Financial Statements
Garnering a detailed context from a Balance Sheet, Income Statement or Cash Flow Statement would allow you, as an investor, to better understand what is financially occurring within the given company. In this section, we will start with a company’s Balance Sheet and work our way through the Income Statement, before finally taking a look into the Cash Flow Statement. Below we have detailed to you Southwest Airlines ($LUV) as the sample company in which we will familiarize ourselves with their End-of-Year (EOY) financial data from 2018 and 2017, respectively. This section may be used as a simple-step guide for what you may want to look at when perusing through a company’s Financial Statements.
The Different Types of Financial Statements
Balance Sheet Analysis
As we start with the Balance Sheet, remember that these statements are easier to read than most beginners may presume to believe. They may come across as more intimidating to look at and overall may be a headache for someone who does not casually peruse Financial Statements on a regular basis. To negate from this overwhelming effect, we have inserted the financial data into spreadsheets to give you a better perspective of what we are really looking at. Now, let’s take a look at the Balance Sheet for Southwest Airlines within 2017 and 2018, with 2018 being the ‘current’ time:
You may notice some highlighted areas, which will be detailed further as we dig into this. To start, we should know what it is we are looking for, as you may know the Balance Sheet is made up of a company’s Assets, Liabilities and Stockholders’ Equity. Within these three separate areas you will want to find: the 3 largest Assets, the 3 largest Liabilities, and the proportion of Total Assets financed by the Owners (Equity) and Non-Owners (Debt).
From the yellow-highlighted areas, starting with the top, Southwest Airlines PPE, net (Property, Plant & Equipment) is its largest asset, second once we account for Depreciation & Amortization. This amount sits at $19.5 Billion, which is represented from the BS (Balance Sheet) as $19,525 Million, which takes up 74.4% of Southwest’s Total Assets. This is indeed its largest asset and shows that this company is highly invested within its Property and Equipment.
If we dig further into what its PPE is made up of, you will see that the Flight Equipment sits at $21.8 Billion ($21,753 Million), before depreciation and amortization, and is just shy of 83% of Southwest’s Total Assets; keep in mind the Total Assets area is accounting for the depreciation and amortization. It’s next largest Asset within this would be its Ground Property and Equipment, showing us as being just shy of $5 Billion ($4,960 Million), before depreciation and amortization, and is making up 18.9% of its Total Assets. One may make the assumption that the Flight Equipment and its Ground Property and Equipment are the Assets with which revenue is being generated from, big surprise I know. This is important in any case, as you now know that these assets are considered to be important to the particular business and may now draw a multitude of hypothetical conclusions to better your investment analysis.
Next you will want to take a look at what the largest Liabilities are for Southwest. Air Traffic Liability makes up $4,134 Million, about 15.8% of its Total Assets. Its Long-Term Debt is its second largest at $2,771 Million, about 10.6% of its Total Assets. Finally, the Deferred Income Taxes are sitting at $2,427 Million, about 9.3% of its Total Assets. Each of these Liabilities hold further information to make hypothetical assumptions or educated assumptions. Air Traffic Liability represents tickets sold for future travels and estimated refunds or exchanges of tickets sold for past travel dates. Long-Term Debt relates to debt that would be due past one year, in this case it would be after 2018. Deferred Income Taxes arise when a company’s accounting methods result in a difference from its income recognition within different tax laws. A company’s payable income tax may not equate to the total tax expense reported within the specified time period. This difference is usually caused by differences in methods used by the IRS and GAAP Accounting reporting for income, which causes this deferred income tax. These three Liabilities show what would be considered important to the business itself or a normal causation as a result of running the business, in this case an airline.
We will now take a look at the proportion of Total Assets which are financed by the Owners and Non-Owners. Owners would be considered the Equity section of the Balance Sheet and Non-Owners would be considered the Total Liabilities from the BS. In 2018 & 2017, the amount of Total Assets financed by the Owners would be 37.5% and 38.4%, respectively. The proportion of Total Assets financed by Non-Owners in 2018 & 2017, respectively would be 62.5% and 61.6%. You may ask what this would tell you, as an investor. Well, you now know that Southwest has a high-debt ratio to function as it does. Over 60% of the business is funded through its Liability section, it is important to note that this is in-line with the industry average. As of 2021, the Industry average of Debt-to-Equity Ratio (D/E) is 1.1562, which means that for every $1 of Shareholders’ Equity, the average company in the industry has $115.62 in Total Liabilities. As of 2018, the D/E ratio is 1.6635, which is moderately above the Industry average (for more on D/E Ratio, please see our Ratio Section).
Again, for what to cover within a company’s Balance Sheet, you will want to deduce the 3 Largest Assets, the 3 Largest Liabilities, and the Proportion of Total Assets financed by Owners and Non-Owners. This is a very good way to simplify a Balance Sheet and extract further information you may be looking for within an investment!
For more information on Balance Sheets, and understanding how they work, check out this useful page from Investopedia:
https://www.investopedia.com/articles/04/031004.asp
Income Statement Analysis
The Income Statement can speak volumes to what the business really invests their money into and how financially healthy a company is for the investor. Revenue, Expenses & Net Income are the three main components of a business’ Income Statement and can provide a good outlook overall with yearly trend analysis and simply within performance of a singular provided year. Simply put, the Income Statement shows one how Revenue transverses its way to a Profit or Loss. Let’s dive into the Income Statement for Southwest Airlines between the end of 2017 and the end of 2018:
The highlighted areas above will be broken down below, but overall the Income Statement can be clearly seen to be made up of three overall categories, this would be as follows: Revenue, Expenses, & Net Income (or Loss). To dig into an Income Statement, the easiest way to get an overall view of the business would be to note the Revenue, Compare the Three Largest Expenses for a year and the previous year, note any Unusual Expenses, and finally deduce whether the current year was more or less profitable than the previous and try to answer why this occurred.
From the provided Income Statement with Southwest Airlines, you may find Operating Revenue at the very top, this would of course be all of the money acquired through operating within the past fiscal year of 2018, 2017 & 2016, respectively. Revenue is just one piece of the puzzle within this statement, but is important to note as it shows how much in sales the business actually does. It can be seen from the above graphic that Southwest had an Operating Revenue of ~$22 Billion in EOY 2018 and ~$21.1 Billion in EOY 2017. If you were to break this Income Statement down into percentages, the Revenue piece would be considered 100% and everything below would become a piece of that 100%.
Next, we will dive into the Three Largest Expenses. For both 2018 & 2017, Southwest’s largest expense would be for Salaries, Wages & Benefits. Respectively, this would chalk up to around $7.6 Billion (34.8% of 2018’s Revenue) & $7.3 Billion (34.6% of 2017’s Revenue). The second largest would be Fuel & Oil, which would respectively be $4.6 Billion (21% of 2018’s Revenue) & $4.1 Billion (19.3% of 2017’s Revenue). The third largest would be on ‘Other’ Expenses, respectively this would be $2.9 Billion (13% of 2018’s Revenue) & $2.8 Billion (13.5% of 2017’s Revenue). With these three in mind, you can accurately see what this company prioritizes to accrue their yearly Revenue.
Most obviously, the employees of the airline would be it’s number one priority (or asset), their wages account for almost 35% of their yearly revenue. Their second highest expense priority would be Fuel & Oil, with which the company needs to operate their vehicles (typically their planes). We can see that this typically garnishes about 20% of Southwest’s yearly Revenue. It is important to note here that already, on average, Southwest’s Revenue is 55% expensed from their Wages & Fuel Expenses. Applied generally to any business, you can see what priorities or obligations this company has within their yearly expense categories. The last expense that we mentioned would be their ‘Other’ Operating Expenses, which can include a multitude of items which may be broken down within the company’s SEC 10-K (Yearly Statement) or 10-Q (Quarterly Statement). In this case, the Other Expenses cost Southwest about $2.9 Billion (13% of 2018’s Revenue) & $2.9 Billion (13.5% of 2017’s Revenue). All together these expenses account for around 68% of the company’s Revenue for each year. Very obviously, this company relies on these expenses to continue their operations and gives a good overall view of what the company requires to operate.
Next you would want to see if there are any Unusual Expense activities throughout the year, or previous years, looking at at least two years of financial data would be useful for this process as the comparison allows one to deduce whether there is an actual Unusual Expense for the current year. In this example, there are no Unusual Expenses that are immediately seen, but this should be something that stands out when compared to previous years. The last thing to look at within the Income Statement would be to compare the year-over-year profitability from the current year to the previous year, and try to deduce why it was higher or lower for the current year. As can be seen within the example, the 2018 Net Income was lower than 2017 Net Income, these were $2.5 Billion (2018) & $3.4 Billion (2017), respectively. The main reason for this difference, however, can be seen through the Provision (Benefit) For Income Taxes, which in 2017 was a benefit of $92 Million, but in 2018 this was an actual provision of $699 Million. A provision being a payment in taxes for that provided year. If you add in the provision from 2018 to the Net Income from the same year, you end up around $3.2 Billion, which shows that this large difference is really coming through this expense category.
For more information on Income Statements, and understanding how they work, check out this useful page from Investopedia:
https://www.investopedia.com/articles/04/022504.asp
Statement of Cash Flows Analysis
The Statement of Cash Flows isn’t the most popular statement to read or analyze, but is very useful to see how Balance Sheet accounts and Income affect cash & cash equivalents. The Cash Flow Statement is broken down into three categories: Operating, Investing, & Financing Activities. The Cash Flow Statement differs from the Income Statement in that it does not account for (i.e. isn’t manipulated) by non-cash transactions, such as Depreciation. Without further ado, let’s dig into a real Cash Flows Statement and go over an easy way to analyze one!
We discussed previously that there are three separate activities to pay attention to, this would entail: Operating, Investing & Financing Activities. The best way to compare each one is to use previous years, as we had with the Balance Sheet & Income Statement. Looking at each from an overall perspective, and then, if so inclined, digging into the little pieces to make connections. The above example is being pulled from Southwest Airlines and we will be focusing on 2018 & 2017, respectively for each category.
For Cash Flows from Operating Activities, one can see the Net Income and each of the adjustments underneath to reconcile Operating Expenses. Without digging too deep the strategy of breaking this down would be to compare the total. As can be seen from the highlighted area, one can easily tell that the total Net Cash Provided by Operating Activities, in both 2018 & 2017 were greater than Net Income. However, 2018 is exponentially higher than the Net Income for the year. This can be caused by a multitude of items listed, but the easiest to see would be from the Deferred Income Taxes for 2018 versus 2017.
Within Cash Flows from Investing Activities, for both 2018 & 2017, we can see that Southwest used cash rather than generate income from their investment activities. This is important to note as investing activities could potentially be devastating for a company, especially within Short Term assets, but this would of course be circumstantial. Generally, companies would pick safe short terms and can cover a wide variety of financial instruments. Nonetheless, cash was spent rather than made within Southwest’s case on a seemingly regular basis.
Finally we have the Cash Flows from Financing Activities, and again within this section it is important to note whether the company generated or used cash from their Financing Activities. For both 2018 & 2017, respectively, Southwest used cash rather than generating income. However, Financing Activity is a tad different as this would be cash being used to fund the company. It can be important to note in any case when looking into a company.
This of course is a very broad look into the Cash Flow Statements, but we believe this is a truly easy way to break down the Cash Flow Statement and try to deduce something from it, whether that be a negative or a positive. We chose not to bring up the data directly within this section as an overall view will suffice, however digging into each category can of course reveal more to a potential investor of a company!
For more information on Cash Flow Statements, and understanding how they work, check out this useful page from Investopedia:
https://www.investopedia.com/investing/what-is-a-cash-flow-statement/