How to Read and Understand Financial Statements

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When looking over your investments, do you ever wonder how the value of the companies you’ve put your money in is determined? What factors decide how well a company is really doing? What’s the source of the company’s financing? Will it meet or exceed this quarter’s projections? While some consider the stock market to be little more than a house of cards, subject to the whims of individual investors, there are, in fact, some very real and measurable things that can help you to diagnose the financial health of a company.

Whether you’re an investor or own your own business, knowing how to read and understand financial statements is essential, as they can be used to make future predictions, help project growth, and identify potential causes for concern. 

What Are Financial Statements?
Financial statements are records of a business’ financial activities during a certain period. There are three financial statements: the balance sheet, income statement, and statement of cash flows. With financial statements, you can get a general idea of what’s happening with the money coming in and going out of your business.

Below, we’ll go over what financial statements are, along with the four basic financial statements you’ll typically encounter and how to read them. Read from end-to-end to better grasp how to read financial statements, or use the list below to navigate to a section that touches upon a specific financial statement.

What Is a Financial Statement?

Financial statements are records that highlight a business’s activities and how they are performing financially. There are numerous types of financial statements companies use to determine their financial health, and each measures different areas of a business’s finances. Government agencies, accountants, and private firms also audit financial statements to ensure they’re accurate for tax, investing, and financing purposes.

What Are the Four Basic Financial Statements

It’s not an interrogation, but you’ll want to ask the hard questions before you invest. Only by examining, drawing conclusions, and understanding financial statements will you truly know how well a company is doing. 

At first glance, you will see that a financial statement is made up of four main sections, the balance sheet, the income statement, the cash flow statement, and the statement of shareholders’ equity. These four financial statements, which we cover in detail below, each depict a different aspect of a business’s overall financial picture.

Balance Sheets

The balance sheet details companies’ current assets, which are any assets that can be sold within a year. Examples of current assets include:

  • Cash
  • Prepaid expenses
  • Accounts receivable
  • Stock inventory
  • Marketable securities

The balance sheet shows the financial position on a particular date. This statement also tells you what the current liabilities, or existing debt, must be paid within that year by a company. Examples of debt include: 

  • Accounts payable
  • Salaries payable
  • Dividends
  • Income taxes payable
  • Short-term debt

The amount of current assets over current liabilities determines the amount of working capital or leftover cash the company has to cover other operating expenses. Whether or not there is enough money left over after the current debt is paid off tells you whether the company is on solid financial ground or might be headed for destruction.

Income Statements

The income statement summarizes the profits a business has earned for a specified period of time. This is where you would see the amount of revenue or profits obtained for a companies’ products or services and the expenses incurred for salaries, supplies, or income taxes. 

The difference between the revenue and expenses gives you the net income, which, when compared over a period of say two years, shows you how the net income is rising or falling, which can be a relatively good indicator of a business’s profitability. Basically, this statement tells you if the company has revenue coming in.

Cash Flow Statements

The cash flow statement is particularly important when considering new ventures, such as an internet startup. The ability to balance cash flow now can be a sign that the business has a long and profitable future ahead of it. This reports the cash going out and coming in from operating, investing, and financing activities. In this statement, changes in the net cash flow indicate the company’s ability to meet its debt obligations and pay dividends, how much external financing the company is using, and its ability to generate cash flow in the future. 

Operating cash flow can be described as the cash effects from revenue and expense transactions. Investing cash activities comes from the purchasing and selling of properties or assets, while financing cash activities shows how owners of the company have used loans from creditors to finance their business.

Statement of Shareholders’ Equity

The statement of shareholder’s equity, also called owner’s equity and stockholders’ equity, highlights the change in value to a shareholder’s equity in the company, or how much ownership interest they have in the business, and is often listed on the balance sheet. 

Suppose you’re wondering how to invest in stocks for beginners. In that case, it’s always worth looking at the statement of shareholder’s equity, as it can tell whether a company can pay its liabilities or not. For example, most investors might look at a company with negative shareholder equity as a risky investment. On the other hand, a company with positive shareholder equity might seem stable and profitable.

As a note, it’s important to remember that each of these financial statements don’t serve as true indicators of a company’s financial health when analyzed alone. Instead, most investors look at each financial statement together, along with other metrics and tools, to better understand a company’s finances.

How to Read a Financial Statement

To better understand your investments, it’s important to know how to read a financial statement. One of the biggest financial mistakes you can make as an investor is not doing your research to understand the financial health of the companies you’re looking to invest in. When reading a financial statement, you’ll be able to get a better sense of how a business is performing. Below, we’ll go over how to read financial statements:

Balance Sheets

A balance sheet provides information on a company’s assets, liabilities, and shareholder’s equity at the end of a reporting period. In the example balance sheet graphic below, you will notice the balance sheet is split into two halves. The top half of the balance sheet lists the company’s assets, including current assets and long-term assets. The bottom half of the balance sheet lists the company’s liabilities and shareholders’ equity, including short-term liabilities and long-term liabilities.

When reading a balance sheet, one crucial fact to remember is that it must balance. This means a company’s assets must be equal to its liabilities and shareholders’ equity. If the balance sheet is not balanced, there could be a recording or financial error. The standard equation to determine whether a balance sheet balances goes as follows:

Assets = Liabilities + Shareholder’s Equity

As you read a company’s balance sheet, use this equation to determine whether everything is accurately recorded. Knowing how to read this financial statement is essential as an investor or business leader because it gives you insights into what a company owns versus what they owe.

Income Statements

The income statement, also referred to as the profit and loss (P&L) statement, provides information on the impact of revenue, expenses, gains, and losses for a given period. As you read over an income statement, you will notice a list of income and expenses, which allow investors and business leaders to track financial trends and make comparisons over time.

In the income statement example below, you will notice the company’s cost of goods sold, operating income, and other income, which can be used to determine the company’s net income. The net income formula goes as follows:

Net Income = Total Revenues – Total Expenses

In the example, you will notice the company’s total revenues (gross profit and total other income) equaled $75,500, while its total expenses equaled $15,500. This left the company with a net income of $60,000. As an investor, seeing a company with a positive net income is often a good sign of financial management. 

Using the income statement in conjunction with other financial statements like the balance sheet and cash flow statement can help you understand the bigger picture of a company’s operational results. This will then allow you to predict the company’s future trajectory and devise plans for growth or to cut spending.

Cash Flow Statements

The cash flow statement can give you a clear picture of where money comes in and where money goes out, or how cash flows through a business. Knowing how to read a cash flow statement is important because it shows you how a company can operate short-term and long-term.

When reading a company’s financial statement, you will be able to determine what phase of business they are currently in, whether that’s a period of rapid growth for a startup or a stretch of steady cash flow for a mature and profitable company.

In the graphic of the cash flow statement example below, you will notice the cash flow statement is broken up into three sections: operating, investing, and financing activities. When these are tallied together, you will be able to determine whether a company has positive cash flow or negative cash flow.

Positive cash flow means the company is spending less money than they’re earning, which is typically a good sign of strong financial health. Negative cash flow means a company is spending more money than they’re bringing in. This might mean an error could have been made on the statement, or that the company might have made a large expenditure to expand the business and invest in the future.

Statement of Shareholders’ Equity

The statement of shareholders’ equity shows how much investors invested in a company’s stock, plus or minus the company’s earnings or losses. The statement of shareholders’ equity is typically listed on the company’s balance sheet alongside the company’s liabilities. When reading this statement, shareholder equity can either be positive or negative. 

When positive, it means a company is able to pay off its debts (liabilities) with what it owns (assets). If it’s negative, a company won’t be able to cover its debts with its assets. As an investor, it’s smart to look for companies with positive shareholders’ equity, as it signals the company is in good financial health and can pay its investors their shares should they liquidate.

Wrapping Up on How to Read and Understand Financial Statements

Investing should never be based on emotion. Just like a compound investment account or any type of financial security, you want to know how it works and performs. While you might be tempted to invest in a company because you like its products or because you’ve just read a favorable article about it in a magazine or newspaper, you should make sure you’ve done your research before ponying up your hard-earned cash. That’s why it’s important to learn how to read a financial statement. Think of the financial statement as a kind of scorecard that helps you determine which company is the one you should invest in. 

What you’ll find is a hard look at the financial structure of a business that shows you what it’s really made of. Ask yourself a few questions and see if the statements help answer them. Does the revenue exceed expenses in the income statement? Does the amount of assets exceed liabilities on the balance sheet? Once you’ve done diligent research and have concrete answers to these questions, you’re ready to start investing wisely.

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