How to Read Financial Statements

Financial statements can be intimidating. They're full of figures and complex words and look confusing at first glance. Even those with financial know-how are often reluctant to delve into the income statement, balance sheet and cash flow statement. But they're missing a trick.

Taking the time to read financial statements can give you a confident edge in your investment decisions. Here's a run-down on the three key documents to get to grips with, along with a few more worth mentioning.

Income Statement

The income statement is also known as the profit and loss statement. This is usually the first document a financial professional will peruse before moving on to the balance sheet and, finally, the cash flow statement. 

The income statement shows company revenues and expenses for a set period, usually a fiscal quarter or a year. Ultimately this gives us an at-a-glance insight into the company's profitability.

The common phrase' top line revenue' comes from the top line of the income statement, which gives us total company sales.

Likewise, the phrase 'bottom line' reflects the net income figure at the bottom of the income statement, which gives us the company's profits for the period.

Between the top and bottom line, we see expenses which include the cost of goods sold (COGS), wages, rent, and other operating expenses, such as research and development (R&D), sales and marketing, general and administrative, and interest expenses.

While company profits are of keen interest to investors, they are not the only metric worth considering. One-off events such as an asset sale or legal settlement can impact profits. Examining EBIT, EPS, and Free Cash Flow per share can help you get a clearer picture of the company's performance and whether profitability is sustainable.

Balance Sheet

The balance sheet is the second financial document that should be on your radar. This gives us a snapshot of a company's financial position at a specific time. It lists the company's assets, liabilities, and equity.

Company assets include cash, investments, and property. Indeed, anything with monetary value. These are split further into current assets and non-current assets.

Liabilities are the debts the company owes, such as loans, dividends, wages, interest and accounts payable. These are split further into current liabilities and non-current liabilities.

Equity is what remains after liabilities are subtracted from assets. This can include preferred stock, common stock, and retained earnings.

The balance sheet is well worth a read because it gives us a better idea of what the company is worth and whether its finances can comfortably fund its operations while paying any debts.

Cash Flow Statement

Finally, the cash flow statement shows cash moving in and out of the business over a determined period. Here you can see cash flow from operating, investing, and financing activities.

The cash flow from the operating activities section tells us how much cash the company's core business operations have generated. The investing activities section tells us how much money the company's assets have generated, and the cash flow from financing activities shows how much cash is generated or spent in the company's financing activities.

Ultimately, the cash flow statement shows investors whether the company is generating enough cash to fund its operations and pay its debts.

Other Financial Statements

We hope this helps you better understand financial statements and how to read them.

Investing is a long-term process that benefits from careful evaluation and the passage of time. Learning to read financial statements gives you a head start with this.

But financial metrics are only one part of the puzzle when evaluating a company's financial health. Investors should also consider other factors, such as the company's management style, industry trends, and economic conditions.

In addition to the income statement, balance sheet, and cash flow statement, there are a few other financial statements that investors may want to consider when evaluating a company's financial health.

Statement of Stockholders' Equity

The statement of stockholders' equity shows us any changes in a company's equity structure over a specific period. It includes share issuance and repurchase and any dividends paid out.

This statement can give us an idea of this investment's value to shareholders.

Statement of Comprehensive Income

The statement of comprehensive income shows the company's net income, foreign currency translation adjustments and unrealized gains or losses on securities.

This document adds more color to a company's financial performance, including items that may not be reflected in the net income on the income statement.

Notes to Financial Statements

You can sometimes find hidden gems in the additional notes and explanations accompanying financial statements.

These notes could include information on accounting policies, important transactions or events, and any uncertainties or contingencies that could affect the company's financial position.

Reviewing these notes carefully is essential as they can provide valuable insights into a company's operations and financial health.

Understanding financial statements can initially seem overwhelming, but with some practice and knowledge, you can begin to decipher and interpret them like a pro. By regularly reviewing financial statements and other company information, investors can make informed decisions about whether or not a company looks like a good investment.

Tips for Reading Financial Statements

To get you on your way to investing prowess, here are a few tips to help you get the most out of financial statements:

• Start with the big picture: Before diving into the nitty-gritty details, look at the company's overall financial health. Are the numbers trending up or down? How does the company compare to its peers or benchmarks?

• Look for red flags: Keep an eye out for any warning signs indicating financial trouble. These could include declining revenues, rising debt levels, or significant changes in accounting policies.

• Understand the assumptions and estimates: Financial statements are based on future projections, so it's important to understand what these are and how they may affect the numbers. If a company uses an unachievable discount rate to calculate the present value of its future cash flows, it may result in a lower net income.

• Use ratios and other tools: Various financial ratios and calculations can help you better understand a company's financial performance and position. Some ratios include the price-to-earnings ratio (P/E Ratio), debt-to-equity ratio (D/E Ratio) and return on investment (ROI).

• Keep up with the latest developments: Financial statements date quickly, so it's good to keep abreast of the latest company developments and watch for news or company updates. This could include earnings releases, conference call transcripts, press releases, and other company updates.

Conclusion

Learning to read financial statements is a worthwhile skill that anyone can learn. By regularly reviewing the income statement, balance sheet, and cash flow statement, you can gain valuable insights into a company's financial health and make informed investment decisions.

Remember to consider other factors, such as management, industry trends, and economic conditions, and consult with a financial professional if you have any questions or concerns.

As always, it's important to consider the company's overall financial health and do your due diligence before making investment decisions.

Why not continue your investing education journey with some of our other informative articles:

How to Find Investment Opportunities

How to Read a Balance Sheet

How to Read a Cash Flow Statement

How to Read an Income Statement

What Do Financial Professionals Look for in a Balance Sheet?