Which Financial Statement is Most Important?

From our previous discussions we've known that the three financial statements constitute an integral whole. Each of them has a specific responsibility: Income statement mainly describes operating activities. Balance sheet focuses on investing and financing activities. And cash flow statement tells us the risk condition of the company. Each statement complements one another to form a complete description of a company's financial and economic condition.

Additionally, because they play different roles, we can imagine that when we make different decisions, we might rely more on one than the other. For example, suppose that I want to get loan from the bank. Which financial statement do you think the bank concerns the most? 

Which financial statement does a bank care the most?

You may choose the balance sheet, because balance sheet tells us what the company actually has. If the company cannot repay the debt, the bank can sell off what the company has on the balance sheet to repay the debts.

Altough this logic makes sense at the first glance, banks rarely expect companies to repay their debts this way, i.e. repaying debts by selling off assets on the balance sheet.

Why is that?

Once a company sells off assets, especially fixed assets and other crucial intangible assets such as technology or land usage rights, the company will be close to be liquidated. The next step is likely bankruptcy. Obviously banks don't want to see the companies they lend money to get to this stage.

Therefore, banks actually prefer companies to repay debts through normal operation. In other words, they hope companies will have enough cash to repay debts. 

Once we know this, we will know that what banks concern the most is actually not balance sheet, but cash flow statement.

Put it in another way: what balance sheet tells us is what the financial condition could be if the company can survive. What cash flow statement describes is the risk condition the company faces, i.e. the likelihood of its survival.

Should banks be more concerned about a company's financial prospects, or survival likelihood?

The latter, actually. Why? 

Because no matter how much the company earns, it will not share its net profits with banks. The most important thing for the bank is that the company returns principal and pays interest. So from this perspective, the answer is cash flow statement.

Which financial statement does an investor care the most?

If you are an investor interested in investing in a company, which financial statement of the company would you pay the most attention to?

Perhaps you will say it is the income statement. As an investor, what you care about is the return of a company. However, do you care about past return, or future return?

Apparently it is the future return, as past returns are useless to investors. This is where things become tricky, as no financial statement (or in that regard, anything) can help us predict the future.

However, even though we are NOT in the business of fortunetelling, we can indeed distill some level of future financial performance predictability. 

Recall that income statement not only tells us how much the company is earning currently, but it also provides info for predicting future returns by categorizing profits into operating and non-operating profits. The more the operating profits, the more sustainable the profits are in the future.

Therefore, as an investor interested in the company's future performance, the most direct source of information is the company's income statement.

Which financial statement does a potential corporate buyer care the most?

There are a lot of mergers and acquisitions nowadays. Suppose you are going to acquire another company, and before you make the decision, you'd definitely want to take a look at the financial reports of the company. At the least, you would want to know what you are getting from the acquisition. 

In order to accomplish this, which financial statement would you pay attention to the most? 

Some people might choose income statement. They might want to make money from the acquisition, so they want to at least know the target company's business scope, business model, and the sustainability, etc.

However, it is not uncommon that a company endures radical changes to any or all of the above after being acquired; if they do change, the performance of the company will change too.

Similarly, we could hardly learn about future profits from cash flow statement. 

Therefore, since my top concern is that I don't get what I think I was going to get before making the deal, I will drill deep into the company's balance sheet. 

Why is that?

First let's back it up a little bit.

If we acquire a company, what are we really acquiring? 

Is it just the company's assets? Liabilities? Or shareholder's equity?

At face value, the answer should be shareholder's equity. However, since shareholder's equity equals assets minus liabilities, we are actually acquiring both assets and liabilities of the company as part of the acquisition deal.

You might have heard of a term called "Zero Cost Acquisition". What it means is that the potential buyer pays zero dollar for the company's shareholder's equity, and at the same time, assumes all liabilities and assets as well. 

Just like a rational consumer buying everyday groceries, who is afraid of overpaying, a corporate buyer is also afraid of the same thing. The target company's assets might be overvalued, and liabilities undervalued.

To lower the risk, I can certainly engage professional law firms and accounting firms to help with due diligence. They can help me evaluate all asset and liability items in an attempt to prevent the overvaluing of the former and the undervaluing of the latter. However, I can only analyze and prevent such things from happening based on the information provided; if the target company NEVER provides all the information, I can hardly detect and avoid all potential pitfalls. For example if the company actually owed 50 persons money, but it only provided me with 30 of them and hide the other 20, I can analyze all day on the 30 persons but still miss the whole picture.

In merger and acquisitions, the risk associated with liabilities is actually more important to us. The seller could inflate the value of assets, but it will never hide an asset. However, he might hide a liability item from us; that is to say, if we fail to detect some liabilities of the company and they show up after the acquisition, we could face devastating situations. For example, there might be a contingent liability that comes back to bite us. A contingent liability is a liability that may show up when the target company promises to pay the debt of another company contigent on its failure to repay the debt by itself.

In addition to contingent liability, there could be other situations where the target company has off-balance-sheet liabilities, which we will cover later in our discussions.