Understanding Financial Statements

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When looking over your investments, do you ever wonder how the value of the companies you’ve put your money in is determined? What factors decide how well a company is really doing? What’s the source of the company’s financing? Will it meet or exceed this quarter’s projections? While some consider the stock market to be little more than a house of cards, subject to the whims of individual investors, there are, in fact, some very real and measurable things that can help you to diagnose the financial health of a company.

Take a statement

It’s not an interrogation but you’ll want to ask the hard questions before you invest. Only by examining and drawing conclusions from a financial statement, will you truly know how well a company is doing. At first glance, you will see that a financial statement is made up of three main sections, the balance sheet, the income statement and the cash flow statement. Each statement depicts a different aspect of the overall financial picture of a business. The balance sheet details companies’ current assets such as cash and prepaid expenses. It shows the financial position at a particular date. This statement tells you what the current liabilities or existing debt the company has, that has to be paid within that year. Examples of debt include accounts payable, salaries payable or income taxes payable. The amount of current assets over current liabilities determines the amount of working capital or leftover cash the company has to cover other operating expenses. Whether or not there is enough money left over after the current debt is paid off, tells you whether the company is on solid financial ground or might be headed for destruction.

The income statement is a summary of the profits a business has earned for a specified period of time. This is where you would see the amount of revenue or profits obtained for a companies’ products or services and the expenses incurred for salaries, supplies or income taxes. The difference between the revenue and expenses gives you the net income, which when compared over a period of say two years shows you how the net income is rising or falling, a fairly good indicator of how profitable the business is. Basically, this statement tells you if the company has revenue coming in.

The cash flow statement is particularly important when considering new ventures such as an internet startup. The ability to balance cash flow now is a sign that the business has a long and profitable future ahead of it. This reports the cash going out and coming in from operating, investing and financing activities. In this statement, changes in the net cash flow indicate the company’s ability to meet its debt obligations and pay dividends, how much external financing the company is using and its ability to generate cash flow in the future. Operating cash flow can be described as the cash effects from revenue and expense transactions. Investing cash activities comes from the purchasing and selling of properties or assets and financing cash activities shows how owners of the company have used loans from creditors to finance their business.

Know the facts

Investing should never be based on emotion. While you might be tempted to invest in a company because you like its products or because you’ve just read a favorable article about it in a magazine or newspaper, you should make sure you’ve done your research before ponying up your hard earned cash. Think of the financial statement as a kind of scorecard that helps you determine which company is the one you should invest in. What you’ll find is a hard look at the financial structure of a business that shows you what it’s really made of. Ask yourself a few questions and see if the statements help answer them. Does the revenue exceed expenses in the income statement? Does the amount of assets exceed liabilities on the balance sheet?

Notes often accompany financial statements. Read these notes carefully as they disclose information that can help you interpret the financial information on the statements. The notes reveal any changes that could have an impact on the company’s finances. It can provide some startling insights such as what type of debt the company purchased, for how long and for what purpose. For example, the notes might state that company A entered into a two year term note of which the proceeds were used to purchase the company’s out of state manufacturing facility and headquarters. Essentially, the notes are a complement to the statement providing more details. If you’re a shareholder, it’s your company. So you’ll want to make sure you know as much as you can about it.