Knowing how to deal with the numbers in the company’s financial statements is a basic skill for stock investors. Meaningful interpretation and analysis of the balance sheet, income statement and cash flow statement to identify the company’s investment quality is the basis for wise investment choices.
However, the diversity of financial reports requires us to be familiar with certain financial statement characteristics before focusing on individual company finances. In this article, we will show you what financial statements must provide and how to use them to your advantage.
- Knowing how to read a company’s financial statements is a key skill for any investor who wants to make an informed investment choice.
- The company’s financial statements have four parts: balance sheet, income statement, cash flow statement and notes.
- Prudent investors may also want to view the company’s 10-K, which is the company’s detailed financial report filed with the U.S. Securities and Exchange Commission (SEC).
- Investors should also review non-financial information that may affect the company’s returns, such as economic conditions, the quality of the company’s management, and the company’s competitors.
1. Financial statements = scorecard
There are millions of individual investors around the world, and although a large proportion of them choose mutual funds as their preferred tool for their investment activities, many other investors also invest directly in stocks. Prudent investment practices require us to look for high-quality companies with sound balance sheets, sound earnings, and positive cash flows.
Whether you are a do-it-yourself investor or rely on the guidance of investment professionals, it is very useful to learn some basic financial statement analysis skills.About 30 years ago, businessman Robert Follett wrote a book entitled How to keep score in business. His main point is that in business you use US dollars to keep scores, and a scorecard is a financial statement. He realized that “many people don’t understand scoring in business. They confuse profits, assets, cash flow, and return on investment.”
The same can be said for most of the investing public today, especially when determining the value of investments in financial statements. But don’t let this scare you; it can be done.
2. Financial statements used
The financial statements used in investment analysis are balance sheets, income statements, and cash flow statements, with additional analysis of the company’s shareholders’ equity and retained earnings. Although income statements and balance sheets usually receive most of the attention of investors and analysts, it is also important to include a cash flow statement that is often overlooked in your analysis.
3. What is behind the numbers?
The figures in the company’s financial statements reflect the company’s business, products, services and macro fundamental events. If you can visualize the underlying reality of the fundamentals that drive quantitative information, these numbers and the financial ratios or indicators derived from them will be easier to understand. For example, before starting to calculate the numbers, it is important to understand the company’s business, products and/or services, and the industry in which it operates.
4. Diversity of reports
Don’t expect financial statements to fit a single mold. Many articles and books on financial statement analysis adopt a one-size-fits-all approach. Inexperienced investors may get lost when they encounter account introductions that are not mainstream in the so-called “typical” company. Remember, the diversity of business activities has led to the diversity of financial statements. This is especially true for the balance sheet. The income statement and cash flow statement are less susceptible to this phenomenon.
5. Understand financial terminology
The lack of any obvious standardization of financial reporting terminology complicates the understanding of many financial statement subjects. This situation may confuse beginners. In the foreseeable future, there is little hope of change in the situation of this problem, but a good financial dictionary will be of great help.
Investment encyclopedia Terminology Provide you with thousands of definitions and detailed explanations to help you understand terms related to finance, investment and economics.
6. Accounting: art, not science
The presentation of the company’s financial status described in the financial statements is subject to management’s estimation and judgment. In the best case, management will be meticulously honest and frank, while external auditors will be strict, strict and uncompromising. In any case, the inherent inaccuracies in the accounting process mean that prudent investors should take an inquisitive and skeptical approach to financial statement analysis.
7. Main accounting practices
General Accounting Standards (GAAP) or International Financial Reporting Standards (IFRS) are used to prepare financial statements. Both methods are legal in the United States, although GAAP is the most commonly used. The main difference between the two methods is that GAAP is more “rules-based” while IFRS is more “principles-based.” Both have different ways of reporting asset value, depreciation, and inventory, to name a few.
8. Non-financial information
Information about economic conditions, industries, competitive considerations, market forces, technological changes, management quality, and labor will not be directly reflected in the company’s financial statements. Investors need to realize that financial statement insights are only part of a larger investment puzzle, albeit important.
9. Financial ratios and indicators
The absolute numbers in financial statements have little value for investment analysis unless these numbers are transformed into meaningful relationships to judge the company’s financial performance and measure its financial health. The resulting ratios and indicators must be observed over a long period of time to discover trends. Please note that the assessed financial indicators may vary depending on the industry, company size, and development stage.
10. Notes to the Financial Statements
The financial statement numbers do not provide all the disclosures required by regulators. Analysts and investors agree that a thorough understanding of the notes to the financial statements is essential for the correct assessment of the company’s financial status and performance. As the auditor pointed out in the financial statements, “the accompanying notes are an integral part of these financial statements.” Please conduct a thorough review of the above comments in your investment analysis.
11. Annual report/10-K
Prudent investors should only consider investing in companies with audited financial statements, which is a requirement for all listed companies. Perhaps even before delving into the company’s financial situation, investors should check the company’s annual report and 10-K. Most of the content of the annual report is based on 10-K, but it contains less information and is presented in the form of a saleable document for shareholders. 10-K reports directly to the U.S. Securities and Exchange Commission or SEC and often contains more detailed information than other reports.
The annual report includes an audit report, which expresses an audit opinion on the application of accounting principles. The “clean opinion” gives you the green light to proceed. Restrictive comments may be benign or serious; for the latter, you may not want to continue.
12. Consolidated statements
Usually, the word “consolidated” appears in the headings of financial statements, just like in a consolidated balance sheet. The merger of a parent company and its controlling (more than 50% ownership or “effective control”) subsidiary means that the merger activity of an independent legal entity is represented as an economic unit. The assumption is that combining different entities into one entity makes more sense than separate reports.