Financial statement analysis is the practice of reviewing financial reports to evaluate an organization’s financial health. Common statements include the balance sheet, the cash flow statement, and the profit and loss statement.
Investors often use financial statements to decide if it makes sense to invest in a company. So why might you dig through financial reports, and what are some potential pitfalls of relying on financial statements for investment decisions?
Definition and Examples of Financial Statement Analysis
Financial statement analysis involves reviewing financial reports with a goal of learning about a company’s financial health. Investors study income, expenses, cash holdings, profitability, and other financial measures to learn how successful a business has performed. With that knowledge, some investors hope to predict how the business will perform going forward.
Three of the most popular financial statements are:
- Balance sheets
- Income statements
- Cash flow statements
Those are the most commonly used financial reports, but there are others. Investors can use the reports that meet their needs.
How Does Financial Statement Analysis Work?
Investors who research companies use financial statements to understand the past and make informed decisions about investing in a company. By reviewing financial details, you can see how a company’s financial information has changed over time and how it compares to competitors in the same industry.
Financial statements are used by investors as well as managers who evaluate internal operations and regulators who monitor financial activity. Creditors and regulators also review financial statements.
Financial statements provide information you can use for financial ratio analysis, or the practice of calculating financial data to try to understand a company’s financial position. For example, you might calculate the price-to-earnings ratio using the earnings per share (EPS) information from an income statement.
A balance sheet details a company’s assets and liabilities. With that information, you can see if a company has high levels of debt relative to assets. And reviewing previous balance sheets, you might uncover trends, such as an increasing reliance on debt or debt elimination. Balance sheets also include the statement of shareholder equity, which explains the value of outstanding shares. This statement of shareholder equity reports changes in the number of shares as well as buybacks and other activities.
Income statements, also known as profit and loss statements, show how much revenue a company brings in and where that money goes. Expenses are organized into categories such as operating expenses and the cost of goods sold, which helps investors identify where a business spends money. The bottom line of an income statement shows net profits, which is the amount left over after paying all expenses. Income statements show investors whether the company operates at a loss.
Cash Flow Statements
A cash flow statement lists payments into and out of a company. Cash flow is critical, as running out of liquid cash can cause a company to become insolvent. Cash flow is different from profits shown on an income statement. The income statement might include “expenses” that are not related to cash flows (such as depreciation or amortization), so its profits may not provide enough precision about a company’s cash position. As a result, it’s important to evaluate a company’s cash inflows and outflows separately from figures on an income statement.
What It Means for Individual Investors
Financial statement analysis helps investors familiarize themselves with the company’s finances to make informed investing decisions. But it’s critical to consider several key points about the practice of using financial statements:
- Each report is a snapshot of financial data at a specific point in time, and the company’s finances can change after a report is generated.
- You can understand how a company’s finances evolve over time by using more than just one financial statement.
- Many investors choose to learn how competitors’ financial statements compare to the company they’re studying.
- If you rely on financial statement analysis, you should still continually monitor the company and industry.
- Seemingly positive trends can quickly reverse course and are sometimes actually signs of trouble.
The numbers you find in financial reports are just one piece of a bigger picture. For more clarity on any company you’re considering investing in, you also need a qualitative understanding of what’s going on. That may require reading through narrative descriptions, news reports, and other sources.
Financial statement analysis is an ongoing process for investors—not a one-time task.
You do not necessarily need to dive into financial statement analysis if you want to invest. This practice is primarily for stock pickers, and you don’t need to analyze and select individual stocks when you invest. As an alternative, you can practice passive investing using index funds and passive ETFs. With that approach, you invest in the market as a whole instead of choosing individual securities (or having somebody pick stocks for you).
- Financial statement analysis is the practice of reading company reports to learn about an organization’s financial health.
- Financial statements provide information you can use for calculations, ratio analysis, and trend analysis.
- Investors who take a passive investing approach do not need to select individual stocks or analyze company reports.
- Try to go beyond the numbers available in financial statements. Research big-picture trends, competitors, management issues, and more.