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How to read financial statements?
Understanding financial statements is vital to long-term business and investing profitability. Reading and understanding financial statements accurately and quickly is a hallmark of the most successful investors.
This article will guide you through the ins and outs of the major financial statements so you can quickly and accurately gauge the financial health of a given company, possibly including your own.
QUOTE
"Unless you are willing to put in the effort to learn accounting - how to read and interpret financial statements - you really shouldn't select stocks yourself."
Big ideas
- It’s not enough to have a passing knowledge of financial statements - these are the main indicators of business viability. Learning how to read financial statements is just the first step.
- The primary financial statements will be found in the company's annual report. Financial statements are a regulatory necessity, and companies need to submit them or face penalties.
- Different investors will place different weights on specific accounting metrics within financial statements, depending on what business and industries they are interested in.
Understand financial statements: the basics
A financial statement definition would simply be a written record that signifies the business activities of a company. There are multiple kinds of financial statements, and each has a specific use case. Financial statements can also be combined in order to give a more holistic and balanced analysis of a given firm.
There are three main financial statements to be aware of. The first is the balance sheet, the second is the income statement, and the third is the cash flow statement. These three financial statements will provide an accurate picture of a company’s position. The balance sheet is sometimes referred to as a “statement of financial position”, while the income statement is often referred to as the “profit and loss” or “P&L” statement.
There are three main financial statements to be aware of. The first is the balance sheet, the second is the income statement, and the third is the cash flow statement. These three financial statements will provide an accurate picture of a company’s position. The balance sheet is sometimes referred to as a “statement of financial position”, while the income statement is often referred to as the “profit and loss” or “P&L” statement.
QUOTE
"Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets."
The main financial statements are included in a company’s annual report, which is given to shareholders each year for assessment. But bear in mind that accounting is not always honest. There are things that companies can do that make it seem better than it’s doing, at least from an accounting perspective.
Still, learning how to read income statements, balance sheets, as well as cash flow statements is essential for thriving in the world of commerce.
Still, learning how to read income statements, balance sheets, as well as cash flow statements is essential for thriving in the world of commerce.
Financial statement example: Balance sheet
Source: AccountingCoach.comThe balance sheet is a key financial statement that consists of assets, liabilities, and shareholders' equity. Assets include everything the company owns that has an objective value, though the asset can be intangible, such as a logo or intellectual property. It includes accounts receivable, cash, inventory, property, investments, etc.
Liabilities are all outgoing debts that need to be repaid, such as creditors, suppliers, employees, etc. The equity represents items such as retained earnings and funds contributed by its shareholders. Both sides of the balance sheet must … balance.
Liabilities are all outgoing debts that need to be repaid, such as creditors, suppliers, employees, etc. The equity represents items such as retained earnings and funds contributed by its shareholders. Both sides of the balance sheet must … balance.
FORMULA
Assets = Liabilities + Equity
When reading a balance sheet, there will be two equal numbers down the bottom, with double lines. One figure will represent assets, the other liabilities + equity. Otherwise, there has been an accounting discrepancy. Business analysts can use a variety of metrics and ratios to assess a balance sheet. This might include:
- Inventory turnover ratio - indicates how quickly a company sells its entire inventory and replenishes its stock in a given year
- Asset turnover - indicates how efficiently a company uses its assets to generate revenue
- Receivables turnover - indicates how quickly a company can collect accounts receivable from customers in a given year
- Payables turnover - indicates whether a company is paying suppliers on time or not
- Debt to assets - indicates how much of a company's assets are supported through debt
- Debt to equity - indicates how much equity is available to cover debt obligations
This is just a small sample of a huge number of ratios and metrics analysts can use to assess a given company. But industry knowledge is key, and there are many nuances. Acceptable ratios will change per industry.
Some industries have no inventory (software firms), others will have high volume sales of low-priced items, and sometimes a company might be doing better than the books seem to indicate! This is why learning how to read financial statements is an ongoing process.
Some industries have no inventory (software firms), others will have high volume sales of low-priced items, and sometimes a company might be doing better than the books seem to indicate! This is why learning how to read financial statements is an ongoing process.
Financial statement example: Income statement
While the balance sheet shows the overall value of a company, the income statement is more specific and granular. It denotes a company's profit or loss over a given period. At the top level, it simply subtracts all total income from total expenses to leave either a profit or a loss.
FORMULA
Net Earnings = Gross Profit -Total Expenses - Tax
To get the net earnings for a given time period, the formula is: Net Earnings = Gross Profit -Total Expenses - Tax. The essential terms you need to understand in order to read the income statement will include:
- Revenue - the total amount of money a business takes in.
- Expenses - the total amount of money a business spends.
- Costs of goods sold (COGS) - The total cost of making whatever a business sells.
- Gross profit - the total revenue minus the cost of goods sold.
- Operating income - the gross profit minus operating expenses.
- Income before taxes - the operating income minus non-operational expenses.
- Net income - the income before taxes.
- Earnings per share (EPS) - a division of net income by the total number of outstanding shares.
- Depreciation - the extent to which assets lose value with time.
- EBITDA - Earnings before interest, taxes, depreciation, and amortization.
The income statement will indicate if a company is profitable for the accounting period. In contrast, the balance sheet shows how much a company is worth including all of its assets.
Financial statement example: Cash flow statement
A cash flow statement is designed to indicate the cash operations of a business over a given time period. It shows how much cash is flowing in and out of the business. A standard cash flow statement is broken into three parts - operational, investing, and financing.
Operational cash flow includes all money made or lost in the course of standard business, including revenue and expenses. Investing cash flows typically refers to the buying and selling of assets, such as property, machinery, or patents, using cash. Financing cash flow mainly refers to debt and equity financing.
Operational cash flow includes all money made or lost in the course of standard business, including revenue and expenses. Investing cash flows typically refers to the buying and selling of assets, such as property, machinery, or patents, using cash. Financing cash flow mainly refers to debt and equity financing.
Quote
"Making more money will not solve your problems if cash flow management is your problem."
Cash flow and profits are not the same things, and both metrics need to be understood distinctively from one another. A cash flow statement can help investors to see what activities generate cash and how it flows within a company, informing more specific investment decisions than a bottom line profit or loss as seen on the income statement.
One of the most important points to keep in mind is that a positive cash flow, while certainly a good sign, does not mean a company is profitable. A firm can be profitable without generating significant cash flows. Huge cash flows can also be generated without any profits.
A business might also have a negative cash flow due to expansion or investment. The cash flow statement needs to be read along with the income statement and balance sheet to offer a well-rounded analysis. It’s also relevant to take the industry into account, which affects acceptable cash flow parameters, alongside other metrics.
One of the most important points to keep in mind is that a positive cash flow, while certainly a good sign, does not mean a company is profitable. A firm can be profitable without generating significant cash flows. Huge cash flows can also be generated without any profits.
A business might also have a negative cash flow due to expansion or investment. The cash flow statement needs to be read along with the income statement and balance sheet to offer a well-rounded analysis. It’s also relevant to take the industry into account, which affects acceptable cash flow parameters, alongside other metrics.
Other financial statements to be aware of
The balance sheet, income statement, and cash flow statement will all be contained within a company’s annual report. The annual report will also contain more information such as management discussions, industry events, the market outlook, projections, accounting policies, and additional information.
If you want to learn how to read financial statements, these are the ones to focus on. But there are more. US shareholders can also gain more information from the 10-K, which informs investors of a business’s financial status before they buy or sell shares.
Another financial statement is the change in equity. This shows shareholder contribution and movement in equity, as well as equity balance at the end of the accounting period. However, the statement of change in equity will be automatically derived from a correctly prepared income statement and balance sheet.
The notes to financial statement is an essential statement that is often overlooked. It includes additional information that the major financial statements will not include. For example, the balance sheet might list fixed assets. But the notes to financial statement, also called financial disclosure, might contain additional information about those fixed assets.
A trial balance is not a formal financial statement, but it is good to understand what it is. The trial balance is an internal accounting metric that is prepared before an income statement. The trial balance provides more detailed information at the account level than the balance sheet, but is not distributed outside the company.
If you want to learn how to read financial statements, these are the ones to focus on. But there are more. US shareholders can also gain more information from the 10-K, which informs investors of a business’s financial status before they buy or sell shares.
Another financial statement is the change in equity. This shows shareholder contribution and movement in equity, as well as equity balance at the end of the accounting period. However, the statement of change in equity will be automatically derived from a correctly prepared income statement and balance sheet.
The notes to financial statement is an essential statement that is often overlooked. It includes additional information that the major financial statements will not include. For example, the balance sheet might list fixed assets. But the notes to financial statement, also called financial disclosure, might contain additional information about those fixed assets.
A trial balance is not a formal financial statement, but it is good to understand what it is. The trial balance is an internal accounting metric that is prepared before an income statement. The trial balance provides more detailed information at the account level than the balance sheet, but is not distributed outside the company.
How to read financial statements for investing?
It can take a long time to become fluent in financial statements. There are many accounting nuances per industry, and you will have to learn to combine financial data with other, non-tangible data sources. There are also different accounting methodologies to become familiar with.
But to get a general overview in learning how to read financial statements for stocks, this is what you will want to look out for when reading the balance sheet, income statement, and cash flow statement:
But to get a general overview in learning how to read financial statements for stocks, this is what you will want to look out for when reading the balance sheet, income statement, and cash flow statement:
- Company debt, ability to repay debt, how quickly it repays debt.
- Profit and losses per quarter of the most recent year.
- Profits and losses each year, with more weight given to recent years.
- Investment required to carry the business forward.
- Operational expenses as compared to revenue generated.
To find this information on the Trading 212 app, select the stock of the company you are researching and scroll down until you see ‘Financials’. Here you can find the income statement, balance sheet and cash flow statement for the past three years in an easy-to-see bar chart.
By tapping ‘More financials’ you can see the full quarterly and annual statements.
These insights can then be combined with other factors to see whether the investment is worth it or not. For some industries, certain accounting metrics are more important than others. This will require specialized research and knowledge on your part. Alternatively, some investors will be on the lookout for certain types of companies and disregard other metrics.
For instance, an investor might own a firm that specializes in taking over small businesses in a certain sector, businesses with poor profitability but the potential to be revamped by the investor. The financial statements might read poorly to the majority of investors, but be perfectly suited to the investing style and existing resources of that particular investor.
For instance, an investor might own a firm that specializes in taking over small businesses in a certain sector, businesses with poor profitability but the potential to be revamped by the investor. The financial statements might read poorly to the majority of investors, but be perfectly suited to the investing style and existing resources of that particular investor.
Recap
Understanding how to read financial statements is essential for investors and business owners. Businesses are created to generate finance. Financial statements and the associated accounting terms are the language of finance, and people need to become fluent to succeed.
At the same time, it's important to keep in mind that financial statements often do not tell the whole story. Some investors prefer to look at capital that is not reflected in the balance sheet, such as human resources and market conditions. How are customers and employees treated, and what is their sentiment about the company?
Ultimately, it's as much an art as a science, and the best investors learn what the financial statements are telling, and what they are unable to express.
At the same time, it's important to keep in mind that financial statements often do not tell the whole story. Some investors prefer to look at capital that is not reflected in the balance sheet, such as human resources and market conditions. How are customers and employees treated, and what is their sentiment about the company?
Ultimately, it's as much an art as a science, and the best investors learn what the financial statements are telling, and what they are unable to express.
Q: What are the financial statements?
Financial statements are the basic indicators of business activity. They are accounting forms that denote how money is distributed within a company, the overall profit and loss of a company, and what the book value of each component (machinery, land, cash, patents, etc) within the company is.
Financial statements have to be submitted regularly to avoid fines from authorities and to keep shareholders accurately informed. There are three financial statements to be aware of before the rest: the balance sheet, the profit and loss statement (P&L), and cash flow statement (CFS).
Financial statements have to be submitted regularly to avoid fines from authorities and to keep shareholders accurately informed. There are three financial statements to be aware of before the rest: the balance sheet, the profit and loss statement (P&L), and cash flow statement (CFS).
Q: What is a consolidated financial statement?
A consolidated financial statement is an aggregated financial statement that includes a parent company and its subsidiaries. For international companies there are very strict requirements for consolidated reports, set out by the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS).
US public companies must report in line with GAAP, while private companies have fewer accounting regulations to comply with. A consolidated financial statement will still show a balance sheet, income statement, and cash flow statement. But it will do so for the parent and all of its subsidiaries. A subsidiary is any company where 50% is owned by another legal entity (the parent/holder).
US public companies must report in line with GAAP, while private companies have fewer accounting regulations to comply with. A consolidated financial statement will still show a balance sheet, income statement, and cash flow statement. But it will do so for the parent and all of its subsidiaries. A subsidiary is any company where 50% is owned by another legal entity (the parent/holder).
Q: What are the generally acceptable accounting principles (GAAP)?
GAAP is a series of accounting principles that US public companies must comply with. It aims to set a unified series of standards for companies so that company financial positioning can be clearly understood and communicated. GAAP lays down ten major accounting principles.
Companies can also report non-GAAP accounting which exclude once-off expenditures. Non-GAAP metrics include earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortization (EBITDA). But be careful, as there are no regulations around non-GAAP figures.
An alternative to GAAP is the International Financial Reporting Standards (IFRS), which is currently used in over 166 jurisdictions.
Companies can also report non-GAAP accounting which exclude once-off expenditures. Non-GAAP metrics include earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortization (EBITDA). But be careful, as there are no regulations around non-GAAP figures.
An alternative to GAAP is the International Financial Reporting Standards (IFRS), which is currently used in over 166 jurisdictions.
Q: What are the key differences between the balance sheet and income statement?
The balance sheet is more broad and contains the full value of long-term investments and debts. It is divided so that there is a balance between three major accounts - assets, liabilities, and equity.
The income statement is more specific to income and expenditure than capital infrastructure. It quickly indicates whether or not a company is profitable, where revenue is strong, and where the majority of expenditures is going.
Though both financial statements contain overlapping information, a key distinction is that the balance sheet is only concerned with the overall balance at a certain point in time, while an income statement monitors a period of time.
The income statement is more specific to income and expenditure than capital infrastructure. It quickly indicates whether or not a company is profitable, where revenue is strong, and where the majority of expenditures is going.
Though both financial statements contain overlapping information, a key distinction is that the balance sheet is only concerned with the overall balance at a certain point in time, while an income statement monitors a period of time.
Q: Where can I find financial statements?
The major financial statements (balance sheet, income statement, cash flow statement) can be found in the company annual report. You can access the annual report for major public companies online. In the USA, you can visit the SEC website to access the annual report and many other regulatory filings, such as the 10-K and 10-Q.
EDGAR online can also be used for a more rapid and accurate service, though it comes at a price. In the UK, you can access company information via Companies House or another provider. However, you will have to pay a charge to download forms and reports.
You can often find information about the executives, date of incorporation, legal status, jurisdiction of operation, and registered address online. Companies are typically required to make this information publicly accessible.
EDGAR online can also be used for a more rapid and accurate service, though it comes at a price. In the UK, you can access company information via Companies House or another provider. However, you will have to pay a charge to download forms and reports.
You can often find information about the executives, date of incorporation, legal status, jurisdiction of operation, and registered address online. Companies are typically required to make this information publicly accessible.
- Annual Report: A comprehensive document published by a company each year, detailing its financial performance, business activities, and future outlook. It typically includes financial statements, management discussions, and other key disclosures for investors.
- Shareholders: Individuals or entities that own shares in a company, giving them partial ownership and, in many cases, voting rights and eligibility for dividends.
