How to Read Financial Statements–for Fun and Profit
Even if the company is a “brand name” with seemingly predictable growth prospects, a solid understanding of its financials always is worthwhile for any investor.
You don’t have to be an expert or get too far into the weeds. However, if you want to be a savvy stock investor, you should understand the importance of crucial financial concepts, such as return on equity and free cash flow. That’s particularly true, if you’re considering an investment in a company that might involve future uncertainties.
Think of financial statements as a company’s medical charts, and you’re the doctor who’s using these charts to determine a diagnosis as to the company’s financial health.
Here are the “Big Three” financial statements:
• The balance sheet
The balance sheet is a snapshot of a company’s financial condition. The majority of public companies publish an interim balance sheet each quarter and a comprehensive one at the end of their fiscal year. Typically, the end of the calendar year is defined as the end of a reporting year. The balance sheet reveals a firm’s financial resources and obligations at a given moment in time.
• The income statement
The income statement summarizes a firm’s financial transactions over a defined period of time. The balance sheet and income statement match money coming in (revenues) with the expenses tied to generating those revenues.
• The cash flow statement
This reflects a company’s liquidity. Generally expressed, a healthy company will spend and hang onto less money than it takes in—and the difference is profit that’s distributed to the shareholders and owners. This dynamic is called a “positive cash flow.”
Let’s take a closer look at all three elements.
The Balance Sheet
The balance sheet will give you an indication as to the sensitivity of a company’s bottom line to market ups and downs—especially important knowledge, for cyclical firms whose fortunes are tied to economic conditions. The balance sheet will reveal the company’s risks during hard times and its upside during good times.
What follows is a breakdown of the most important lessons that you can learn from a balance sheet—the meaning of key terms, and how to extract and interpret the information that’s of most use to investors.
The balance sheet is broken into two sides. Assets are on the left side and the right side contains the company’s liabilities and shareholders’ equity. The balance sheet is said to be “in balance” when the value of the assets equals the combined value of the liabilities and shareholders’ equity.
The balance sheet is sectioned into two parts, according to the following formula: Assets equal Liabilities, plus Shareholders’ Equity.
In other words, assets (the inherent means necessary to keep the company operating) are “balanced” by: 1) the company’s financial obligations, and 2) equity investment and retained earnings. Scrutinize these aspects:
• Current assets
Current assets can be easily turned into cash, because they have a lifespan of 12 months or less. These assets include accounts receivable, and inventory cash and cash equivalents. Cash includes non-restricted checks and bank accounts. Cash equivalents include extremely safe assets, such as US Treasuries, that can be easily transformed into cash.
• Non-current assets
Non-current assets are assets that can’t be easily converted into cash; they have a lifespan of more than a year. This class of asset includes buildings, land, machines, computers, etc. Non-current assets also can be intangible assets, such as patents, copyrights, or other intellectual property.
• Liabilities
Liabilities reside on the other side of the balance sheet. They include a company’s financial obligations to outside parties. As with assets, they are classified as either current or long-term.
• Long-term liabilities
These financial obligations are debts as well as non-debts, due after a period of at least one year from the balance sheet’s date.
• Current liabilities
These are the company’s liabilities that must be paid within 12 months. These include both short-term borrowings, such as accounts payables, and the current payment on long-term borrowing.
• Shareholders’ equity
This is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder’s equity account.
This account represents a company’s total net worth. Total assets on one side must equal total liabilities plus shareholders’ equity on the other—only then does the balance sheet actually “balance.”
Here’s a graphical depiction of how a balance sheet works:
The Income Statement
With a greater understanding of the balance sheet and how it is constructed, we can now look at the income statement.
Here’s a breakdown of the important aspects for investors:
• Gross profit
Gross profit is the basic difference between the cost of producing products and/or services and the revenues generated by them. The selling, general and administrative (SG&A) category entails administrative and marketing expenses and overall overhead involved in operating the business. Another category is expenses for research and development (R&D).
• Operating profit
This statistic is calculated as:
Operating Profit = Operating Revenue – Operating Expenses
Operating profits are earned from a company’s everyday core business operations. This figure doesn’t account for any profit earned from the company’s investments and the effects of interest and taxes. Operating profits also are called “Earnings Before Interest and Tax” (EBIT).
The Cash Flow Statement
A cash flow statement shows how changes—the continual ebb and flow, if you will—in balance statement accounts and income affect cash and cash equivalents. Simply put, the cash flow statement reflects the flow of cash in and out of the company.
The cash flow statement is an important barometer for investors, because it reveals the short-term viability of a company. Most importantly, it can show you the ability of a company to pay its bills.
The cash flow statement leaves out transactions that don’t directly affect cash receipts and payments; it only includes inflows and outflows of cash (or cash equivalents).
The cash flow statement directly applies to activities related to these three areas: financing, operating and investing. As an investment tool, it’s the best way for you to determine a company’s liquidity and solvency.
• Free cash flow
This indicator is crucial. Here’s the formula for determining free cash flow:
Net Income
+ Amortization/Depreciation
– Changes in Working Capital
– Capital Expenditures
= Free Cash Flow
Essentially, free cash flow is operating cash flow minus capital expenditures. It represents the cash that a company is capable of generating after spending all of the money necessary to maintain its asset base.
As an investor, think of free cash flow as “steroids” that boost the growth rate of the company. That’s because free cash flow can be used to make acquisitions, repurchase stock, or repay debt, all of which are highly positive actions that enhance earnings per share.
Financial Ratio Analysis
Using the yardsticks conveyed by these financial statements, you can perform interpretive analysis of the company’s finances and its operations, to assist you in your efforts to gauge the company’s suitability as an investment. This is known as “financial ratio analysis.”
When scrutinizing financial statements and extracting certain numbers from them, you can calculate financial ratios that provide you with a clearer understanding of the company’s financial condition, as well as the efficiency of its operations.
It’s not as complicated as it sounds. Keep in mind, though, that to perform some of these ratios, you’ll need to extract information from more than one financial statement.
The main types of ratios that use information from the balance sheet are activity ratios and financial strength ratios.
Activity ratios focus on current accounts to reflect how efficiently the company manages its receivables, inventory and payables, which all come under the heading of “operating cycle.” These ratios can provide insight into the company’s operational efficiency.
Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how they are leveraged.
• Debt-to-equity ratio
The ratio is determined this way: D/E = Debt(liabilities)/equity.
This ratio reveals the company’s financial leverage. Debt that has been financed with every dollar of equity would constitute a ratio of 1; scant debt compared to assets would represent a low ratio, such as 0.2. Any ratio above 1 tells you that the company owes more than it’s actually worth—surely, not a good sign for investors.
• Working capital ratio (or, “current ratio”)
Here’s the formula for determining this ratio:
Current assets
= ____________
Current liabilities
The working capital ration can give you inklings as to the company’s financial stability and the manner in which it finances itself. A declining working capital ratio over a sustained period of time is a very bad sign.
• Return on equity (ROE)
For investors, this ratio is hugely important. It’s calculated by dividing the net income by the shareholder’s equity. It’s a measure of the company’s rate of return on the money provided by its owners. An ROE of about 12 percent is roughly average for public companies.
Now that you’re armed with the basics of financial statement analysis, sharpen your pencil and put on your green eyeshades. You’re ready to do some financial sleuthing—if not for fun, then certainly for profit.
John Persinos is editorial director of Personal Finance and its parent website Investing Daily.
Stock Talk
We encourage you to engage with our analysts and your fellow subscribers on our website. To ask a question or post a comment related to a particular article, please do so in the Stock Talk field at the bottom of that article.
Or, to ask a general question, please go to the main Stock Talk page found under the Resources menu for each publication.
You don’t have to be an expert or get too far into the weeds. However, if you want to be a savvy stock investor, you should understand the importance of crucial financial concepts, such as return on equity and free cash flow. That’s particularly true, if you’re considering an investment in a company that might involve future uncertainties.
Think of financial statements as a company’s medical charts, and you’re the doctor who’s using these charts to determine a diagnosis as to the company’s financial health.
Here are the “Big Three” financial statements:
• The balance sheet
The balance sheet is a snapshot of a company’s financial condition. The majority of public companies publish an interim balance sheet each quarter and a comprehensive one at the end of their fiscal year. Typically, the end of the calendar year is defined as the end of a reporting year. The balance sheet reveals a firm’s financial resources and obligations at a given moment in time.
• The income statement
The income statement summarizes a firm’s financial transactions over a defined period of time. The balance sheet and income statement match money coming in (revenues) with the expenses tied to generating those revenues.
• The cash flow statement
This reflects a company’s liquidity. Generally expressed, a healthy company will spend and hang onto less money than it takes in—and the difference is profit that’s distributed to the shareholders and owners. This dynamic is called a “positive cash flow.”
Let’s take a closer look at all three elements.
The Balance Sheet
The balance sheet will give you an indication as to the sensitivity of a company’s bottom line to market ups and downs—especially important knowledge, for cyclical firms whose fortunes are tied to economic conditions. The balance sheet will reveal the company’s risks during hard times and its upside during good times.
What follows is a breakdown of the most important lessons that you can learn from a balance sheet—the meaning of key terms, and how to extract and interpret the information that’s of most use to investors.
The balance sheet is broken into two sides. Assets are on the left side and the right side contains the company’s liabilities and shareholders’ equity. The balance sheet is said to be “in balance” when the value of the assets equals the combined value of the liabilities and shareholders’ equity.
The balance sheet is sectioned into two parts, according to the following formula: Assets equal Liabilities, plus Shareholders’ Equity.
In other words, assets (the inherent means necessary to keep the company operating) are “balanced” by: 1) the company’s financial obligations, and 2) equity investment and retained earnings. Scrutinize these aspects:
• Current assets
Current assets can be easily turned into cash, because they have a lifespan of 12 months or less. These assets include accounts receivable, and inventory cash and cash equivalents. Cash includes non-restricted checks and bank accounts. Cash equivalents include extremely safe assets, such as US Treasuries, that can be easily transformed into cash.
• Non-current assets
Non-current assets are assets that can’t be easily converted into cash; they have a lifespan of more than a year. This class of asset includes buildings, land, machines, computers, etc. Non-current assets also can be intangible assets, such as patents, copyrights, or other intellectual property.
• Liabilities
Liabilities reside on the other side of the balance sheet. They include a company’s financial obligations to outside parties. As with assets, they are classified as either current or long-term.
• Long-term liabilities
These financial obligations are debts as well as non-debts, due after a period of at least one year from the balance sheet’s date.
• Current liabilities
These are the company’s liabilities that must be paid within 12 months. These include both short-term borrowings, such as accounts payables, and the current payment on long-term borrowing.
• Shareholders’ equity
This is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder’s equity account.
This account represents a company’s total net worth. Total assets on one side must equal total liabilities plus shareholders’ equity on the other—only then does the balance sheet actually “balance.”
Here’s a graphical depiction of how a balance sheet works:
The Income Statement
With a greater understanding of the balance sheet and how it is constructed, we can now look at the income statement.
Here’s a breakdown of the important aspects for investors:
• Gross profit
Gross profit is the basic difference between the cost of producing products and/or services and the revenues generated by them. The selling, general and administrative (SG&A) category entails administrative and marketing expenses and overall overhead involved in operating the business. Another category is expenses for research and development (R&D).
• Operating profit
This statistic is calculated as:
Operating Profit = Operating Revenue – Operating Expenses
Operating profits are earned from a company’s everyday core business operations. This figure doesn’t account for any profit earned from the company’s investments and the effects of interest and taxes. Operating profits also are called “Earnings Before Interest and Tax” (EBIT).
The Cash Flow Statement
A cash flow statement shows how changes—the continual ebb and flow, if you will—in balance statement accounts and income affect cash and cash equivalents. Simply put, the cash flow statement reflects the flow of cash in and out of the company.
The cash flow statement is an important barometer for investors, because it reveals the short-term viability of a company. Most importantly, it can show you the ability of a company to pay its bills.
The cash flow statement leaves out transactions that don’t directly affect cash receipts and payments; it only includes inflows and outflows of cash (or cash equivalents).
The cash flow statement directly applies to activities related to these three areas: financing, operating and investing. As an investment tool, it’s the best way for you to determine a company’s liquidity and solvency.
• Free cash flow
This indicator is crucial. Here’s the formula for determining free cash flow:
Net Income
+ Amortization/Depreciation
– Changes in Working Capital
– Capital Expenditures
= Free Cash Flow
Essentially, free cash flow is operating cash flow minus capital expenditures. It represents the cash that a company is capable of generating after spending all of the money necessary to maintain its asset base.
As an investor, think of free cash flow as “steroids” that boost the growth rate of the company. That’s because free cash flow can be used to make acquisitions, repurchase stock, or repay debt, all of which are highly positive actions that enhance earnings per share.
Financial Ratio Analysis
Using the yardsticks conveyed by these financial statements, you can perform interpretive analysis of the company’s finances and its operations, to assist you in your efforts to gauge the company’s suitability as an investment. This is known as “financial ratio analysis.”
When scrutinizing financial statements and extracting certain numbers from them, you can calculate financial ratios that provide you with a clearer understanding of the company’s financial condition, as well as the efficiency of its operations.
It’s not as complicated as it sounds. Keep in mind, though, that to perform some of these ratios, you’ll need to extract information from more than one financial statement.
The main types of ratios that use information from the balance sheet are activity ratios and financial strength ratios.
Activity ratios focus on current accounts to reflect how efficiently the company manages its receivables, inventory and payables, which all come under the heading of “operating cycle.” These ratios can provide insight into the company’s operational efficiency.
Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how they are leveraged.
• Debt-to-equity ratio
The ratio is determined this way: D/E = Debt(liabilities)/equity.
This ratio reveals the company’s financial leverage. Debt that has been financed with every dollar of equity would constitute a ratio of 1; scant debt compared to assets would represent a low ratio, such as 0.2. Any ratio above 1 tells you that the company owes more than it’s actually worth—surely, not a good sign for investors.
• Working capital ratio (or, “current ratio”)
Here’s the formula for determining this ratio:
Current assets
= ____________
Current liabilities
The working capital ration can give you inklings as to the company’s financial stability and the manner in which it finances itself. A declining working capital ratio over a sustained period of time is a very bad sign.
• Return on equity (ROE)
For investors, this ratio is hugely important. It’s calculated by dividing the net income by the shareholder’s equity. It’s a measure of the company’s rate of return on the money provided by its owners. An ROE of about 12 percent is roughly average for public companies.
Now that you’re armed with the basics of financial statement analysis, sharpen your pencil and put on your green eyeshades. You’re ready to do some financial sleuthing—if not for fun, then certainly for profit.
John Persinos is editorial director of Personal Finance and its parent website Investing Daily.
Stock Talk
We encourage you to engage with our analysts and your fellow subscribers on our website. To ask a question or post a comment related to a particular article, please do so in the Stock Talk field at the bottom of that article.
Or, to ask a general question, please go to the main Stock Talk page found under the Resources menu for each publication.