ALEXANDRIA, VA (April 21, 1998) -- Before getting into the balance sheet, I thought it might be useful to review the meaning of these statements. Analyzing financial statements in and of itself is an entertaining intellectual pursuit, but there is a larger end to it than just as an intellectual diversion. The end to the means is superior investment returns -- an end to which I think I can say we all aspire. (As you read, remember that for definitions of terms used you can visit our Financial Services Glossary.)
The balance sheet is one of the three financial statements of paramount importance to investors. The other two statements are the income statement and the cash flow statement, otherwise known as the statement of cash flows or the statement of funds flows or the statement of sources and uses of cash.
The income statement shows the company's return on capital while the cash flow statement reconciles the return on capital with changes in capital throughout the year. Frequently, what is shown on the income statement doesn't fully reflect economic return on capital, though. Return on capital and economic earnings are two flows of value that the investor can choose to look at differently than methods mandated by Generally Accepted Accounting Principles, or GAAP.
While GAAP is necessary to put accounting into standard vocabulary and provide standard methods of description and expression, that doesn't mean the economic substance of a corporation's value is totally captured or expressed well by GAAP-guided financial statements. Amortization of goodwill expense and the asset of goodwill, for instance, is one clear set of GAAP mandates that misses the economic substance of how an investor or business person looks at the wealthfare of his or her enterprise.
In all, though, the codification of accounting expression is a highly useful development for investors. The meritocratic formation of wealth and the efficient operation of capital markets depend upon, among other things, standard expressions of accounting. Deciphering the information presented in a company's financial statement and assessing value is a role that a securities analyst or investor must live up to. The three financial statements together form a sort of capital flow ecosystem, showing the interdependence of the financial statement accounts and the reflexivity of capital flows during the accounting period. As an ecologist would look at the absence of a certain predator in an ecosystem or a buildup of algae in a lake and make informed judgements as to the possible results of those developments, a practiced securities analyst can look at a set of financials, whether more of a snapshot look or a a look at a number of years' financials, and make informed judgements as to what's going on with the company in question.
The balance sheet for a bank should be read, as with all financials but especially in the case of a bank, along with the copious notes and appendixes to financial statements. In the case of deposits, for instance, the balance sheet often just gives you one line: "Deposits." The composition of that account is very important, however. An investor should pay close attention to the composition of deposits. The mix between noninterest bearing deposits and interest bearing deposits is one very important determinant of a bank's profitability. Noninterest bearing deposits come mainly in the form of checking accounts, known in banking as transaction deposits. If a bank has an average float (average assets of which it has use but which are fully backed by liabilities or reserves) of $5 billion in checking deposits, it obviously can generate more earnings sticking those assets in money market funds yielding 5% than a bank paying 5% on a similar amount of deposits and buying bonds that yield 8%.
We'll continue with more from the balance sheet tomorrow.
Have a good Tuesday night,