A company’s financial statements are like a report card that tells investors how much money a company has made, what it spends on, and how much money it currently has.
Knowing how to read a financial statement and understand the key performance indicators it includes is essential for evaluating a company. Any investor conducting fundamental analysis will pull much of the information they need from past and present financial statements when valuing a stock and deciding whether to buy it.
Each publicly traded company in the United States must produce a set of financial statements every quarter. These include a balance sheet, income statement, and cash flow statement. In addition, companies produce an annual report. These statements tell a fairly complete story about a company’s financial health.
Understanding Each Section of a Financial Statement
Along with a company’s earnings call, reading financial statements can give investors clues about whether or not it’s a good idea to invest in a given company.
Here’s what the different sections of a financial statement consist of.
Balance Sheet
A company’s balance sheet is a ledger that shows its assets, liabilities, and shareholder equity at a given point in time. Assets are anything the company owns with quantifiable value. This includes tangible items, such as real estate, equipment, and inventory, as well as intangible items like patents and trademarks. The cash and investments a company holds are also considered assets.
On the other side of the balance sheet are liabilities — the debts a company owes — including rent, taxes, outstanding payroll expenses and money owed to vendors. When liabilities are subtracted from assets, the result is shareholder value, or owner equity. This figure is also known as book value and represents the amount of money that would be left over if a company shut down, sold all its assets, and paid off its debt. This money belongs to shareholders, whether public or private.
Income Statement
The income statement, also known as the profit and loss (P&L) statement, shows a detailed breakdown of a company’s financial performance over a given period. It’s a summary of how much a company earned, spent, and lost during that time. The top of the statement shows revenue, or how much money a company has made selling goods or providing services.
The income statement subtracts the costs associated with running the business from revenue. These include expenses, costs of goods sold, and asset depreciation. A company’s revenues less its costs are its bottom-line earnings.
The income statement also provides information about net income, earnings per share, and earnings before interest, taxes, depreciation, and amortization (EBITDA).
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Cash Flow Statement
A cash flow statement is a detailed view of what has happened with regards to a business’ cash over the accounting period. Cash flow refers to the money that’s flowing in and out of a company, and it is not the same as profit. A company’s profit is the money left over after expenses have been subtracted from revenue. The cash flow statement is broken down into three sections:
• Cash flow from operating activities is cash generated by the regular sale of a company’s goods and services.
• Cash flow from investment activity usually comes from buying or selling assets using cash, not debt.
• Cash flow from financing activity details cash flow that comes from debt and equity financing.
At established companies, investors typically look for cash flow from operating activities to be greater than net income. This positive cash flow may indicate that a company is financially stable and has the ability to grow.
Annual Report and 10-K
Public companies must publish an annual report to shareholders detailing their operations and financial conditions. Look for an annual report to include the following:
• A letter from the company’s CEO that gives investors insight into the company’s mission, goals, and achievements. There may be other letters from key company officials, such as the CFO.
• Audited financial statements that describe financial performance. This is where you might find a balance sheet, income statement and cash flow statement. A summary of financial data may provide notes or discussion of financial statements.
• The auditor’s report lets investors know whether the company complied with generally accepted accounting principles as they prepared their financial statements.
• Management’s discussion and analysis (MD&A).
In addition, the Securities and Exchange Commission (SEC) requires companies to produce a 10-K report that offers even greater detail and insight into a company’s current status and where it hopes to go. The annual report and 10-K are not the same thing. They share similar data, but 10-Ks tend to be longer and denser. The 10-K must include complete descriptions of financial activities. It must outline corporate agreements, an evaluation of risks and opportunities, current operations, executive compensation and market activity. They must be filed with the SEC 60 to 90 days after the company’s fiscal year ends.
MD&A
The management’s discussion and analysis provides context for the financial statements. It’s a chance for company management to provide information they feel investors should have to understand the company’s financial statements, condition, and how that condition has changed or might change in the future. The MD&A also discloses trends, events and risks that might have an impact on the financial information the company reports.
Footnotes
It can be really tempting to skip footnotes as you read financial statements, but they can reveal important clues about a company’s financial health. Footnotes can help explain how a company’s accountants arrived at certain figures and help explain anything that looks irregular or inconsistent with previous statements.
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Financial Statement Ratios and Calculations
Financial statements can be the source of important ratios investors use for fundamental analysis. Here’s a look at some common examples:
Debt-to-Equity
To calculate debt-to-equity, divide total liabilities by shareholder equity. It shows investors whether the debt a company uses to fund its operation is tilted toward debt or equity financing. For example, a debt-to-equity ratio of 2:1 suggests that the company takes on twice as much debt as shareholders invest in the company.
Price-to-earnings (P/E)
Calculate price-to-earnings by dividing a company’s stock price by its earnings per share. This ratio gives investors a sense of the value of a company. Higher P/E suggests that investors expect continued growth in earnings, but a P/E that’s too high could indicate that a stock is overvalued compared to its earnings.
Return on equity (ROE)
Calculated by dividing net income by shareholder’s equity, return on equity (ROE) shows investors how efficiently a company uses its equity to turn a profit.
Earnings per share
Calculate earnings per share by dividing net earnings by total outstanding shares to understand the amount of income earned for each outstanding share.
Current Ratio
This metric measures a company’s abilities to pay off its short-term liabilities with its current assets. Find it by dividing current assets by current liabilities.
Asset turnover
Used to measure how well a company is using its assets to generate revenue, you can calculate asset turnover by dividing net sales by average total assets.
The Takeaway
The financial statements that a company provides are all related to one another. For instance, the income statement reflects information from the balance sheet, while cash flow statements will tell you more about the cash on the balance sheet.
Understanding financial statements can give you clues that could help you determine whether a stock is a good value and whether it makes sense to buy or sell.
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