used to represent operating cash flow).
As FCF = C I, we could change our relationship of dividends and cash flow from:
d = C I + F
to:
d = FCF + F
The term cash flow is often used to refer to a number of different things. Cash flow can refer to operating cash
flow (C) (which is the cash generated by the operations of a business without allowing for on-going capital
investment into the business), to free cash flow (FCF) (the cash generated by a business after allowing for on-
going capital investment) or to various earnings based measures used to approximate cash flow such as
EBITDA (pronounced e-bit-dah). EBITDA is a short way of saying earnings before interest, tax, depreciation
and amortisation, which is quite a mouthful. You can see why we prefer to say EBITDA. In this book when
using the words cash flow we will mean free cash flow (FCF).
If a firm had no debt or borrowings, it would have no net cash flow from debt owners (F) and so F would equal
zero. We can see from our relationship between dividends and free cash flow (d = FCF + F), that if this was the
case dividends (that is, the net cash flow between a firm and its equity investors) would simply equal a firms
free cash flow (that is, its operating cash flow less capital outlays). However, usually a firm does have some
borrowings (or alternatively some spare cash reserves it does not need in its business which it lends to others,
such as putting it in the bank).
In 2013, Ryman Healthcare paid its equity investors a dividend of $45.5 million in cash and also bought back
$1.3 million of its shares to give a total dividend (or net transfers between a firm and its equity investors) of
$46.8 million. The equity investors who received this dividend included my three children, as well as one of the
Maori iwi (or tribes) Ngai Tahu. However, its free cash flow (FCF) in 2013 was $40.3 million. So how did
Ryman Healthcare pay a dividend (that is, net cash flow to its equity investors) of $46.8 million if it only had
free cash flow from its activities that year of $40.3 million? Where did the cash of $46.8 million come from to
pay my children (and the other equity investors) their dividends?
My children did receive their dividends from Ryman Healthcare into their bank accounts in 2013, which they
used to help pay for iPhones, buy tickets to music festivals, support communities in need in Tanzania and meet
other essential expenses they had that year. This cash could only come from Ryman Healthcare borrowing from
its bankers (ANZ and Commonwealth Bank) to help fund its dividend to shareholders. Since there is a
relationship between a firms dividends (its net cash payments to its equity investors) and its free cash flow
from its operating activities (FCF), we can focus on the free cash flow (FCF) of a business instead of on
dividends, when seeking to form a view about the value of our equity investments in a firm.
Conclusion
In this chapter we have seen there are two key financial statements businesses prepare: the balance sheet and the
income statement. The balance sheet shows the assets, liabilities and equity of a firm on a particular day. The
income statement shows a firms revenue and expenses for a period of time, usually a year. These two financial
statements set out the five elements of accounting, which we can express as:
Assets + Expenses = Equity + Revenue + Liabilities
We also saw how the income statement and balance sheet are interconnected. The bottom line of the income
statement, which is a firms profit for a period, is included in a firms equity in the balance sheet at the end of
the period. There are two other financial statements, a statement of changes in equity (which shows how equity
has changed during a period) and a cash flow statement (which shows how cash has changed during a period).
Both of these two statements are also interconnected with a firms balance sheet, showing details about how two
key items in a balance sheet (equity and cash) changed during a period. With the growing availability of general
purpose financial statements, people began to develop ways of using them to help them engage with the
economic and business realities of firms. A key approach that quickly developed was to calculate various ratios,
which give the relationship between two or more items in a firms financial statements.
We discussed how the value of an equity investment in a firm is the present value (PV) today of the expected
future dividends of a firm; and that it is based on expectations about an uncertain future which rarely end up
actually happening exactly as people expect. We also saw we can look at the free cash flow (FCF) of a business,
instead of its dividends, when we seek to value the equity in a firm; and that we will often simply use cash
flow to refer to FCF. In the next chapter, we will consider how we can analyse a firms financial statements to
help us engage with and understand a firms economic and business realities. We will look into the concepts of
cash flow and also economic profit and will see the value of restating a firms financial statements to clearly
separate a firms operating and financial activities. We will also look at how we can analyse, or break into bits,
key aspects of a firms financial statements to possibly help us better understand a firms economic and business
realities.
Questions
Question 3-1
What is wrong with just doing what works in relation to analysing financial statements? There are plenty of
experienced practitioners in our capital markets. Why do we not simply find out what most are doing and just
do this ourselves? What do you think and why?
Question 3-2
What is the benefit of having a structure, such as the du Pont companys framework, to help use ratios to
analyse a firms financial statements? Is it any better (or worse) than simply doing what experienced
practitioners do? Why or why not?
Footnotes
1. Alternatively, your firm may just have its group accounts in its financial statements, with its parents
accounts in a footnote.
2. Sometimes companies may include all of their firms income (including other comprehensive income)
in their income statement, and have only one income statement (often then called a statement of
comprehensive income).
References
Archibald, RC 1950, The first translation of Euclids Elements into English and its source, The American
Mathematical Monthly, vol. 57, no. 7 (Aug.Sep.), pp. 443445, Book V, Definition 3.
Bliss, James H 1923, Financial and operating ratios in management, The Ronald Press Company, New York.
In his preface, James Bliss indicated the principal aim of his book was to develop certain standard ratios for
the use of managing executives in securing more effective control of the finances and operations of their
business While the book is primarily intended for business executives and accountants, it aims also to be
helpful to anyone having or expecting to have a financial interest in a companybankers, credit men,
individual investors, etc.
Buffett, WE 1984, The Superinvestors of Graham-and-Doddsville, Hermes, Columbia Business School
Magazine, pp. 415.
This article was based on a speech Warren Buffett gave at Columbia Business School, 17 May 1984, at a
seminar marking the 50th anniversary of the first publication in 1934 of Benjamin Graham and David
Dodds Security Analysis.
Buffett, WE 2012, Chairmans Letter to the Shareholders of Berkshire Hathaway Inc., Berkshire Hathaway
Inc Annual Report 2012: http://www.berkshirehathaway.com/l http://www.berkshirehathaway.com/letters/letters.html
etters/letters.html
You can view Warren Buffetts letters to shareholders from 1977 to 2012 on the Berkshire Hathaway
website.
Foulke, RA 1968, Practical financial statement analysis, 6th edn, McGraw-Hill, New York, p. 4.
As noted by Foulke, these accounts are reproduced in detail in Enrico Bensa, Francesco de Marco da Prata
Milan: Fratelli Treves 1928, pp. 414417.
Graham, B & Dodd, D 1940, Security analysis: principles and techniques, 2nd edn, McGraw-Hill, New York &
London, p. 49.
The first edition of this book was published in 1934 and it has reached a sixth edition. The second edition
was a comprehensive revision of the first edition and is considered by many to be significantly superior to
the first edition and to be the classic edition of this book. Reprints of this second edition are often available
in libraries.
Graham, B 1949, The intelligent investor, (re-issue of original 1949 edition) Collins 2005, New York, ISBN 0-
06-075261-0.
Benjamin Graham first published The Intelligent Investor in 1949. The last revised edition was the 4th
revised edition (1973). It contained a preface and appendixes by Warren Buffett. Commentaries and new
footnotes were added to the fourth edition by Jason Zweig, and this new revision was published in 2003:
Graham, B & Zweig, J 2003, The intelligent investor, HarperCollins, New York.
Heath, TL, Sir 1908, The thirteen books of Euclids elements translated from the text of Heiberg with
introduction and commentary. Three volumes. University Press, Cambridge, 1908. Second edition: University
Press, Cambridge, 1925. Reprint: Dover Publ., New York, 1956. Book V, Definition 3.
Horrigan, J 1968, A short history of financial ratio analysis, The Accounting Review, vol. 43, no. 2. (Apr), pp.
284294.
Wall, A 1919, Study of credit barometrics, Federal Reserve Bulletin, March. vol. V, pp. 229243.
References: financial statement analysis
Belkaoui, AR 2001, Financial statements: present and future scope, Quorum Books, Westport, CT.
Bernstein, L 1989, Financial statement analysis: theory, application, and interpretation, 4th edn, Richard D.
Irwin, New York.
Copeland, T, Koller, T & Murrin, J 2000, Valuation: measuring and managing the value of companies, 3rd edn,
Wiley, New York
Damodaran, A 2002, Investment valuation: tools and techniques for determining the value of any asset, 2nd
edn, Wiley, New York.
Fernandez, P 2002, Valuation methods and shareholder value creation, Academic Press, San Diego, California.
Foster, G 1986, Financial statement analysis, 2nd edn, Englewood Cliffs, N.J.: Prentice-Hall.
Fridson, MS 2002, Financial statement analysis: a practitioners guide. Wiley, Chichester.
Gibson, CH & Frishkoff, PA 1986, Financial statement analysis: using financial accounting information. Kent
Pub. Co., Boston, Mass.
Giroux, G 2003, Financial analysis: a user approach. Wiley, New York.
Helfert, EA 2002, Techniques of financial analysis: a guide to value creation, 10th edn, Irwin/McGraw-Hill,
London.
Holmes, G & Sugden, A 1990, Interpreting company reports and accounts, 4th edn, University Press,
Cambridge.
Lev, B 1974, Financial statement analysis; a new approach, Prentice-Hall, Englewood Cliffs, NJ.
Myer, JN 1969, Financial statement analysis, 4th edn, Prentice-Hall, Englewood Cliffs, NJ.
Palepu KG & Healy, PM 2008, Business analysis and valuation: using financial statements: text & cases, 4th
edn, Thomson/South-Western, Mason, OH.
Penman, SH 2009, Financial statement analysis and security valuation, 4th edn, McGraw-Hill/Irwin, New
York.
Stickney, CP 1996, Financial reporting and statement analysis: a strategic perspective, 3rd edn, The Dryden
Press, Fort Worth.
Tamari, M 1978, Financial ratios: analysis and prediction. Paul Elek Ltd, London.
Weston, JF & Brigham, EF 1972, Managerial finance, 4th edn, Holt, Rinehart and Winston, New York.
White, GI, Sondhi, AC, & Fried D 1994, The analysis and use of financial statements, John Wiley & Sons, Inc.,
New York.
Also see the following chapter:
Beaver, W 1977, Financial statement analysis, Handbook of modern accounting, 2nd edn, eds Davidson, S &
Weil, R, McGraw-Hill, New York.