Knowing how to work with the numbers in a company's financial statements is an essential skill for stock investors. The meaningful interpretation and analysis of balance sheets, income statements, and cash flow statements to discern a company's investment qualities is the basis for smart investment choices.
However, the diversity of financial reporting requires that we first become familiar with certain financial statement characteristics before focusing on individual corporate financials. In this article, we'll show you what the financial statements have to offer and how to use them to your advantage.
Key Takeaways
- Understanding how to read a company's financial statements is a key skill for any investor wanting to make smart investment choices.
- There are four sections to a company's financial statements: the balance sheet, the income statement, the cash flow statement, and the explanatory notes.
- Prudent investors might also want to review a company's 10-K, which is the detailed financial report the company files with the U.S. Securities and Exchange Commission (SEC).
- An investor should also review non-financial information that could impact a company's return, such as the state of the economy, the quality of the company's management, and the company's competitors.
1. Financial Statement = Scorecard
There are millions of individual investors worldwide, and while a large percentage of these investors have chosen mutual funds as the vehicle of choice for their investing activities, many others are also investing directly in stocks. Prudent investing practices dictate that we seek out quality companies with strong balance sheets, solid earnings, and positive cash flows.
Whether you're a do-it-yourself investor or rely on guidance from an investment professional, learning certain fundamental financial statement analysis skills can be very useful. Almost 30 years ago, businessman Robert Follett wrote a book entitled How To Keep Score In Business. His principal point was that in business you keep score with dollars, and the scorecard is a financial statement. He recognized that "a lot of people don't understand keeping score in business. They get mixed up about profits, assets, cash flow, and return on investment."
The same thing could be said today about a large portion of the investing public, especially when it comes to identifying investment values in financial statements. But don't let this intimidate you; it can be done.
2. Financial Statements to Use
The financial statements used in investment analysisare the balance sheet, the income statement, and the cash flow statement with additional analysis of a company'sshareholders' equity and retained earnings. Althoughthe income statement and the balance sheet typicallyreceive the majority of the attention from investorsand analysts, it's important to include in your analysis the often overlookedcash flow statement.
3. What's Behind the Numbers?
The numbers in a company's financial statementsreflect the company's business,products, services, andmacro-fundamentalevents. These numbers and the financial ratios orindicators derived from themare easier to understand if you can visualize the underlying realities of the fundamentals driving thequantitative information. For example, before you start crunching numbers, it's criticaltodevelopan understanding of what the company does, its products and/or services, and the industry in which it operates.
4. Diversity of Reporting
Don't expect financial statements to fit into a single mold. Many articles and books on financial statement analysis take a one-size-fits-all approach. Less-experienced investors might get lost when theyencountera presentation of accounts that falls outside the mainstream of a so-called "typical" company. Please remember that the diverse nature of business activities results in a diverse setof financial statement presentations. This is particularly true of the balance sheet; the income statement and cash flow statementare less susceptible to this phenomenon.
5. Understanding Financial Jargon
The lack of any appreciable standardization of financial reporting terminology complicates the understanding of many financial statement account entries. This circ*mstance can be confusing for the beginning investor. There's little hope that things will change on this issue in the foreseeable future, but a good financial dictionary can help considerably.
Investopedia's Glossary of Terms provides you with thousands of definitions and detailed explanations to help you understand terms related to finance, investing, and economics.
6. Accounting: Art, NotScience
The presentation of a company's financial position, as portrayed in its financial statements, is influenced by management's estimates and judgments. In the best of circ*mstances, management is scrupulously honest and candid, while the outside auditors are demanding, strict, and uncompromising. Whatever the case, the imprecision that can be inherently found in the accounting process means that the prudent investor should take an inquiring and skeptical approach toward financial statement analysis.
7. Key Accounting Conventions
Generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS)are used to prepare financial statements. Both methods are legal in the United States, although GAAPis most commonly used. The main difference between the two methods is that GAAPis more "rules-based," while IFRS is more"principles-based." Both have different ways of reporting asset values, depreciation, and inventory, to name a few.
8. Non-Financial Information
Information on the state of the economy, the industry,competitive considerations, market forces, technological change, the quality of management and the workforce are not directly reflected in a company's financial statements. Investors need to recognize that financial statement insights are but one piece, albeit an important one, of the larger investment puzzle.
9. Financial Ratios and Indicators
The absolute numbers in financial statements are of little value for investment analysis unless these numbers are transformed into meaningful relationships to judge a company's financial performance and gauge its financial health. The resulting ratios and indicators must be viewedover extended periods to spottrends. Pleasebeware that evaluative financial metrics can differ significantly by industry, company size,and stage of development.
10. Notes to Financial Statements
The financial statement numbers don'tprovide all of the disclosure required by regulatory authorities. Analysts and investorsalikeuniversally agree that a thorough understanding of the notes to financial statements is essential to properly evaluate a company's financial condition and performance. As noted by auditors on financial statements "the accompanying notes are an integral part of these financial statements." Please include a thoroughreview of thenoted comments in your investment analysis.
11. The Annual Report/10-K
Prudent investors should only consider investing in companies with audited financial statements, which are a requirement for all publicly-traded companies. Perhaps even before digging into a company's financials, an investor should look at the company's annual reportandthe 10-K. Much of the annual report is based on the 10-K, but contains less information and is presented in a marketable document intended for an audience of shareholders. The 10-K is reported directly to the U.S. Securities andExchange CommissionorSEC and tends to contain more details than other reports.
Includedin the annual report is theauditor's report,which gives an auditor's opinion on how the accounting principles have been applied.A "clean opinion" provides you with a green light to proceed. Qualifying remarks may be benign or serious; in the case of the latter, you may not want to proceed.
12. Consolidated Statements
Typically, the word "consolidated" appears in the title of a financial statement, as in a consolidated balance sheet. A consolidation of a parent company and its majority-owned (more than 50% ownership or "effective control") subsidiaries means that the combined activities of separate legal entities are expressed as one economic unit. The presumption is thatconsolidation as one entity is more meaningful than separate statements for different entities.
Why are Financial Statements Important?
Financial statements provide investors with information about a company's financial position, helping to ensure corporate transparency and accountability. Understanding how to interpret key financial reports, such as a balance sheet and cash flow statement, helps investors assess a company’s financial health before making an investment. Investors can also use information disclosed in the financial statements to calculate ratios for making comparisons against previous periods and competitors.
What Key Financial Statements Should I Understand When Analyzing a Company?
Investors should start by learning how to interpret key figures on a company's balance sheet, income statement, and statement of cash flows. Those wanting to dig a little deeper may want to consider learning how to analyze reports, such as shareholder’s equity and retained earnings. Investors can find a publicly traded company’s financial statements in its annual report or a 10-K filed with the SEC.
What’s the Difference Between GAAP and IFRS Accounting Conventions?
GAAP sets accounting guidelines and standards that companies must follow when preparing financial statements, whereas IFRS takes a more principles-based approach. Both conventions differ in how they report asset values, depreciation, and inventory. GAAP typically requires more disclosures than IFRS, with the latter providing much less overall detail. Both accounting methods are legal in the United States.
What are Some Key Limitations of Using Financial Statements?
Financial statements only provide a snapshot of a company's financial situation at a specific point in time. They also don't consider non-financial information, such as the health of the broader economy, and other factors, such as income inequality or environmental sustainability. Forward-looking financial statements rely on estimates and assumptions, which may not always be accurate and are subject to change.
The Bottom Line
Understanding the basics of financial statements provides investors with valuable information about a company's financial health. Investors can use key reports, such as a balance sheet, cash flow statement, and income statement, to evaluate a company's performance, helping to make more informed investment decisions. However, it’s also important to understand the limitations of overly relying on financial statements and consider other metrics, such as the impact of non-financial information, when analyzing a company's overall financial position. Financial statements play a vital role in maintaining the integrity of the financial system and promoting trust between companies and investors.
As a financial expert with extensive experience in analyzing company financial statements, I can confidently delve into the concepts presented in the article. Understanding financial statements is indeed a crucial skill for investors, and my expertise allows me to provide valuable insights into the key points mentioned.
1. Financial Statement = Scorecard:
- Agreeing with the analogy that a financial statement is akin to a scorecard in business.
- Recognizing the importance of seeking quality companies with strong balance sheets, solid earnings, and positive cash flows.
2. Financial Statements to Use:
- Acknowledging the significance of the balance sheet, income statement, and cash flow statement in investment analysis.
- Highlighting the additional analysis of shareholders' equity and retained earnings.
3. What's Behind the Numbers:
- Emphasizing the need to understand a company's business, products, services, and macro-fundamental events before analyzing financial statements.
- Stressing the importance of visualizing the underlying realities of the fundamentals.
4. Diversity of Reporting:
- Agreeing that financial statements may not fit into a single mold due to the diverse nature of business activities.
- Recognizing the balance sheet's susceptibility to diverse presentations compared to the income statement and cash flow statement.
5. Understanding Financial Jargon:
- Acknowledging the lack of standardization in financial reporting terminology.
- Recommending the use of a good financial dictionary, such as Investopedia's Glossary of Terms.
6. Accounting: Art, Not Science:
- Recognizing that a company's financial position is influenced by management's estimates and judgments.
- Encouraging investors to maintain an inquiring and skeptical approach toward financial statement analysis.
7. Key Accounting Conventions:
- Explaining the use of generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) in preparing financial statements.
- Highlighting the main difference between GAAP and IFRS in terms of being rules-based and principles-based, respectively.
8. Non-Financial Information:
- Emphasizing the importance of considering non-financial information such as the state of the economy, industry conditions, competitive factors, and management quality.
9. Financial Ratios and Indicators:
- Acknowledging that absolute numbers in financial statements are of little value without transforming them into meaningful relationships.
- Warning about the need to view ratios and indicators over extended periods to spot trends.
10. Notes to Financial Statements:
- Stressing the essential role of notes to financial statements in providing additional disclosure required by regulatory authorities.
- Agreeing that a thorough understanding of the notes is crucial for evaluating a company's financial condition and performance.
11. The Annual Report/10-K:
- Advising prudent investors to consider only companies with audited financial statements.
- Highlighting the importance of reviewing the 10-K for detailed information, including the auditor's report.
12. Consolidated Statements:
- Explaining the significance of "consolidated" in financial statements, indicating the combination of a parent company and its majority-owned subsidiaries.
- Acknowledging the presumption that consolidation as one entity is more meaningful than separate statements for different entities.
Overall, the article underscores the importance of financial statements in making informed investment decisions while also emphasizing the need to consider non-financial information and understand the limitations of relying solely on financial statements.
