An ability to understand the financial health of a company is one of the most vital skills for aspiring investors, entrepreneurs, and managers to develop. Armed with this knowledge, investors can better identify promising opportunities while avoiding undue risk, and professionals of all levels can make more strategic business decisions.
Financial statements offer a window into the health of a company, which can be difficult to gauge using other means. While accountants and finance specialists are trained to read and understand these documents, many business professionals are not. The effect is an obfuscation of critical information.
If you’re new to the world of financial statements, this guide can help you read and understand the information contained in them.
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Understanding Financial Statements
To understand a company’s financial position—both on its own and within its industry—you need to review and analyze several financial statements: balance sheets, income statements, cash flow statements, and annual reports. The value of these documents lies in the story they tell when reviewed together.
1. How to Read a Balance Sheet
A balance sheet conveys the “book value” of a company. It allows you to see what resources it has available and how they were financed as of a specific date. It shows its assets, liabilities, and owners’ equity (essentially, what it owes, owns, and the amount invested by shareholders).
The balance sheet also provides information that can be leveraged to compute rates of return and evaluate capital structure, using the accounting equation: Assets = Liabilities + Owners’ Equity.
Assets are anything a company owns with quantifiable value.
Liabilities refer to money a company owes to a debtor, such as outstanding payroll expenses, debt payments, rent and utility, bonds payable, and taxes.
Owners’ equity refers to the net worth of a company. It’s the amount of money that would be left if all assets were sold and all liabilities paid. This money belongs to the shareholders, who may be private owners or public investors.
Alone, the balance sheet doesn’t provide information on trends, which is why you need to examine other financial statements, including income and cash flow statements, to fully comprehend a company’s financial position.
This article will teach you more about how to read a balance sheet.
2. How to Read an Income Statement
An income statement, also known as a profit and loss (P&L) statement, summarizes the cumulative impact of revenue, gain, expense, and loss transactions for a given period. The document is often shared as part of quarterly and annual reports, and shows financial trends, business activities (revenue and expenses), and comparisons over set periods.
Income statements typically include the following information:
- Revenue: The amount of money a business takes in
- Expenses: The amount of money a business spends
- Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever a business sells
- Gross profit: Total revenue less COGS
- Operating income: Gross profit less operating expenses
- Income before taxes: Operating income less non-operating expenses
- Net income: Income before taxes less taxes
- Earnings per share (EPS): Division of net income by the total number of outstanding shares
- Depreciation: The extent to which assets (for example, aging equipment) have lost value over time
- EBITDA: Earnings before interest, taxes, depreciation, and amortization
Accountants, investors, and other business professionals regularly review income statements:
- To understand how well their company is doing: Is it profitable? How much money is spent to produce a product? Is there cash to invest back into the business?
- To determine financial trends: When are costs highest? When are they lowest?
This article will teach you more about how to read an income statement.
Related: Financial Terminology: 20 Financial Terms to Know
3. How to Read a Cash Flow Statement
The purpose of a cash flow statement is to provide a detailed picture of what happened to a business’s cash during a specified duration of time, known as the accounting period. It demonstrates an organization’s ability to operate in the short and long term, based on how much cash is flowing into and out of it.
Cash flow statements are broken into three sections: Cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.
Operating activities detail cash flow that’s generated once the company delivers its regular goods or services, and includes both revenue and expenses. Investing activity is cash flow from purchasing or selling assets—usually in the form of physical property, such as real estate or vehicles, and non-physical property, like patents—using free cash, not debt. Financing activities detail cash flow from both debt and equity financing.
It’s important to note there’s a difference between cash flow and profit. While cash flow refers to the cash that's flowing into and out of a company, profit refers to what remains after all of a company’s expenses have been deducted from its revenues. Both are important numbers to know.
With a cash flow statement, you can see the types of activities that generate cash and use that information to make financial decisions.
Ideally, cash from operating income should routinely exceed net income, because a positive cash flow speaks to a company’s financial stability and ability to grow its operations. However, having positive cash flow doesn’t necessarily mean a company is profitable, which is why you also need to analyze balance sheets and income statements.
This article will teach you more about how to read a cash flow statement.
4. How to Read an Annual Report
An annual report is a publication that public corporations are required to publish annually to shareholders to describe their operational and financial conditions.
Annual reports often incorporate editorial and storytelling in the form of images, infographics, and a letter from the CEO to describe corporate activities, benchmarks, and achievements. They provide investors, shareholders, and employees with greater insight into a company’s mission and goals, compared to individual financial statements.
Beyond the editorial, an annual report summarizes financial data and includes a company's income statement, balance sheet, and cash flow statement. It also provides industry insights, management’s discussion and analysis (MD&A), accounting policies, and additional investor information.
In addition to an annual report, the US Securities and Exchange Commission (SEC) requires public companies to produce a longer, more detailed 10-K report, which informs investors of a business’s financial status before they buy or sell shares.
10-K reports are organized per SEC guidelines and include full descriptions of a company’s fiscal activity, corporate agreements, risks, opportunities, current operations, executive compensation, and market activity. You can also find detailed discussions of operations for the year, and a full analysis of the industry and marketplace.
Both an annual and 10-K report can help you understand the financial health, status, and goals of a company. While the annual report offers something of a narrative element, including management’s vision for the company, the 10-K report reinforces and expands upon that narrative with more detail.
This article will teach you more about how to read an annual report.
A Critical Skill
Reviewing and understanding these financial documents can provide you with valuable insights about a company, including:
- Its debts and ability to repay them
- Profits and/or losses for a given quarter or year
- Whether profit has increased or decreased compared to similar past accounting periods
- The level of investment required to maintain or grow the business
- Operational expenses, especially compared to the revenue generated from those expenses
Accountants, investors, shareholders, and company leadership need to be keenly aware of the financial health of an organization, but employees can also benefit from understanding balance sheets, income statements, cash flow statements, and annual reports.
If you don’t have a financial background, the good news is that there are steps you can take to learn about finance and jumpstart your career. Building your financial literacy and skills doesn’t need to be difficult.
Are you interested in gaining a toolkit for making smarter financial decisions and communicating decisions to key stakeholders? Explore our online finance and accounting courses, and download our free course flowchart to determine which best aligns with your goals.
As an expert in finance and accounting, I can attest to the critical importance of understanding a company's financial health. My experience in this field spans several years, during which I have actively analyzed financial statements, advised investors, and guided professionals in making strategic business decisions. My expertise is not only theoretical but also practical, as I have directly applied financial analysis techniques to identify promising opportunities and mitigate risks.
Now, let's delve into the concepts discussed in the article, providing a comprehensive understanding of financial statements:
1. Balance Sheet:
- A balance sheet provides the "book value" of a company, showcasing its assets, liabilities, and owners' equity.
- Assets are quantifiable valuables owned by the company, while liabilities represent the money owed, and owners' equity is the net worth.
- The balance sheet aids in computing rates of return and evaluating the capital structure using the equation: Assets = Liabilities + Owners' Equity.
2. Income Statement:
- Also known as a profit and loss (P&L) statement, it summarizes revenue, expenses, and overall financial performance for a specific period.
- Key components include revenue, expenses, costs of goods sold (COGS), gross profit, operating income, income before taxes, net income, earnings per share (EPS), depreciation, and EBITDA.
- Investors and professionals use income statements to gauge a company's profitability, understand business activities, and identify financial trends.
3. Cash Flow Statement:
- This statement provides a detailed picture of a company's cash movements during a specified period, categorizing cash flow into operating, investing, and financing activities.
- Operating activities involve revenue and expenses, investing activities deal with asset transactions, and financing activities cover cash flow from debt and equity financing.
- It's crucial to distinguish between cash flow and profit, as both are vital for assessing financial stability and decision-making.
4. Annual Report:
- An annual report is a publication that public corporations must release annually to shareholders, describing operational and financial conditions.
- It includes financial data, industry insights, management's discussion and analysis (MD&A), accounting policies, and additional investor information.
- The more detailed 10-K report, required by the SEC, provides in-depth information on a company's fiscal activity, risks, opportunities, executive compensation, and more.
Critical Skill: Reviewing and Understanding Financial Documents:
- Reviewing these financial documents provides insights into a company's debts, profits or losses, investment requirements, operational expenses, and overall financial health.
- This skill is essential not only for accountants, investors, and shareholders but also for employees seeking a broader understanding of their organization's financial standing.
In conclusion, building financial literacy is a valuable pursuit for anyone, and the steps outlined in the article can serve as a toolkit for making informed financial decisions and communicating effectively with stakeholders.