10 reasons to read the notes to financial statements
Notes that accompany financial statementsFinancial statements Reports that sum up a company’s financial data and tell you how it is doing. The four basic statements are: the statement of financial position (balance sheet, statement of profit or loss (income statement), cash flow statement, and statement of changes in equity.+ read full definition are often as important as the financial statements themselves. They can provide critical information not found on the balance sheetBalance sheet A financial statement showing a company’s assets, debts and how much money shareholders have invested in the company as at a certain date.+ read full definition, income statementIncome statement See Operating Statement.+ read full definition, cash flow statementCash flow statement A record of the flow of cash in and out of a company over a set period of time.+ read full definition or statement of changes in equity.
Notes can include text, tables and graphs, and explain financial details about a company such as when revenue is recognized or how write-offs are calculated.
If you’re researching for a company to invest in or trying to better understand one that you’ve already invested in, notes are helpful when evaluating a company’s financial performance and strength as well as any risks that you should be aware of.
Notes can give details about where revenue comes from, payment terms, amounts allocated for refunds or warranties, and other relevant information. Revenue isn’t necessarily the same as cash collected, so it’s important to understand how it is affected by the company’s accounting policies.
2. Going concern
Financial statements are prepared on a “going concern” basis, which assumes the company will continue in operation for the foreseeable future and will be able to pay its liabilities, such as employee wages, in the normal course of business.
When doubt exists about a company’s ability to continue as a going concern, details are disclosed in the notes. It could include information about the underlying reasons and information about its future, vulnerabilities and overall risk.
3. Accounting policies & changes
Almost all figures reported in the financial statements are affected by a company’s accounting policies. A change in an accounting policy can impact financial results. For example, changing revenue recognition policies could increase or decrease the reported amounts for revenue, net income and accounts receivable. If such a change is not disclosed, comparing the financial results year-over-year or between similar companies would be difficult, if not impossible.
4. Critical accounting estimates and judgments
The preparation of financial statements requires a company’s management team to make estimates and judgments that affect the reported amounts. For example, management may need to estimate the uncollectable amount for an outstanding receivable or the expected useful life of a capital asset. The application of different estimates or judgments could lead to significantly different financial results.
This does not mean that the financial statements are not reliable; it means, rather, that financial statements should be approached with a clear sense of their underlying characteristics and the understanding that the things they depict could have been measured differently by using other, often equally reasonable, estimates or judgments.
Understanding the critical accounting estimates and judgments can help you better assess the numbers underlying a company’s financial position and performance and gauge, to some extent, the reasonability of these estimates or judgments taking into consideration your knowledge of the company, industry, and other external information (e.g., political, economic, socio-cultural, legal, technical, and environmental).
5. Operating segments
To evaluate the financial effects of a company’s different business activities and the economic environments in which it operates, the notes include important information about the distinct components of a company, called operating segments. These are sometimes referred to as departments, divisions, or geographic regions or industry areas. It can give you a deeper understanding of how certain areas perform relative to others.
6. Distinct items
A company could have transactions or events that may be considered distinct, unusual or otherwise unique, compared to its normal operations. Examples could include an unexpected loss from a natural disaster or the sale of a manufacturing plant. It could lead to unusually high or low income or expenses compared to previous periods or expectations.
When assessing a company’s financial performance, make a note of distinct items as they may not be repeated in the future but could significantly influence financial results for a given period of time.
7. Related party transactions
Related party transactions are between parties that can influence each other, like a sale of equipment between two companies owned by the same person. The price or terms may be more favourable compared to transactions between unrelated parties.
The notes can reveal important information on related party transactions, including outstanding balances and commitments. This information can help you identify certain transactions for further assessment, commentary, or consideration.
Since related parties include key management personnel, the notes are also the place to look if you want to know the compensation for this group.
8. Debt obligations & covenants
To understand the extent of risks, including future cash outflows, arising from debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date.+ read full definition obligations and how the company manages those risks, the notes can reveal some information, such as:
- terms on outstanding debt (e.g., interest rates, repayment periods, conversion features)
- access to unused credit (e.g., lines of credit)
- assets pledged as security
- how the recorded debt amount compares to its fair value
- compliance with covenants (and consequences of non-compliance)
This information can help you gain insight into a company’s financial position, including credit and liquidity riskLiquidity risk The risk of being unable to sell your investment at fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. In some cases it may not be possible to sell the investment at all.+ read full definition.
9. Commitments & contingencies
Some commitments (e.g., unfulfilled purchase orders) or potential obligations (e.g., pending lawsuits or disputes) are not recorded in the financial statements. A commitment or contingency may result in a future liability (and cash outflows) depending on the outcome of certain events (e.g., delivery of goods in satisfaction of the purchase order, unfavorable legal judgment against the company). Until that time, these items remain “off-balance sheet” and unrecorded. In order to appreciate the nature and extent of risks associated with these items, as well as future cash flows, the notes can reveal important information that you can factor into your analysis (e.g., projections).
Until there is more information or certainty, these items remain “off-balance sheet” and unrecorded. However, the notes may provide clues on the company’s expectations of future events or outcomes based on the limited information.
10. Subsequent events
A subsequent event is an event that occurs after a reporting period (the date on the financial statement), but before the financial statements authorised for issue. Although certain subsequent events may not be recorded in the financial statements, information regarding these events may be disclosed in the notes, when material. Examples include:
- changes in the value of certain assets (e.g., impairments)
- destruction of company assets (e.g., fires, thefts)
- new guarantees or commitments
- new financing (e.g., sale of shares, debt)
Information on such events provides early notice of items that will affect the future financial statements – allowing you to incorporate them into your analysis today.