Financial Statements Have One Major Purpose Each

Financial statements encourage us to look at the bottom line.  The bottom line indicates the purpose of financial statement.  With an income statement, the purpose is to show us how much the company has profited.  With a balance sheet, the purpose is to show us how much the company is worth on a book value basis.  Now, book value is nowhere near perfect, but neither is it to be neglected, so neglect book value, particularly tangible book value at your peril.

Then there is the cash flow statement.  The main idea that there is to look at the change in net cash of the corporation.  But the subordinate goals of the cash flow statement are to show us how much cash has been generated from operations, how much has been used in investing, and how much has been acquired through financing.  There are many scams with the cash flow statement most of which try to recharacterize cash flows from financing or investing into operations if they are positive.

Finally, there’s the statement of shareholder equity.  This forgotten statement helps to clarify who owns what and clarify where book value comes from.  What is the effect on book value from new shares and their equivalents?  How was book value increased or decreased various corporate actions and why?

That said, the financial statements each have one major purpose, unless they can be adjusted for other purposes.  A stock investor will want to understand earnings per share and how it is changing.  But a bond investor will want to look at EBITDA, which shows how much cash is available to service debt.  To the stock investor, EBITDA is not very useful, except in the situation where the company might be a takeover target.  In that case, the acquirers may be looking at EBITDA because they will be financing the acquisition with a large slug of debt.

Someone doing an analysis of the industry on the whole is going to abstract from interest, taxes, depreciation, amortization, and will focus on gross revenues or maybe even revenues.  It all depends on the type of analysis that you are doing.  In one sense, every analyst must adjust the statements that they look at in order to reflect the claim priority of the investor for which they are analyzing.

Common stockholders should view statements differently than preferred stockholders who should view statements differently than junior debtholders who should view statements differently than senior debtholders. (Need I mention the bank debt holders or trade claimants? Nah, but they have different goals as well, and use the statements differently.)

Existing income statements and balance sheets and cash flow statements are designed for equity investors, because they run the calculations for the residual income claimant, the equity investor.  Bond investors, bank debt investors, have to think in these terms: what type of revenue or operating income is necessary for me to get paid dollar one, and for me to get paid in full?  And how likely are each of those events?  The same set of questions can be applied to the balance sheet where the debt investor asks what it would take for his claim to be impaired in bankruptcy, or wiped out in full.  And then the debt investor can ask how likely those events could be.

The boundary line answers for these questions may be easily calculated, but the probabilities will be more subjective, and depend on estimates of the likelihood of future revenue or operating earnings.

I don’t have a lot more to say here.  Just be aware of what question you’re trying to ask of financial statements, and if you’re other than the equity investor, make the necessary adjustments so that you get the answer that is tailored to your questions.

1 Comment

  • matt says:

    How does EBITDA show a fixed income investor how much is available to service fixed income cash flows? If I understand it correctly, EBITDA doesn’t account for the capital reinvestments required to keep the business a going concern.

    To me, it seems like EBIT accruals or FCFF would be better measures for bond investors.

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