How to Read Financial Statements
The Beginner's Guide to Reading and Understanding 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, and those of any companies you may invest in. 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 the many forms and filings to find the financial information you're seeking.
The Annual Report
Much of the information that you need to understand a company's finances is contained in its annual report. If you're considering buying stock in a company, you can view the annual report on its website for free. As opposed to the 10-K filings, which are created for the Securities and Exchange Commission (SEC), annual reports are addressed directly to the shareholders, and therefore are often easier for the average reader to digest. They may include a letter from the CEO explaining the successes and shortcomings of the past year in simple language.
Since annual reports are written with the public reader in mind, they often display a unique company voice and contain personal touches, giving insight into the tone within the company, which can be difficult to glean from balance sheets and financial figures alone.
It's important to read both the annual shareholder report and 10-K 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.
10-K and the Financial Statements
The 10-K is a special collection of financial statements that a company is required to file with the SEC every year. It contains 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
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 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.
The Income Statement
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.
Accounting Methods and Tricks
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.
Even though publicly held companies are monitored and held to certain standards, fraud does happen, often through manipulating financial statements to deceive shareholders or to reduce tax accountability.
The savvy investor knows to read a company's financial statements with scrutiny, because while numbers don't lie, they can be designed to portray a company in the best light possible. 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 potential for misinterpretation; EPS calculates the overall profit of a company distributed across its outstanding common stock, and shareholders often use this figure to predict how they might benefit from a company's growth. However, consider a company that is on the verge of a new merger or acquisition. The EPS could be a misleading measurement for investors because it doesn't reflect how the impending change will trickle down. 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 the shareholder.
To become a savvy investor you should assess financial statements through many lenses, including for particular indicators of certain patterns, and also as a broader view of overall company health. Financial ratios are handy tools for gaining information about specific company metrics—like taking a company's vitals. Ideally, you can learn to calculate and utilize every financial ratio, but you can start with the basics.
If you're just getting started and want to focus on the basics, some of the most important ratios 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 is legally obligated to 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 general public from faulty or misleading practices. However, there are different ways to calculate the same numbers. If you aren't familiar with the different methods and what they represent, you could have an inaccurate sense of a company's financial health. Revenue, for example, can be measured at different points in a company's full sales cycle, which can have 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 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.