How to Read and Understand Financial Statements
The Beginner's Guide to Financial Statements
Financial statements are the report card of a business. Whether you are a new investor, a small business owner, an executive, or just trying to keep track of your personal finances, you need to understand how to read, analyze, and create financial statements so you can get a full and accurate understanding of your finances. Financial statements will tell you how much money the operation has stashed away, how much debt is owed, the income coming in each month, and the expenses going out the door.
This guide will teach you how to sort through all the different forms and entries to find the financial information you're seeking. Each section gives a brief introduction to a form or concept. Click on the links to dive deeper into any idea you want to further explore.
Many of the financial statements you need to understand in a company are contained in its annual report. If you're considering buying stock in a company, you can view the annual report on their website for free. As opposed to the 10K filings (see below), annual reports are often easier for the average reader to digest. They're addressed directly to shareholders, as opposed to addressing regulators with the Securities and Exchange Commission. They may include a letter from the CEO, explaining the successes and shortcomings of the past year in simple language. These personal touches give insight into the tone within the company, which can be difficult to glean from balance sheets and financial figures alone.
However, the tone isn't everything, and it's important to read both the annual shareholder report and 10K filing to get a clear picture of a company's overall financial health. You may find that some companies forgo the shareholder reports altogether, since they're only legally obligated to produce annual reports for the SEC.
The 10K is a special collection of financial statements that a company is required to file with the Securities and Exchange Commission annually. It usually includes much more information than the annual report, including both an income statement and a balance sheet. Instead of simply saying how much debt the company has, for example, these statements will break down exactly where each of its debt obligations lies—whether it's in deferred taxes, short-term loans, or overhead costs. Publicly traded companies are legally obligated to provide these documents, and if you can't access them directly through the company's site, you can find them on government agency websites.
The balance sheet provides a snapshot in time of what is owned (assets), what is owed (liabilities), and what is leftover (net worth or book value). Learning how to read and understand a balance sheet can be tough since there's so much information packed into each line, but that's also what makes them so important to read. Many of the ratios and figures that analysts use when discussing a company's financial health are calculated from the balance sheet.
Sometimes called the profit and loss (P&L) statement, the income statement shows you money coming in the door (revenue), money going out the door (expenses), and what's left over (income, or profit). The income statement is important because you can use it along with the balance sheet to calculate the return you are earning on your investment. If you are serious about learning financial statements and how financial statement analysis works, keep a reference list of ratio formulas on hand and try working through the calculations yourself for a company you're watching.
The goal is to understand how to calculate and utilize every financial ratio, but you have to start somewhere. Some of the most important ratios to start with include the price-to-cash-flow ratio (and its close relative, the price-to-earnings ratio), the asset turnover ratio, and the current ratio. You may also find that it's helpful in the beginning to mentally compartmentalize all financial ratios into five categories: leverage, liquidity, operating, profitability, and solvency.
A company knows the ins and outs of financial statements better than the beginning investor—and they know how to manipulate the data to spruce up their image on paper. As you become more familiar with financial statements, you may start catching some of these ways that ratios are more misleading than they may seem at first.
For example, if a company is on the verge of a new merger or acquisition, the earnings per share (EPS) could be a misleading measurement for investors. Instead, they'd want to calculate the diluted earnings per share, which captures a more complete picture of the company's financial health as it relates to you, the shareholder.
A company is legally obligated to tell the truth in its financial statements. However, there are different ways of calculating the same numbers. If you aren't familiar with the differences between them, you could have an inaccurate sense of a company's financial health. Different revenue recognition models can count sales as complete in the books well before the customer receives the item or service they purchased. If you familiarize yourself with all the different models, you'll have a better understanding of how much money a company has made, and whether their business model is a sound one.