How to Read Financial Statements

The Beginner's Guide to Reading and Understanding Financial Statements

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Financial statements are the report card of a business. Learn how to read these documents, and you will gain insight into your own finances and those of any company you may invest in. Financial statements will tell you how much money the firm has and how much debt it owes. You'll be able to figure out how much income the firm makes each month, and how much it sends out the door.

This guide will teach you how to sort through the many forms to find the data you're seeking.

What Is an Annual Report?

Much of what you need to understand a company's finances is in its annual report. You can view a company's annual report on its website for free.

Unlike 10-K filings, which are created for the Securities and Exchange Commission (SEC), annual reports are addressed to the shareholders. As a result, they're often easy to digest. They may include a letter from the CEO talking about the successes and shortcomings of the past year in simple terms.

Since these reports are written with the public reader in mind, they often display a unique company voice. This gives you insight into the tone at the company that you couldn't get from a balance sheet.

Read both the annual report and 10-K filing to get a clear picture of a company's financial health. You may find that some firms forgo the shareholder report since they're only legally obligated to produce annual reports for the SEC.

What Is a 10-K?

The 10-K is a collection of financial statements that a company must file with the SEC every year. It contains much more insight than the annual report. The 10-K includes both an income statement and a balance sheet. Instead of simply saying how much debt the firm has, for instance, these statements will break down where each debt lies. You will learn about any deferred taxes, short-term loans, or overhead costs.

Publicly traded companies must provide these documents. If you can't access them through the company's site, you can find them on government agency websites.

What Is a Balance Sheet?

The balance sheet provides a snapshot in time of what is owned (assets), what is owed (liabilities), and what is left (net worth or book value).

Learning how to read a balance sheet can be tough since there's so much data 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 talking about a firm's financial health are calculated from the balance sheet.

What Is an Income Statement?

The income statement is sometimes called the profit and loss (P&L) statement. It shows you money coming in the door (revenue), money going out the door (expenses), and what's left over (income, or profit).

You can use the P&L statement along with the balance sheet to calculate the return you are earning on your investment. If you want to learn how financial statement analysis works, keep a list of ratio formulas on hand. You can try working through the numbers yourself for a company you're watching.

Accounting Methods and Tricks

A company knows the ins and outs of financial statements better than the beginning investor. And, they know how to tweak the data to spruce up their image on paper.

Even though publicly held companies are monitored, fraud does happen. Firms may manipulate financial statements to deceive shareholders or to reduce taxes.

The savvy investor knows to read a company's financial statements with care. While numbers don't lie, they can be used to portray a firm in the best light. As you become more familiar with financial statements, you may start catching some of the ways that ratios are more misleading than they may seem at first.

Earnings Per Share

The earnings per share (EPS) is a good example of a metric that has the potential for misinterpretation. EPS calculates the overall profit of a company distributed across its outstanding common stock. Shareholders often use this figure to predict how they might gain from a company's growth.

But, consider a company that is on the verge of a new merger. The EPS could be a misleading measurement for investors because it doesn't reflect how the change will trickle down. Instead, they'd want to calculate the diluted earnings per share. This captures a more complete picture of the firm's financial health.

Financial Ratios

To become a savvy investor, you should assess financial statements through many lenses. Look at the data for indicators of certain patterns, and also as a broader view of company health. Financial ratios are handy tools for gaining information about specific metrics. They're like taking a firm's vitals. Over time, you can learn to calculate and use every financial ratio. But, you can start with the basics.

If you're just getting started and want to focus on the basics, begin with some of the most important ratios. These 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 to think of these ratios in five categories: leverage, liquidity, operating, profitability, and solvency.

Calculating Revenue

By law, a company must tell the truth in its financial statements. Multiple government agencies and standards bodies are in place to regulate company statements, promote transparency, and protect investors and the public from misleading practices. But, there are many ways to look at the same numbers.

If you aren't used to the different methods and what they represent, you could have an inaccurate sense of a company's financial health. Revenue, for instance, can be measured at different points in a company's full sales cycle. This can have a dramatic effect on how actual profits are displayed. 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 learn all the different models, you'll have a better understanding of how much money a company has made. It will be easier for you to tell whether their business model is a sound one.