Financial statements are a useful tool for judging the health of a company, and for comparing it to its competitors. They show what the company owns and owes, the profits or loses it has made over a given period, and how financial position has changed since the last statement. Generally, if you can tell which direction a company is heading in, you can also estimate future stock prices with some accuracy.
Gaining a basic knowledge of financial statements, and applying this knowledge when choosing or assessing investments can help you pick tomorrow’s winning stocks, while avoiding tomorrow’s losers.
Of course, financial statement analysis will not always factor in significant news events, unexpected incidents, changes in management, and other factors which may influence share prices, but it provides a starting point from which to gauge the present value of shares, independent of future occurrences.
Let us examine some details on simple financial statement explanation and analysis methods. Although the topic can get much deeper and more complex, a basic understanding will give investors the ability to understand the numbers and financial data. Hence, they can be able to use that knowledge to assist them to make better decisions when doing their due diligence.
Income statements and balance sheets are two common financial statements which contain information about a company’s performance for a particular year and present a snapshot of the health of the company at a given point in time. The cash flow statement is another financial report that shows how changes in the balance sheet and income statement affect cash. Publicly traded companies are required to file them with the Securities and Exchange Commission (SEC) so that they can be made available to the public. Understanding the information contained in these financial statements can help an investor make better decisions.
The balance sheet shows a company’s financial position at a specific date, usually the last day of the company’s fiscal year for annual reports. One side of the balance sheet shows what the company owns and has owing to it, called assets. Asset items on the balance sheet are listed in the order of their liquidity or availability for use as company funds. Commonly listed asset items on the balance sheet are cash, accounts receivable, current assets and fixed assets. Cash covers all funds maintained on hand and in the banks. Accounts receivable are debts owed to the firm which are expected to be converted to cash within the year. On top of cash and accounts receivables, the other current assets are inventory, marketable securities, and prepaid expenses (rent, for example). Fixed assets are depreciated over time and are tangible, long-lived resources like plants and machinery.
The other side represents liabilities, which are what the company owes, and also has shareholders’ equity, which represents the excess of the company’s assets over its liabilities. Liabilities include current liabilities (debts owed within the year) and long term debt (payments due over one year). Shareholder’s equity, often referred to as book value, represents the total value of shares owned by shareholders.
Total assets are equal to the sum of the company’s liabilities plus the shareholders’ equity. In other words, take away liabilities from assets and the remainder is that value owned by the shareholders. Stockholder equity, or book value, represents the amount shareholders would theoretically receive if a firm went immediately out of business. The market value of the company is generally higher as firms do tend to make money. How much higher this market value is can help the investor determine if a stock is overvalued or, perhaps, undervalued. Analyzing the balance sheet can uncover the value of the company, the debt load, and cash position.
Also called the Earnings Statement or Profit and Loss Statement, it shows how much revenue a company received from the sale of its products and services and the expenses the company incurred due to wages, taxes, operating costs and other expenses for a particular period. The difference between the revenue and expenses is the company’s profit or loss for the covered period. The amount left over after taxes is the net income or earnings.
An income statement will always contain figures for revenue, cost of goods sold (COGS), selling, general, and administrative expense (SG&A), and earnings. Revenue is gross income. It is the total income derived from the sale of products and services before any deductions are made for the operating costs and expenses. Cost of Goods Sold (COGS) or Cost of Sales (COS) pertains to the cost of purchasing raw materials and production costs. This is where accurate inventories are important because COGS equals the beginning inventory plus the cost of produced goods during the previous year, less the previous inventory. COGS figures show the cost of producing goods. These costs can show how well managed a firm is. Selling, general and administrative expenses (SG&A expenses), also known as operating expenses, consist of salaries, commissions, and traveling costs for management and salespeople, advertising costs, and payroll costs. These figures also need to be controlled by management because, if they get out of control, they affect the profitability of the firm. Finally, earnings are the company’s revenue less expenses (COGS, SG&A, and taxes).
Net earnings are basically saying how much money the company ‘really’ made over the course of the period. Some companies can have low earnings if they used much of their money for research and development in order to fuel aggressive growth or to acquire other companies or to move into new markets. This is much more favorable than if the company had low earnings because it did not generate enough revenues to cover the operating expenses.
Statement of Changes in Financial Position
This shows how the company’s financial position changed from one year to the next. Also called the cash flow statement, this details how the company generated and spent its cash during the year.
This statement can be used in evaluating the liquidity and solvency of a company. It also shows if the company has the ability to generate cash internally, to repay its debts and to reinvest in itself. This report is useful in determining the financial strength of the firm and its ability to function as an ongoing concern.
Having a basic understanding of the financial statements and knowing how to interpret them, you can compare how your company levels with your competitors in the similar industry. If you are interested to invest on publicly-traded companies, it is best to compare the financial statements of those companies you are interested in before deciding to invest. Here are some comparative queries to address :
Balance Sheet :
- Which of the companies has the greatest long term debt load?
- Do any of the companies have greater current liabilities than current assets?
- Compare the current share price to the shareholder’s equity (book value): is the share price much greater or less than the book value?
Income Statement :
- What were the revenues of the most recent year (or quarter)?
- Does the number represent an increase or decrease from the previous period?
- How much money per share did the company earn (or lose) in the most recent period?
Statement of Changes in Financial Position :
- Has company debt been increasing or decreasing?
- What was the greatest expense the company incurred according to the statement?
Before making a decision, understand that financial statements can provide investors with a partial fundamental snapshot of a company. They only represent one piece of the puzzle. Remember that, while financial statements can help investors compare several companies, comparison is limited only to the numbers provided.
In other words, you can see that one company made money while the other lost money, but you don’t know which has the better technical outlook (based on analysis of the trading chart), which is a potential takeover target and which will have the best future earnings. As it relates to share prices, the impact of the financial statements tends to be long-term. Four quarterly reports showing increasing earnings may push the stock into an upward trend as the market begins to recognize the fundamental improvements of the underlying company; but one quarter of increasing earnings may or may not have a significant impact on shares.
Hence, most investors use financial statements as part of a greater overall decision making process. But certainly, you can benefit more if you take the time to make educated investment decisions with the understanding and interpretation of the financial data provided by the financial statements.