One of the most crucial skills for investors to have is the ability to comprehend and analyse financial statements because they can provide insight into the operating and financial health of a company. Armed with this knowledge, investors can better identify promising opportunities while avoiding undue risk, and professionals of all levels can make more strategic business decisions.
Generally, financial statements include balance sheet, income statement, and cash flow statement. In this article, I used Silicon Valley Bank’s 2022 annual financial statements as an example to show you how to read financial statements. And after reading this article, you can think about why this bank collapsed and how to avoid investing companies like this.
How to Read a Balance Sheet
Balance Sheet is a snapshot of a company’s financial position, which shows company’s assets, liabilities, and equity.
Here is SVB’s consolidated balance sheet:
First, we need to be aware of balance sheet’s framework. Balance sheet consists of three parts – assets, liabilities, and equity. Assets minus liabilities equals to equity. Assets are what the company owns, while liabilities and equity are what the company owes to investors. Also, we need to be aware that loans are assets for banks, but liabilities for other companies. Lending loans to borrowers is bank’s main business and interest payments on these loans are bank’s one of main revenue resources. The deposits are bank’s liabilities because bank need to pay interest to clients who put their money in the bank. In this situation, banks are more like borrowers while clients are more like lenders.
Then, we check its cash ratio. The cash ratio helps measure a company's liquidity. Liquidity is a measurement of a company's ability to pay their current liabilities. The cash ratio is calculated by dividing cash & cash equivalents by current liabilities. If a company has high liquidity, it is able to pay their short-term bills as they come due. If a company has low liquidity, it is going to have a more difficult time paying short-term bills. It is often better to have a high cash ratio. This means a company has more cash on hand, lower short-term liabilities, or a combination of the two. It also means a company will have greater ability to pay off current debts as they come due. It is possible for a company's cash ratio to be considered too high. A company may be inefficient in managing cash and leveraging low credit terms. In these cases, it may be advantageous for a company to reduce their cash ratio. Current liabilities (also called short-term liabilities) are debt a company must pay within a normal operating cycle, usually less then 12 months. In this case, cash & cash equivalents are $13.803b and current liability is $186.674b (including total deposits & short-term borrowings). SVB’s cash ratio is 0.074. Usually, a good cash ratio for a bank is above 1, and a ratio under 0.5 considered risky. Therefore, cash ratio of 0.074 indicates that SVB’s financial position is extremely risky.
Debt Equity Ratio (D/E), calculated by dividing a company’s total liabilities by its shareholder equity, is a measure of the degree to which a company is financing its operations with debt rather than its own resources. It also indicates the stability of a company and its ability to raise additional capital to grow. A high D/E could mean the company has too many debts or just takes advantage of low interest rates. Usually, a D/E ratio of 1.5 or lower considered desirable and it’s common for bank to have higher D/E (around 3). However, in this case, SVB’s D/E is almost 12 and interest rate has been increasing, so it’s clearly that SVB has been taking too much risk.
Now we can tell SVB’s liquidity is way too low, and its leverage is way too high, indicating SVB has high financial and operational risk.
How to Read an Income Statement
An income statement is a financial statement that shows you the company's income and expenditures. It also shows whether a company is making profit or loss for a given period.
Here is SVB’s consolidated income statement:
To analyse an income statement, we need to check the main sources of income and expense and see how they have changed. Usually, a bank’s major incomes come from loan interest payment from borrowers and investment return, while major expenses consist of interest on deposit and top managers’ compensation. Both “Total interest income” and “Total interest expense” has been increasing over the last three years, which makes sense because the interest rate has been increasing as well. The “Net interest income” sees an upward trend which is a good sign. However, the huge loss from “Investment securities” is alarming. Therefore, we need to keep this in mind and check SVB’s asset allocation details later. Despite the fall in total non-interest income, the compensation has been increasing sharply over last three years. This might be a sign that there’s a hug problem in SVB’s corporate governance. Unrealised holding losses on AFS securities in 2022 is way too big, which is 1.66x net income available to common stockholders. If SVB need cash urgently and cannot raise more money from investors, they have to sell these assets and suffer a sizable loss.
Based on the alarming “loss from investment securities” and ridiculously high “unrealised holding losses on AFS securities”, checking this company’s asset allocations is the first thing we need to do after analysing its cash flow statement.
How to Read a Cash Flow Statement
The purpose of a cash flow statement is to provide a detailed picture of what happened to a business’s cash during a specified period. The cash flow statement is typically broken into operating activities, investing activities, and financing activities.
Operating activities detail cash flow that’s generated once the company delivers its regular goods or services and includes both revenue and expenses. Investing activities include cash flow from purchasing or selling assets—think physical property, such as real estate or vehicles, and non-physical property, like patents—using free cash, not debt. Financing activities detail cash flow from both debt and equity financing.
Here's SVB’s consolidated cash flow statement:
First, we check “Net cash provided by operating activities”, which has been growing steadily.
Next, we look at “Net cash used for investing activities”, which fell significantly from $90.336 billion in 2021 to $3.638 billion in 2022. This indicates that SVB's investment activities decreased, which may have been due to a shortage of money, a worsening of the economy, or a combination of the two. One detail that got my attention is “Purchase of HTM securities”. Held-to-maturity (HTM) securities are purchased to be owned until maturity, which means they cannot sell this part of assets, if they need money urgently or when the asset value decreases. Interest rate has been increasing, causing asset value decrease sharply. This is the reason why there’s too much unrealised loss in SVB’s income statement. The cash flow statement reveals that SVB's management made a terrible choice in 2021.They bought too much HTM securities ($85b) because they misjudged the interest rate movement and overexposed themselves to interest rate risk.
SVB’s financial activities are also disturbing. The net cash provided by financial activities became negative in 2022. And the details of its financial activities are even more disturbing. The deposits (banks’ main asset source) dropped $16b but SVB still raised tons of debt in term of both short-term and long-term, which increased its leverage risk tremendously.
Now, check SVB’s asset allocations. You can find this information in “Notes to financial statements”.
We focus on the fair value and unrealised losses of available-for-sale securities and hold-to-maturity securities.
When I was reading this, I can’t believe what I've seen. I have never seen a worse investment portfolio than this one. The risk management and investment teams at SVB ought to have been fired a long time ago.
The investment portfolio is way too concentrated in terms of the portfolio structure and risk factor.
Both AFS securities and HTM securities consist of similar kinds of assets, such as residential MBS, agency-issued CMBS, and bonds. Also, U.S. Treasury securities occupy 76% of total AFS securities and residential MBS takes up 75% of total HTM securities. And 85% of securities are those with a maturity of 12 months or longer, which creates a significant liquidity risk. More importantly, all these assets expose to a same risk factor – interest rate. When interest rate goes up, all these assets value will go down.
Investment industry is a crazy world. I hope this article can help you identify the rotten apples before the public did.
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