Accountants have been preparing some sort of financial statements since the beginning of written records, which were developed by the Sumerians in cuneiform around 3400 BCE. A more formal, and familiar, report was developed around 1350 CE by the merchants of Venice, Genoa, and surrounding areas. In 1494, Luca Pacioli from that area wrote about this, monumentalizing the words Debits and Credits, and he is aptly called the Father of Accounting. Since Pacioli, nothing significant in the format has changed but there have been some additions and plenty of disclosures.
Occasionally, the relevance of financial statements is questioned, and I want to reaffirm their importance.
Balance sheet
When I started in public accounting in the 1960s, the emphasis was on the balance sheet. It was believed that if all the accounts on the balance sheet were fully documented, then the report was considered “right.” Simple! Start with cash and work your way down. The income statement, or profit and loss statement (P&L), was considered correct if the bottom line was the balancing amount on the balance sheet, with the net income represented by the difference between the beginning and ending capital accounts in the balance sheets (with allowances made for dividends and some other defined capital account changes).
Today, there seems to be less regard for the balance sheet, at least for public companies with market capitalizations greatly higher than the stockholders’ equity, or book value. Book value used to be an important metric; not so anymore, at least for public companies. However, for private companies, book value is still an important benchmark for loan decisions and bank covenants because reductions in book value indicate an operating loss or a withdrawal of capital, both no-no’s in the lending world. Further, market values for private companies are less definite and perhaps pretty vague, leaving the book value as a uniform or consistent yardstick.
For all companies, balance sheets are useful to measure a company’s internal resources and liquidity, its working capital, asset utilization and asset base that supports the operations, and how well equity is leveraged with its debt and its return on equity. Public companies are usually referred to as having a “strong” or “weak” balance sheet. This refers to its debt and cash positions, both of which are important and obtainable from the balance sheet. Book value is also an indication of what might be realized in a liquidation, but that is subject to many factors. Unless there are valuable assets that are not recognized on the balance sheet, it is a starting point which is nibbled down, making the book value more of a maximum amount. Still, a starting point is useful.
For most public companies, but also for many private companies, the value of the company is not measured by the balance sheet, but rather by the company’s cash flow or earning capacity. These reduce the importance of the balance sheet, but don’t render it irrelevant.
Profit & Loss Statement
At some point in the last 30 or 40 years, emphasis shifted to the P&L statement. Investors gave greater focus to sales changes, gross margin and fixed cost increases or decreases, net income, and trends within these elements. Balance sheets weren’t disregarded, but were relegated to a lesser role.
Investment bankers got fancy with different acronyms to describe a company’s earnings, coming up with EBIT (Earnings before interest and taxes), EBITDA (Earnings before interest, taxes, depreciation and amortization), and FCF (Free Cash Flow).
EBIT and FCF have merit, but I find EBITDA to be a fallacious metric. While most Form 10-Ks from 15 to 20 years ago reported EBITDA as a “non-GAAP” metric, it is not used much anymore in 10-Ks, being replaced by FCF—which I believe is a much better metric. Just to comment on these two acronyms, EBITDA does not recognize the recurring expenditures by companies for equipment replacements and additions, which are not P&L amounts but certainly are a drain on cash flow. Such expenditures are as much of a “loss” in earnings as adding back depreciation is a “cash” earner. FCF recognizes this by reducing the cash flow from operations, not the net income, by fixed asset expenditures. FCF represents cash available from operations, which may be used for distributions to owners, investment in the business, reducing debt, and shoring up cash reserves. A simpler way might be to use EBIT (Earnings before interest and taxes) which uses the income statement as it presents the operations but stopping short a couple of lines from the bottom. If any special circumstances appear, they can be adjusted for.
Whether net income, EBIT, EBITDA, FCF, or any other description of the results of the Company’s operations are used, the income on the P&L has become the dominant measure and the starting point to determine a company’s value.
Earnings as the driver of value
Earnings are now the primary metric that is used to determine a public company’s value. There are exceptions, but a vast majority of publicly traded companies are priced based on earnings. Some are based on dividends, and some have distinct reasons for high or particularly low valuations, i.e., price to earnings ratios (PE), but it is the earnings that primarily determine the value.
“Earnings” is a term that can represent current reported earnings (which is a trailing measure), the most recent quarter projected for the next year, a projected amount at a point in the future, or any other way an investor might choose to evaluate, project, or adjust the earnings. Earnings are usually capitalized to determine a company’s value. For instance, if an investor seeks a 5% return, they would divide the earnings by 5% to get the value. An illustration is a company with a $100,000 net income would be worth $2,000,000 ($100,000 ÷ 5% = $2,000,000). In investor lingo, this translates to a price to earnings ratio (PE) of 20. (1 ÷ 5% = 20), meaning that company or its shares would be valued at 20 times its current earnings. One with a PE of 10 would be valued at 10 times earnings and a PE of 30 would value the company at 30 times earnings.
The PE, from one standpoint, represents an expected return on investment over a period of time the investor chooses. This return would be from a combination of dividends and increases in the value of the shares. A growing company would have a higher PE, while a stable company would have a PE more representative of current expected returns on investment for that industry or sector. The market value of the company is generally referred to as “market capitalization” or “market cap.” However the value is determined, it is based somewhat on the reported earnings in the financial statements.
If the book value were to be subtracted from the market cap, the difference would be an “intangible” value that would reflect the greater value based on expectations of future cash flow and/or growth. In many cases, the market caps are substantially greater than the book values. By the way, book values might be adjusted for assets the value of which are not reflected properly on the balance sheet and that involve judgement and perhaps access to data that is not generally available. This doesn’t reduce the relevance of the balance sheet; it makes the P&L more dominant.
When earnings determine the value, their importance is greatly elevated. Investors then provide their own analysis as to growth, sustainability and predictability of earnings, and the timing of the earnings as well as perhaps a possible upward [or downward] change in the company’s PE ratio to arrive at a price they would pay, which transmits into the market cap. Investors use other factors as well, such as dividend paying capacity, growth [or declines] in profit margins, containment of expenses, capital expenditures, research and development costs, and expansion into new markets, but all of these have their underpinning in earnings, whether current, expected, or sustainable. There are many other metrics investors use, such as market share and position, pricing power, quality of management, governmental regulations, sustainability initiatives, interest and inflation rates, and new products and services in the pipeline, but earnings or potential for earnings are a starting point in almost all cases.
Delivery of earnings
Earnings are delivered to the public by the audit report. This makes the financial statement extremely important and necessary for the stock and capital markets. The organized accounting industry (and governmental agencies such as the PCAOB and SEC) has developed sound ways of measuring earnings, with promulgations affecting revenue recognition, post-retirement benefits, provisions for income taxes, valuations of acquired assets, software development, research costs, inventory valuations, depreciation and amortization charges, and many other areas. Most of these promulgations can be viewed in the summary of significant accounting policies at the beginning of the notes to financial statements. More detailed explanations and disclosures as necessary are contained in separate notes to the financial statements for those items.
Further, these rules have been developed from a company neutral and independent position, with the intention of bringing consistency, disclosure, and transparency to a company’s financial statements.
Other reports
A complete set of financial statements also include statements of cash flows and other comprehensive income. These statements play important roles, but earnings are still used in these as the starting and dominant measure. Converting earnings into its cash flow components provides valuable information, but is still another way of measuring earnings.
Aggregate changes in the values of certain assets and liabilities usually reflect earnings, but for distinct reasons these changes are not reflected in the P&L statement, but rather in the comprehensive income statement. Individual investors must make judgments about these amounts and whether they should be included in their consideration of net income. However an investor chooses to consider these statements, the basis for these statements is earnings or items expected to significantly affect earnings in some manner, either previously, presently, or in the future.
Conclusion
Market values are external measures. While it is significant when a company’s market value is much greater than its book value, companies do not “own” their market values, and it is the internal measures that are evaluated when assessing operations and the potential for future earnings or cash flows. The primary method of reporting earnings and other data is the financial statement.
While all components of a company’s financial statements are important, the dominant measure and key driver of value has become the earnings—specifically, the P&L statement. Focus has shifted from the balance sheet to the P&L statement; but this change should not make the other parts of the financial statements less important, and with added reports and more informative disclosures, the financial statements have become more relevant than ever.
Edward Mendlowitz, CPA, is an emeritus partner at Withum, an adjunct lecturer at Baruch College, and the author of 32 books.
