Being able to work with the numbers contained in a company’s financial statements is a critical ability for stock investors to possess. Understanding and interpreting balance sheets, income statements, and cash flow statements to determine a company’s investment qualities is the foundation for making sound investment decisions.
Nevertheless, because of the wide range of financial reporting, we must first become familiar with key financial statement features before we can begin to analyze the financials of specific corporations. Throughout this post, we’ll show you what financial statements are capable of, as well as how to utilize them to your benefit.
The Most Important Takeaways
- For every investor who wishes to make informed investment decisions, understanding how to read a company’s financial statements is a critical ability.
- The financial statements of a firm are divided into four sections: the balance sheet, the income statement, the cash flow statement, and the explanatory notes (or footnotes).
- It is also recommended that prudent investors analyze a firm’s 10-K, which is the thorough financial report that the company files with the United States Securities and Exchange Commission (SEC) (SEC).
- Non-financial information about a firm, such as the status of the economy, the quality of the company’s management, and the company’s competitors, should be reviewed by an investor in addition to financial information.
1. The financial statement is sometimes known as a scorecard.
Whether you’re a do-it-yourself investor or rely on the advice of a financial advisor, mastering certain fundamental financial statement analysis abilities can be extremely beneficial to your investing strategy. Robert Follett, a successful businessman, published a book titled How To Keep Score In Business about 30 years ago. His main argument was that in business, you keep score with money, and the scorecard serves as a financial summary for the company.
He was aware of this “A large number of people are unfamiliar with the concept of keeping score in business. Profits, assets, cash flow, and return on investment are all terms that they get tangled up in.”
In today’s world, the same may be said about a huge segment of the investing public, particularly when it comes to determining the worth of investments from financial statements. But don’t let this put you off; you can complete the task.
2. The Financial Statements to Be Utilized
The balance sheet, the income statement, and the cash flow statement are the financial statements that are utilized in investment analysis, with further analysis of a company’s shareholders’ equity and retained earnings being performed as well. Despite the fact that the income statement and the balance sheet normally receive the majority of attention from investors and analysts, it is critical to include the cash flow statement in your research, which is something that is often missed.
3. What Is the Meaning of the Numbers?
The statistics contained in a company’s financial statements represent the company’s operations, products, services, and macro-fundamental events (such as the company’s founding). Understanding these figures, as well as the financial ratios or indicators that are produced from them, is easier when the fundamentals that drive the quantitative information can be visualized as well as understood. For example, before you begin crunching figures, it is vital that you gain a thorough grasp of the company’s operations, its products and/or services, and the industry in which it works.
4. Reporting from a Wide Range of Perspectives
Do not anticipate financial statements to be able to be placed in a single mold. An approach that is one size does not fit all is taken by many articles and books on financial statement analysis. A presentation of financial statements that differs from the norm for a so-called “typical” corporation may be confusing to less-experienced investors who are unfamiliar with the accounting principles of the company.
You should keep in mind that the various nature of corporate operations results in a diverse set of financial statement presentations. However, the balance sheet is particularly prone to this occurrence; the income statement and cash flow statement are less vulnerable to this issue.
5. Becoming Familiar with Financial Jargon
The lack of any significant standardization of financial reporting terminology makes it difficult to comprehend many of the account entries in financial statements. When it comes to beginner investors, this situation might be very complicated. The chances of things changing on this front in the foreseeable future are slim, but a decent financial dictionary can be of great use.
A comprehensive glossary of terms on investingclue is available to you at any time, including thousands of definitions and thorough explanations that will assist you in understanding terms connected to finance, investing, and economics.
6. Accounting is an art form, not a science.
A company’s financial status, as represented in its financial statements, is influenced by the estimations and judgments made by its management team. In the best of conditions, management is scrupulously honest and candid, whereas the outside auditors are demanding, rigid, and uncompromising in their demands and requirements.
Whatever the case, the imprecision that can be found fundamentally in the accounting process means that the sensible investor should approach financial statement research with a cautious and inquisitive attitude, regardless of the method used.
7. The Most Important Accounting Conventions
For the purpose of preparing financial accounts, generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS) are applied. Both ways are permitted in the United States, albeit GAAP is the method that is most generally utilized. The most significant distinction between the two methods is that GAAP is more “rules-based,” whereas IFRS is more “principles-based” in nature.
Both companies have their own methods of reporting asset valuations, depreciation, and inventories, to name a few examples of differences.
8. Information that is not financial in nature
The financial statements of a firm do not directly reflect information about the status of the economy, the industry, competitive considerations, market forces, technological change, the quality of management, and the size of the workforce. Investors must understand that financial statement insights are only one component of a bigger investing puzzle, albeit a crucial piece of that puzzle for them.
9. Financial Ratios and Indicators
Unless the absolute numbers in financial statements are turned into meaningful relationships that can be used to analyze a company’s financial performance and gauge its financial health, the statistics in financial statements have little value for investment analysis. In order to detect trends, it is necessary to examine the resulting ratios and indicators over a long period of time.
Please keep in mind that evaluative financial measures can vary greatly depending on the industry, the size of the company, and the stage of development.
10. Financial Statements with Explanatory Notes
The statistics in the financial statements do not give all of the information requested by regulatory agencies. To properly evaluate a company’s financial situation and performance, analysts and investors are unanimous in their belief that a full grasp of the notes to financial statements is vital. In the words of auditors on financial statements, “the accompanying notes are a critical component of these financial statements.” Please consider include a comprehensive evaluation of the stated comments in your investment research as a matter of course.
11. The Annual Report/10-K
Prudent investors should only consider investing in companies that have audited financial statements, which are a prerequisite for all publicly-traded companies in order to be considered for public listing. A company’s annual report and 10-K are two documents that investors should review before delving into its financial statements. A large portion of the annual report is based on the 10-K, although it contains less information and is presented in a marketable document intended for a shareholder audience. The 10-K is filed directly with the Securities and Exchange Commission, or SEC, in the United States, and it typically contains more information than previous filings.
The auditor’s report, which provides an auditor’s opinion on how the accounting principles have been applied, is included in the annual report as an attachment.
In the case of a “clean opinion,” you will be given the go-ahead to move forward. Qualifying remarks might be innocuous or serious; if the latter is the case, you may not want to proceed with the transaction.
12. Financial Statements in Consolidated Form
As in a consolidated balance sheet, the word “consolidated” occurs in the title of the financial statement, as in a consolidated profit and loss statement. A consolidation of a parent company and its majority-owned (more than 50 percent ownership or “effective control”) subsidiaries means that the combined activities of separate legal entities are expressed as one economic unit, rather than as two separate economic units. Presumably, the consolidation of multiple entities into a single statement is more relevant than separate assertions for each individual entity.