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, understanding today’s landscape is key to determining the true value of a potential purchase. Potentially, one of the most important resources for determining merit in a proposal is 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. When analyzed together, they can reveal a stock’s value and growth prospects, financial instability, or accounting improprieties. While no one indicator 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 of Historical Financial Statements
Financial statements provide important information regarding a company’s revenue, expenses, profitability, and debt. These aspects can illustrate the health of a company over a certain period of time and offer 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.
There are three main types of financial statements: the balance sheet, income statement, and statement of cash flows. When interpreting a company’s financial health, institutional investors consider components across these statements, including assets, liabilities, revenues, expenses, and cash flows.
We explore the three main types of financial statements, as well as analyzing ratios, below.
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 its net worth.
Income Statement
An income statement shares a company’s revenue and expenses incurred over a period of time and provides insight into its profitability and performance. Also called a profit-and-loss (P&L) statement or an earnings statement, it 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, management efficiency, underperforming sectors, and its performance relative to an industry.
Statement of Cash Flows
Cash flow statements (CFS) highlight monetary inflows and outflows — in other words, 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.
Moreover, a 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.
Analyzing Ratios
Most investors will also calculate ratios in order to gain an even deeper understanding of performance. Common and most referred to ratios include liquidity, debt, profitability, efficiency, and activity ratios. These ratios correlate with a company’s asset turnover, profitability compared to competitors, debt-to-asset ratios, liabilities outlook, and other important aspects, as well as create a foundation on which investors can base predictions about future performance.
Ratios are frequently used to compare a company’s performance to industry averages, revealing whether a company is performing better or worse than its peers. Trends across a company’s historical financial statements generate critical insights that determine evaluation. For example, abrupt changes in net sales, accounts receivable, or operational cash flow are signals for unusual activity that may require due diligence.
But context is also important. For instance, if a company has undergone a period of rapid growth, it may be beneficial to investors to review statements from the same period in the previous year to identify and account for any potential risks or opportunities that may have been overlooked.
Spotting Red Flags in Historical Financial Statements
Accuracy in financial statements not only underpins sound business decisions but is also a factor used to inform decision-making around compliance. Statements must adhere to Generally Accepted Accounting Principles (GAAP) and other applicable regulations.
Companies must be aware of the potential for fraud and other irregularities in their reporting and ensure internal controls are in place to prevent misstatements or inaccuracies in proper presentation. Misrepresentation can lead to undesirable impacts, such as lost money for shareholders.
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:
Overinflated Financial Results
Does the company’s financial reporting seem unusually impressive when compared to their historical performance? 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 for 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 overestimation and underestimation 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 are a troubling sign. Additionally, a significant change in the senior management of the company is just as worrisome.
Find the Financial Data You Need Faster with AlphaSense
Historical financial statements essentially serve as a company report card, allowing professionals to assess the financial health of a company and maximize investment opportunities. However, to find the financial information you need to make confident investment 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 in one single platform.
Additionally, historical financial statements — found on BamSEC by AlphaSense — allow investors to map the larger picture of a company, building on prior statement data to enable the tracking of directional momentum across performance indicators.
The difference between investing in the right deal and making a costly mistake starts with your due diligence. You need to ask the important questions that will weed out the red flags before you spend capital. Download our infosheet, 5 Crucial Due Diligence Questions to Consider for PE, VC, and M&A Investors.
Discover how a market intelligence platform like AlphaSense can help you make smarter strategic deals. Start your free trial of AlphaSense today.
