The How to Cover Money podcast is back with Jenna Miller as this episode’s host. W.P. Carey School of Business professor Philip Drake and Bloomberg’s Tom Contiliano introduce business reporters to the art of reading financial statements. They share some of their tips for using those statements to investigate a company’s performance, past transactions, and cash flow to understand how well a company is really doing.
Transcript
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Jenna Miller: How to Cover Money: An introduction to interpreting financials.
Philip Drake: Just because it’s on the financial statements doesn’t mean it’s reflecting the economics of what the company does. Its ability to satisfy customers’ needs and wants better than others, is not reflected up here on this balance sheet, and that’s where you have to understand the company to be able to understand the finances.
Miller: Hello and welcome to the Reynolds Center, How to Cover Money podcast. We’re coming to you from the Donald W. Reynolds National Center for Business Journalism based at the Walter Cronkite School of Journalism and Mass Communication at Arizona State University. I’m Jenna Miller, today’s host of the How to Cover Money podcast. Today we hear from Tom Contiliano from Bloomberg News and Philip Drake from Arizona State University’s W P. Carey School of Business about the basics of interpreting financial statements. Tom Contiliano and Philip Drake originally shared these tips at Reynolds Week in January of 2016. Financial statements are essential to the business beat, but they can be complicated and intimidating for beginners. Journalists often utilize financial documents to help investigate how well a company is really doing, checking up on what analysts and company officials are presenting to the public. To do this, it’s important to figure out two basic figures, assets, or the value of what the company has and liabilities, or what it owes. Drake says we can start with the people recording the company’s financial history.
Drake: One of the things you have to be able to do in understanding financial statements is you have to realize that accountants think differently. They don’t see the world as the way you do. We train accountants to be with a certain mindset. So you have to be able to step into their shoes to understand their work product. What I want us to do is kind of look at all the interactions. So for my accountant, what I do is I see the transactions between the customer and the firm. So I see goods and services going out in exchange for cash or promises of cash in the future. And then I look at the vendor side. The same thing, I receive goods and services from my vendors, and I pay cash or promises to pay cash in the future. And then I have shareholders that will give me capital exchange for residual interest. Basically, I don’t owe my shareholders anything. They just get whatever is left over. And then I’ve got my lenders and creditors that provide my loan capital exchange for principal and interest. You have your employees that provide skills and wages, and this is what accountants all seen. They look at all these transactions that happen between the firm and all these entities around here. Have your managers that are directing the operations, and they provide their skills in exchange for their compensation. And we come over here, and we have a government coming in, providing public goods in exchange for its relations. And then I’m gonna throw this last little guy in here just to mess with you. And that’s the auditor, okay? And the auditor basically attests to these financial statements and says whether the financial statements adhere to the rules of accounting.
Miller; Drake has his own name for all of these transactions, the Wheel of Fortune.
Drake: If you can manage this, because all of these people that are interacting with the firm have their own interests, their own agendas, and they’re not all wanting to play nice with one another. And so for a manager, you have to be able to successfully deal with all of these pieces out here. Now, everything that’s on this wheel or circle, is what the accountants see and what the accountants capture. But there is so much more. Okay, you have society. You have cultural impacts that will influence how firms behave competition. What are your competitors doing? How do you anticipate your competitors dealing with things? Then we have global interactions. We have technology, fundamental economics that we are engaged in, demographics, how are they changing? Regulations, what are they doing? What’s coming on with those? And then political and legal elements are all in here. All of these are external factors that will affect how the firm plays this wheel of fortune, but the accountant only sees these elements. So when you look at a set of financial statements, you’re looking at what’s happening here, but you don’t see necessarily, all these other elements that are pushing on it. And so you want to have to be able to step back and say, what is the accountant seeing? What are they doing?
Miller: Now that we’ve identified the various elements of a company, let’s look at the larger picture. What is a company? What is the purpose of a company?
Drake: You know, if you really think about what’s coming on, what’s happening here, all these people on that wheel of fortune are coming to this company, just like you would come to a bazaar to transact business with one another. It’s far more efficient for the vendors and customers to go through that company than to try to do things individually among themselves. So by coming and bringing the company together, it brings all these participants together as well, and this creates a much more efficient way of dealing with value creation. Making things better off for all those participants around there. What I’m trying to say is that everything the firm owns, it, in essence, belongs to my creditors and to my owners. The company is nothing but a shell, and the accounting statements reflect that. Accounting statements say, here are the assets that are held for the benefit of your creditors, your liabilities, and your owners, your equities. And that’s the company itself owns nothing. It just basically holds everything for
everybody.
Miller: So a company is a shell that holds assets and liabilities for the people around it. Let’s go ahead and define those two things.
Drake: This is the formal definition of an asset. It’s something of value that’s owned by the company. Here’s the key element, it has to be the result of one of those exchanges off of that Wheel of Fortune. There has to be a past transaction. There’s a lot of times when we exchange promises for promises that accountants do not capture. So you guys may write up a report about somebody having a new purchase order. You know, Boeing or Airbus decide, agrees to sell a bunch of stuff to another airline. You know, we’re going to deliver 20 planes to have a contract for that. All right? You see share price moving. We see all sorts of clamor going on, discussion like that. And accountants absolutely do nothing. They’re just sitting there going, nothing happens. Nothing happened because it’s not in the Wheel of Fortune until we see a transaction happening. Okay? Liabilities will mirror, very similarly, the idea of an asset. It’s going to be an obligation that’s the responsibility of the entity as a result of a past transaction. So that Wheel of Fortune comes back again to help us define so we have a lot of promises for promises as well that are liabilities. The most common things that we have is, let’s say we spill some chemicals underground, and now we have an EPA violation, and we say, “Not my responsibility. I didn’t spill it.” Okay? So you see people disputing those kinds of things.
Miller: Now that we have all that straight, we can get deeper into the nitty gritty of financial statements.
Drake: Okay. We have three primary financial centers, so balance sheet, we have income statement and we have a statement of cash flows. Now, number one thing you have to recognize is, I am an accountant. Accountants are balance sheet focused. So the key is get the balance sheet right, and then as the balance sheet changes over time, the income statement and the statement of cash flows just fall out on their own, just by the changes. Just because it’s on the financial statements, doesn’t mean it’s reflecting the economics of what the company does. Its ability to satisfy customers’ needs and wants better than others is no where reflected up here on this balance sheet, and that’s where you have to understand the company to be able to understand the financials, because financials will speak a lot more to you when you realize you’re only get getting a portion of what’s going on. One of the good things about accountants is that we lack imagination. So when we give you a title for a name, it typically is reflective of what we actually are trying to talk about. Assets will balance with the liabilities and equities. And every time we have one of those transactions, each one of those has to balance. So this equation has to hold every single time I have a transaction that I record. And it’s inevitable. That’s why accountants are the happiest people in the world, okay? Because they’re always in balance. You know, the balance sheet represents what the firm controls at a point in time. They’re always, if you notice, the balance sheet has as a given date. The income statement is going to show you the revenues less expenses that result in, hopefully, your net income or profits, and those profits belong to the owners. So what you’re going to find here is that this is a period of time, so for a year. And so what happens is you’re gonna get three different years of comparative data, and the operating income just says how successful is just the core business activity. So when you look at an income statement, you’re just trying to get a sense, just in its core business, how is it doing? And what you want to be able to do is, when you have an income statement, you want to also have as a contrast, statement cash flows. Now the statement cash flows picks up on that initial element what I said earlier about financing, investing and operating activities. And so when we look at a statement, cash flows, just like a balance sheet, I mean income statement, it’s for a period of time. And you’re going to have three comparable years side by side. And the first thing we’re going to do is you’re going to look at the cash that we start off at the beginning of the period. So how much cash do we have at the beginning of the year? And then we’re going to say what was our cash from our operating activities.
Tom Contiliano: And that’s because cash flow statement is just like looking at your checking account statement, as Phil showed you earlier, it shows you how much cash you have at the beginning of the period versus how much you have at the end of the period. And the company does you one favor, they itemize onto three lines why that cash went up or down. So here’s the three lines. They’re pretty easy to spot. Cash From Operating Activities, Cash From Investing Activities, Cash from Financing Activities. Here’s the 30 seconds worth of teaching. The most important number on here is the Cash from Operating Activities number. It shows you very simply, does a company generate cash from what they do on an everyday basis? The number should be positive. If you ever see a negative number on the operating line, there’s a company that’s burning through cash from what they do on an everyday basis. That’s not exactly sustainable.
Miller: So now we know what the three primary financial statements are, but we always have to remember to go back to the basics.
Drake: At the end of the day. Comes to pound cash. As a company, you have to generate cash that’s whatever you think of Warren Buffet. Invest in companies that generate cash. At the end of the day, you need to generate cash. And there are plenty companies, even now, that are valued an awful lot that you have to look a long way into the future with a lot of very optimistic models to say that they’re going to generate cash.
Miller: Thank you Tom Contiliano and Philip Drake for giving us a brief introduction to understanding financial statements, and thank you listeners for tuning in to another episode of the How to Cover Money podcast. If you’d like to learn more about financial statements, you can find a video of the full Reynolds Week presentation on businessjournalism.org under the training section and on our YouTube page. If you’re in need of more business journalism training, the Reynolds Center can help. Visit businessjournalism.org to find articles and self-guided training. Download our free eBook: Guide to Business Beat Basics, or sign up for our monthly newsletter. The newsletter will keep you up to date on training opportunities year round. If you enjoy the How to Cover Money podcast, be sure to subscribe on iTunes, Stitcher or SoundCloud, and while you’re there, leave us a rating or review to help make the podcast more visible to other business journalists. Support for the How to Cover Money podcast comes from the Donald W. Reynolds National Center for Business Journalism. Join us on the next episode of our podcast, specifically for business journalism educators on developing a syllabus.
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