Before investing in stocks it’s important to gauge the financial health of a company. An investor can do this by reviewing a company’s financial statements. These statements capture how well it is performing and whether it or not it has growth potential in the long-term.
While business professionals and accountants are trained to read financial statements, it can be overwhelming for average investors. Knowing which statements to read and what to look for can help investors build an appropriate investment strategy.
This article will walk through which financial statements are important, the key information captured in each document, and how to analyze them together to determine which stocks to invest in.
The Short Version
- The primary financial statements an investor will want to review before investing in stocks are the: income statement, balance sheet, cash flow statement, and annual report
- Financial statements indicate a company’s financial health and how well it is structured to facilitate future growth
- Financial statements can be used in a larger investing strategy to look for trends over time across different companies in an industry
Types of Financial Statements to Know
Financial statements are some of the most important tools an investor can use to determine the financial health of a company. These statements can reveal whether or not a company has adequate resources to grow and if it has the right team in place to execute their strategy.
There are four primary statements a prospective investor will want to review:
- Income statement
- Balance sheet
- Cash flow statement
- Annual report.
These documents are prepared quarterly with the exception of the annual report which is prepared at the end of the fiscal year.
Investors can find financial documents for publicly traded companies on the Security and Exchange Commission (SEC)’s EDGAR search tool. Most companies also have an investor relations page on their website where investors can find this information as well.
Each of these documents provides a different insight into how well a company is performing. Analyzing these documents together can help investors assess the financial health of a company and its potential return on investment of its stocks.
The income statement is also known as the profit and loss statement, or P&L. This statement includes revenue, expenses, and operational transactions over a period of time.
An income statement is a snapshot of how a company performs over a specific period of time, with data summarizing the company’s business activities. It can help you understand whether or not the company is profitable (and thus whether or not it makes sense to invest in it).
Comparing income statements across different time periods can help you spot trends in performance. This can also help you identify chronic issues before deciding to invest.
You can find out whether or not a company is performing in line with expectations by reviewing the regularly issued income statements over time. If a company is falling short of expectations, it should be clear on the income statement which specific business activities are contributing to a particular outcome.
An income statement is broken down into four sections:
The revenue and expenses sections show what is coming in and out of a business as a result of its core business operations. The gains and losses section shows income or expenses related to non-core business activities, such as the selling of an asset or paying interest on a debt. These sections quantify the net revenue of a company and thus whether or not it is generating a profit.
How to Read an Income Statement
The income statement can cover quarterly or annual changes in revenue and expenses. This allows investors to compare income statements to see changes happening over time.
There are two different ways to review an income statement: Vertically or horizontally.
- A vertical analysis entails reviewing transactions as percentages. This allows investors to evaluate a company’s performance by comparing different line items in a section. For example, a vertical analysis can show investors which activities generate the most revenue (or which activities require higher expenses).
- Horizontal analysis, on the other hand, is a process of looking for change over time. Investors can look across multiple reporting periods to see if a company’s activities result in increased profit. This method of analysis can help investors determine whether or not a company shows consistent growth and can help an investor evaluate how well a company is performing against its competitors.
The balance sheet captures a business’s assets, liabilities, and owners’ equity. Typically captured on one page, the balance sheet shows investors what resources a company has to expand its operations and whether or not those resources were obtained with too much debt.
Balance sheets tell you whether or not a company is balanced. That means, assets must equal liabilities plus owners’ equity. An unbalanced balanced sheet could indicate reporting errors or fundamental problems with the business’s financial positioning.
A balance sheet is laid out in three sections: assets, liabilities, and owners’ (or shareholders’) equity. There are two ways to format a balance sheet. Accountants and financial professionals use an account format that resembles a “T.” Assets are listed on the left while liabilities and owners’ equity are listed on the right.
The most common format an investor will come across, however, is the report format. This lists assets at the top followed by liabilities, with owners’ equity at the bottom. In this format individual line items are reported in order of liquidity and are grouped as being current or noncurrent.
How to Read a Balance Sheet
Think of a balance sheet as a summary of a company’s financial position. It can tell you whether or not a stock is performing well or has the potential to improve its performance in the future.
Here’s what the information can indicate to potential investors.
Assets are resources that a business owns that it can capitalize on to grow. They are broken down into Current assets and Noncurrent assets:
- Current assets are expected to be converted to cash within the next twelve months.
- Noncurrent assets are hard to convert into cash and should not be expected to be liquidated within an accounting year.
Assets are typically listed in order of their liquidity. A business with too much liquidity on its balance sheet could indicate that it isn’t capitalizing on its growth potential. Meanwhile too little could be a risk should the business fall on hard times and need to leverage it.
Liabilities are financial obligations, like debt or a mortgage. They also include transactions that have not yet been settled. Like assets, liabilities are categorized by those due within an accounting year and those due in more than a year.
Owners’ equity is what remains in a company to be paid out to shareholders after liabilities are subtracted from assets. An investor’s stake in a company is recorded as the number of shares of stock they receive in exchange for their investment.
Owners’ equity also includes retained earnings. This is the net profit a company keeps after paying dividends out to its shareholders. Retained earnings demonstrate whether or not a company is saving money toward future reinvestments and thus creating growth that might lead to a positive return for an investor.
A strong balance sheet is a good sign>>Invest in Companies That Have These Attributes
Cash Flow Statement
A cash flow statement shows how much money is flowing into and out of a company. This demonstrates how well a company can continue operating based on its existing business activities.
The cash flow statement contains three types of cash flows: Operating activities, investing activities, and financial activities.
How to Read a Cash Flow Statement
Cash generated from operating activities shows the revenue and expenses from providing goods or services. There are two ways to calculate cash flow from operating activities: indirect and direct.
The indirect method uses accrual accounting to calculate a cash basis for a period of time. It typically uses net income as a starting point and incorporates non-cash expenses, such as depreciation.
The direct method records all transactions in a period based on actual cash inflows and outflows. This method does not account for non-cash transactions like depreciation. While this method is the most accurate, companies generally use the indirect method to report cash generated from operating activities.
Cash generated from investing activities reflect a company’s invested assets, such as real estate or securities. Investors can see if a company is using their capital wisely to increase future operations. As a result, this section can signal whether or not a company is at a growth stage.
Cash generated from financing activities shows the cash flow coming from debt and equity that is used to fund a company. It can signal to investors whether or not a company has too much debt which might inhibit future growth potential.
Generally, a company in good health should demonstrate a positive cash flow. This indicates it can continue operations without becoming insolvent. Having excess cash flowing in can also provide a company with resources to pay down debt, reinvest in growth, or compensate investors.
A negative cash flow does not indicate a business is unprofitable, however, it could indicate a problem in its operations. If not resolved correctly, it could signal bigger problems for the company down the road.
Public companies are required to publish an annual report every year. This report describes their operational activities and financial position. Unlike other financial reports, the annual report typically includes sections that provide greater insight into a business’s core operations and management’s strategy to grow the company.
How to Read an Annual Report
The annual report is a useful tool for investors to understand the vision driving decisions made by management. Typically this report includes the strategy behind key performance indicators (KPIs) and benchmarks that can be validated by the financials captured in other documents.
Prospective investors can also use the annual report to determine whether or not a company has the right leadership team in place to facilitate future growth.
Looking across different annual reports over time shows how consistently a company’s management team is in achieving key performance objectives and how well they navigate downturns.
What Financial Statements Can Tell You About Your Stocks
Financial statements are some of the most important tools an investor can use to determine the financial health of a company. These statements reveal whether or not a company has resources to grow and if it has the right team in place to execute their strategy.
Financial statements also show how a company ranks compared to its competitors and whether or not a KPI is isolated to a specific company or endemic to the entire sector. This can help investors determine a company's ability to capture future market share to continue growing.
By comparing the financial statements of competing companies, investors can make larger investment decisions about future growth opportunities within a specific industry or sector.
A strong core business model, well financed capital, and good positioning in the market all indicate that a business is poised to succeed.
Before investing in a company it is important to understand its financials. Financial statements reveal different aspects of a company’s operations, financing, and growth potential that are important in making decisions about stocks.
While key financial statements typically capture data for a specific period of time, studying the financial statements of a company over several years can show trends in performance. Consistent performance year-over-year can indicate that a company is not only a good investment but a reliable one.
Financial statements are important when it comes to comparing companies and the growth potential within their sector. This can signal whether or not a company has the potential to continue growing in the long-term and can help shape an investor’s overall investment strategy.
Learn more about investing in stocks>>
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- Pre-IPO Investing: Can You Make Money Investing in Pre-IPO Stocks?
- How to Do Stock Market Research