Using Historical Financial Statements to Understand the Market

Now more than ever, conducting thorough due diligence is critical to evaluating a deal. With so many macroeconomic forces and geopolitical events simultaneously afflicting the market, the true value of a potential purchase starts with understanding today’s landscape. Potentially one of the most important resources for determining merit in a proposal starts with a seller’s financial statements, as these often spell out the monetary red flags a company may be trying to hide. 

Financial statements provide insights into a company’s position, profitability, and growth potential that. When analyzed together, they can reveal a stock’s value and growth prospects, financial instability, or accounting improprieties. While there is no one indicator that can adequately assess a company’s financial position, these metrics can be calculated using the figures released by a company on its financial statements.

But what specifically should you be looking for in historical financial documents? What are “red flags” and where do they hide in these documents? And how can you access them in the age of information overload? 

Below, we dive into the essentials of understanding how to leverage historical financial statements in today’s ever-shifting market.

Understanding the Basics

Within financial statements, you can find important information regarding a company’s revenue, expenses, profitability, and debt—aspects that illustrate the health of a company over a certain period of time, while offering a glimpse into its performance, operations, and cash flow.

In terms of reporting, financial statements take shape in a variety of document forms, including 10-Qs, 10-Ks, and 8-Ks, which are systematically evaluated, scrutinized for positional trends, and examined thoroughly for current and potential risks by analysts and investors. These finance professionals are highly adept at reading and interpreting financial statements to derive critical insights that support their decision-making frameworks.

However, for those who are not as acquainted, we’ve broken down the three main types of financial statements:

Balance Sheet

A balance sheet is typically created to communicate exactly how much a company or organization is worth—its so-called “book value.” The balance sheet achieves this by listing out and tallying up all of a company’s assets, liabilities, and owners’ equity as of a particular date, also known as the “reporting date.”
It’s usually prepared and distributed on a quarterly or monthly basis, depending on the frequency of reporting as determined by law or company policy. Ultimately, it delivers a snapshot of a company’s financial position at a given point in time and can aid in interpreting a company’s net worth. 

Income Statement

An income statement shares a company’s revenues, expenses, and profitability over a period of time. Also called a profit-and-loss (P&L) statement or an earnings statement, an income statement reveals revenue from selling products or services and expenses associated with generating revenue and managing a business.

Ultimately, an income statement provides valuable insights into a company’s operations, the efficiency of its management, underperforming sectors, and its performance relative to an industry.

Statement of Cash Flows

Cash flow statements (CFS) highlight monetary inflows and outflows—otherwise, metrics that can be used to assess liquidity and stability. When interpreting the financial health of a company, institutional investors take into account components across these statements, including assets, liabilities, revenues, expenses, and cash flows.

Moreso, CFS helps creditors determine how much cash is available (referred to as liquidity) for the company to fund its operating expenses and pay down its debts. For investors, it tells them whether a company is on solid financial ground. As such, they can use the statement to make better, more informed decisions about their investments.

How to Spot Red Flags

While financial statements contain the information investors and analysts need to determine a deal’s value, red flags often hide in the numbers and reporting processes or timing. There are a few different indicators that might indicate whether a company is misleading sellers: 

Over-attractive Financial Results

Does the financial reporting of the company seem too impressive? If yes, then you should examine further and look for consistencies in performance or a valid reason for a sudden boost in the financial results.

Auditor’s Report to Management

When financial statements are audited, an auditor tracks all errors and includes the list in their report—therefore, this becomes an extremely important section review. While management can have a different opinion compared to an auditor’s, as a prospective investor, you must ensure that you compare the reports and identify any red flags.

Unusual Accounting Policies

To sidestep trouble, companies adopt unusual accounting practices and methods to make it difficult for investors to compare their performance against competitors. These practices may relate to over/under-estimation of assets, valuation of the inventory, reserves creation, expenses relating to the development of the business, profit management through non-profit activities, etc.

Changes in Financial Reporting

Analyze trends in the balance sheet and profit and loss ratios and look for increasing debt-to-equity ratios. If found, that can indicate a potential problem in the operations of the company. Further, large adjustments made late in a fiscal year to errors and/or inaccurate data is a troubling sign. Additionally, a significant change in the senior management of the company is just as worrisome.

Find the Information You Need

To find the information you need to make confident business decisions, you would typically have to search across disparate sources on consumer-grade search engines. With AlphaSense, regulatory filings and other disclosures (i.e., SEC and global filings, transcripts on earnings calls and investor conferences, investor relations, press releases, etc.) from more than 68,000 companies worldwide are centralized into one single platform.

The difference between investing in the right deal and making a costly mistakes starts with your due diligence. You need to ask the important questions that will weed out the red flags before you spend capital. But what are those questions? Download our infosheet, 5 Crucial Due Diligence Questions to Consider for PE, VC, and M&A Investors, to find out.

Discover how a market intelligence platform like AlphaSense can help you make smarter strategic deals. Start your free trial of AlphaSense today.