How to Analyze Financial Statements

Financial Statements McDonalds is a fast food restaurant chain that operates globally. The company is the leader in the industry, and is one of the most recognized brands in the world. The income statement can reveal a number of things about a company. First, it reveals the revenues that the company has earned. McDonalds has seen its revenues fluctuate over the past three years. In 2012, revenues were $27.567 billion. They increased to just over $28 billion in 2013 but then fell back again in 2014 to $27.441 billion.

The second valuable piece of information from the income statement is the company's expenses. These are broken down into different categories but overall the operating expenses were reduced in 2013 and then spiked back up in 2014. As a result of these changes, the third bit of useful information is revealed -- the net income. McDonalds has seen a substantial decline in its net income over the three-year period, in particular owing to the fact that revenue declined in 2014 but expenses increased.

There is a lot of refined information about types of revenues and expenses contained in the income statement, and the bottom line numbers will also include things like earnings per share and dividends paid in order to provide a greater level of detail for investors to understand the company's financial condition. The balance sheet covers off three important areas -- the assets, the liabilities and the shareholders' equity. The assets for McDonalds have fluctuated over the past three years. In 2012, they were at $35.386 billion, increasing to $36.625 billion in 2013.

The assets decreased in 2014 to $34.281. Assets reflect on the total size of the company. The second important piece of information is about the liabilities. These have increased steadily over the past three years. This means that even though the total size of the company has increased, McDonalds is increasingly financing itself via debt. The shareholders' equity confirms this -- it increased in 2013 after a successful year, but then decreased in 2014 when profits were reduced and the amount of debt was increased.

Understanding how the liabilities and equity are paying for the assets is basically how the balance sheet works -- for every asset there is a corresponding liability or equity transaction, and ultimately how these things balance each other if of concern to those who read the financial statements. The cash flow statement can illustrate what the major sources of financing for the company are. Over the past three years, McDonalds has financed itself through its operations. It has used these to fund its investing activities.

On balance, McDonalds is not using financing activities to finance its operations. The company's net borrowings are lower than the dividends paid, and the company is buying back stock, not issuing it. Thus, it is operations that are being used to finance both the dividends and the stock buybacks, as well as the investing and the ongoing operations. The financial statements are issued by the company. They are prepared internally, but there are people responsible for the entire process.

First, under the Sarbanes-Oxley Act, both the CEO and CFO must sign off on the financial statements, effectively taking personal responsibility for their veracity ("Guide to SEC Filings, no date). In addition, an external auditor must also sign off on the statements, affirming the procedures that were used in the production of the statements and attesting to the accuracy of the statements with respect to the financial condition of the company.

Further, there is responsibility internally on the part of the accounting department, and the writers who put the document together to ensure that everything contained in the statements is accurate. The SEC is responsible for the enforcement of statement accuracy, and with that enforcement power the SEC will investigate any time it feels that the statements may not have been produced properly or may not accurately reflect the financial condition of the company.

Assurance for the accuracy of the financial statements lies with the external auditor, the CEO and the CFO. All three bear specific responsibility for the accuracy of the statements, and have signed off on the statements as per law. This means that these are the bodies that ensure that the people who have produced the statements have done so accurately.

The presence of an enforcing body, the SEC, also provides assurance that if something was amiss with the statements, that there is a body that can investigate such incidents, and make remedies for investors. These different elements combine to provide a significantly high level of assurance for those who participate in the capital markets. In addition to the statements, there are also the notes on the statements. These can be very valuable, as they are what provides context to the numbers.

The statements are aggregated numbers, and the context provided by the notes is very important. If we look at the most recent annual report from McDonalds, we can see examples of notes that provide important, detailed, contextual information. For example, on page 25 there are details about the company's contractual obligations and commitments. These are essentially liabilities, because the company is obligated to spend that money in the future -- note that this section only talks about cash outflows.

This is a form of disclosure in the notes that details all the different things for which McDonalds is obligated to use its cash -- these are details of some of the company's liabilities for the coming years, even if some of these liabilities are off-book. There are also specific notes on things like selling, general and administrative expenses, as on page 20.

This is just one line item on the income statement, but for more refined information, the note provides that greater level of detail that might be of interest to some investors. The business section of a 10K is another valuable source of information. This section is where the company outlines the nature of its business. With McDonalds, we all know the basics, but there is more information in here than most people are aware of.

This is also where the company must talk about the things that are material to investors, so this section can be quite rich with information. In particular, the company discusses things like international operations, or the performance of individual operating units. There is an entire section on the risks of the business, and these are disclosed in significant detail so that investors and prospective investors can know what risks the company faces that could disrupt its revenues or profits.

The SEC mandates a fairly high level of disclosure in this section, so it is quite insightful, often.