An ability to understand the financial health of a company is one of the most vital skills for aspiring investors, entrepreneurs, and managers to develop. Armed with this knowledge, investors can better identify promising opportunities while avoiding undue risk, and professionals of all levels can make more strategic business decisions.
Financial statements offer a window into the health of a company, which can be difficult to gauge using other means. While accountants and finance specialists are trained to read and understand these documents, many business professionals are not. The effect is an obfuscation of critical information.
If you’re new to the world of financial statements, this guide can help you read and understand the information contained in them.
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Understanding Financial Statements
To understand a company’s financial position—both on its own and within its industry—you need to review and analyze several financial statements: balance sheets, income statements, cash flow statements, and annual reports. The value of these documents lies in the story they tell when reviewed together.
1. How to Read a Balance Sheet
A balance sheet conveys the “book value” of a company. It allows you to see what resources it has available and how they were financed as of a specific date. It shows its assets, liabilities, and owners’ equity (essentially, what it owes, owns, and the amount invested by shareholders).
The balance sheet also provides information that can be leveraged to compute rates of return and evaluate capital structure, using the accounting equation: Assets = Liabilities + Owners’ Equity.
Assets are anything a company owns with quantifiable value.
Liabilities refer to money a company owes to a debtor, such as outstanding payroll expenses, debt payments, rent and utility, bonds payable, and taxes.
Owners’ equity refers to the net worth of a company. It’s the amount of money that would be left if all assets were sold and all liabilities paid. This money belongs to the shareholders, who may be private owners or public investors.
Alone, the balance sheet doesn’t provide information on trends, which is why you need to examine other financial statements, including income and cash flow statements, to fully comprehend a company’s financial position.
This article will teach you more about how to read a balance sheet.
2. How to Read an Income Statement
An income statement, also known as a profit and loss (P&L) statement, summarizes the cumulative impact of revenue, gain, expense, and loss transactions for a given period. The document is often shared as part of quarterly and annual reports, and shows financial trends, business activities (revenue and expenses), and comparisons over set periods.
Income statements typically include the following information:
- Revenue: The amount of money a business takes in
- Expenses: The amount of money a business spends
- Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever a business sells
- Gross profit: Total revenue less COGS
- Operating income: Gross profit less operating expenses
- Income before taxes: Operating income less non-operating expenses
- Net income: Income before taxes less taxes
- Earnings per share (EPS): Division of net income by the total number of outstanding shares
- Depreciation: The extent to which assets (for example, aging equipment) have lost value over time
- EBITDA: Earnings before interest, taxes, depreciation, and amortization
Accountants, investors, and other business professionals regularly review income statements:
- To understand how well their company is doing: Is it profitable? How much money is spent to produce a product? Is there cash to invest back into the business?
- To determine financial trends: When are costs highest? When are they lowest?
This article will teach you more about how to read an income statement.
Related: Financial Terminology: 20 Financial Terms to Know
3. How to Read a Cash Flow Statement
The purpose of a cash flow statement is to provide a detailed picture of what happened to a business’s cash during a specified duration of time, known as the accounting period. It demonstrates an organization’s ability to operate in the short and long term, based on how much cash is flowing into and out of it.
Cash flow statements are broken into three sections: Cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.
Operating activities detail cash flow that’s generated once the company delivers its regular goods or services, and includes both revenue and expenses. Investing activity is cash flow from purchasing or selling assets—usually in the form of physical property, such as real estate or vehicles, and non-physical property, like patents—using free cash, not debt. Financing activities detail cash flow from both debt and equity financing.
It’s important to note there’s a difference between cash flow and profit. While cash flow refers to the cash that's flowing into and out of a company, profit refers to what remains after all of a company’s expenses have been deducted from its revenues. Both are important numbers to know.
With a cash flow statement, you can see the types of activities that generate cash and use that information to make financial decisions.
Ideally, cash from operating income should routinely exceed net income, because a positive cash flow speaks to a company’s financial stability and ability to grow its operations. However, having positive cash flow doesn’t necessarily mean a company is profitable, which is why you also need to analyze balance sheets and income statements.
This article will teach you more about how to read a cash flow statement.
4. How to Read an Annual Report
An annual report is a publication that public corporations are required to publish annually to shareholders to describe their operational and financial conditions.
Annual reports often incorporate editorial and storytelling in the form of images, infographics, and a letter from the CEO to describe corporate activities, benchmarks, and achievements. They provide investors, shareholders, and employees with greater insight into a company’s mission and goals, compared to individual financial statements.
Beyond the editorial, an annual report summarizes financial data and includes a company's income statement, balance sheet, and cash flow statement. It also provides industry insights, management’s discussion and analysis (MD&A), accounting policies, and additional investor information.
In addition to an annual report, the US Securities and Exchange Commission (SEC) requires public companies to produce a longer, more detailed 10-K report, which informs investors of a business’s financial status before they buy or sell shares.
10-K reports are organized per SEC guidelines and include full descriptions of a company’s fiscal activity, corporate agreements, risks, opportunities, current operations, executive compensation, and market activity. You can also find detailed discussions of operations for the year, and a full analysis of the industry and marketplace.
Both an annual and 10-K report can help you understand the financial health, status, and goals of a company. While the annual report offers something of a narrative element, including management’s vision for the company, the 10-K report reinforces and expands upon that narrative with more detail.
This article will teach you more about how to read an annual report.
A Critical Skill
Reviewing and understanding these financial documents can provide you with valuable insights about a company, including:
- Its debts and ability to repay them
- Profits and/or losses for a given quarter or year
- Whether profit has increased or decreased compared to similar past accounting periods
- The level of investment required to maintain or grow the business
- Operational expenses, especially compared to the revenue generated from those expenses
Accountants, investors, shareholders, and company leadership need to be keenly aware of the financial health of an organization, but employees can also benefit from understanding balance sheets, income statements, cash flow statements, and annual reports.
If you don’t have a financial background, the good news is that there are steps you can take to learn about finance and jumpstart your career. Building your financial literacy and skills doesn’t need to be difficult.
Are you interested in gaining a toolkit for making smarter financial decisions and communicating decisions to key stakeholders? Explore our online finance and accounting courses, and download our free course flowchart to determine which best aligns with your goals.
As a seasoned financial analyst with a wealth of experience in dissecting company financials, I understand the crucial role financial health plays for investors, entrepreneurs, and managers. My expertise goes beyond theoretical knowledge; I've actively applied financial analysis in real-world scenarios, making investment decisions, guiding entrepreneurs, and aiding managers in strategic business planning.
Now, let's delve into the concepts discussed in the article:
Balance Sheets: A balance sheet provides a snapshot of a company's financial position, showcasing its assets, liabilities, and owners' equity. Assets are what it owns, liabilities are what it owes, and owners' equity represents the net worth. Understanding the balance sheet is vital for evaluating rates of return and capital structure.
Income Statements: Also known as profit and loss statements, income statements summarize revenue, expenses, and profits over a specific period. Key elements include revenue, expenses, gross profit, operating income, income before taxes, net income, and earnings per share. Investors and business professionals use income statements to gauge profitability, track trends, and assess financial performance.
Cash Flow Statements: A cash flow statement details the movement of cash in and out of a business. It consists of operating, investing, and financing activities. Understanding the difference between cash flow and profit is crucial. Positive cash flow signifies financial stability, but it doesn't necessarily mean profitability. Analyzing cash flow statements alongside balance sheets and income statements provides a comprehensive view.
Annual Reports: Annual reports are crucial publications that public corporations release annually. They go beyond financial statements, incorporating editorial elements to provide insights into a company's mission and goals. Annual reports summarize financial data, include industry insights, management's discussion and analysis (MD&A), accounting policies, and additional investor information. The more detailed 10-K report mandated by the SEC offers in-depth information about a company's financial status.
Financial Literacy: Developing financial literacy is emphasized for professionals at all levels. Reviewing and understanding financial documents can unveil insights into a company's debts, profits, investment requirements, operational expenses, and overall financial health. This knowledge is not limited to accountants or investors; employees across various roles can benefit from understanding financial statements.
In conclusion, gaining proficiency in reading and interpreting balance sheets, income statements, cash flow statements, and annual reports is a critical skill. It empowers individuals to make informed decisions, whether they are investors, business leaders, or employees with diverse backgrounds. If you're looking to enhance your financial literacy, exploring online finance and accounting courses is a practical step towards building a robust toolkit for smarter financial decision-making.