Investing 101: How to Read (and understand) Financial Statements (to become a better investor)

The Beginner’s Guide to Investing: How to Analyze Financial Statements

By Andrew Lokenauth

As an investor, it’s critical to understand financial statements to make better-informed investment decisions. Financial statements provide vital information about a company’s profitability, liquidity, and financial health. By analyzing financial statements, you can gain valuable insights into a company’s financial performance, identify potential risks and opportunities, assess growth potential, and evaluate its financial stability. This will enable you to make informed investment decisions.

There are four financial statements that every investor should know:

• Balance Sheet
• Income Statement
• Cash Flow Statement
• Stockholders’ Equity Statement

Income Statement:

The income statement, also known as the profit and loss statement, provides information about a company’s profitability and ability to generate income. It shows a company’s revenues, expenses, and net income over a specific period, making it an essential tool for investors to understand a company’s financial performance.

The income statement is divided into two main sections: the income section and the expense section. The income section lists all the revenues that the company earned during the period, such as sales, interest income, and gains on investments. The expense section lists all the expenses that the company has incurred during the period. This includes the cost of goods sold, selling and administrative expenses, and interest expenses.

The net income (or loss) for the period is determined by subtracting expenses from revenues. This amount is then reported at the bottom of the income statement, along with any applicable taxes and the net income (or loss) per share of common stock.

When analyzing an income statement, there are three key items to look for:

1. Revenue growth: This shows whether a company’s revenue is increasing or decreasing over time, which can be a good indication of the company’s overall health and growth prospects
2. Profit margins: This refers to how much of the company’s revenue is being turned into profits. Higher profit margins are generally a positive sign, as they indicate that the company is managing its expenses
3. Expense management: This indicates whether a company is controlling its expenses. If a company’s expenses are rising faster than its revenues, it can be a red flag

Balance Sheet:

The balance sheet, also known as the statement of financial position, provides information about a company’s financial position, including its liquidity and solvency. It provides a snapshot of a company’s financial position at a specific point in time. It shows the company’s assets, liabilities, and equity, which helps investors understand the company’s net worth.

Courtesy of The Balance

(1) Assets are resources that the company owns or controls and can include things like cash, accounts receivable, and property, plant, and equipment

(2) Liabilities are the debts and obligations that the company owes to others and can include things like accounts payable, taxes payable, and long-term debt

(3) Equity represents the ownership interests of the company’s shareholders. By subtracting the company’s liabilities from its assets, you can arrive at the company’s equity, which represents the value of the company’s ownership interests

When analyzing a balance sheet, there are three key items to look for:

1. Asset quality: This refers to whether the company’s asset base is strong and diverse. High-quality assets can help a company weather economic downturns and provide a solid foundation for growth
2. Debt levels: This shows whether the company is carrying a lot of debt. High levels of debt can increase a company’s financial risk and make it more vulnerable to economic downturns
3. Working capital: This reveals whether the company has enough resources to cover its short-term obligations. A company with strong working capital is generally considered to be more financially stable

Cash Flows:

The statement of cash flows shows how a company generates and uses cash. This helps to understand a company’s financial health and ability to meet its obligations. It presents the inflows and outflows of cash for a specific period of time and can be used to assess the company’s liquidity and solvency.

The statement of cash flows is divided into three sections:

1. Operating activities: This includes cash flows from a company’s core business operations, such as cash received from customers, cash paid to suppliers and employees, and other operating expenses
2. Investing activities: This includes the cash flows from the purchase and sale of long-term assets, such as property, plant, and equipment, as well as investments in other companies, such as through the purchase of stocks or bonds
3. Financing activities: This includes the cash flows from the issuance and repayment of a company’s debt and equity, such as the issuance of new shares of stock, the repayment of loans, and the payment of dividends to shareholders

To analyze a cash flow statement, look at the company’s operating cash flow, which represents the cash the company generates from its day-to-day operations. This provides a sense of the company’s underlying financial strength and ability to generate cash. An essential metric to evaluate is free cash flow, which is calculated by subtracting capital expenditures from operating cash flow. Free cash flow represents the amount of cash a company has left over after investing in its business. This cash can be used to pay dividends, repay debt, or invest in new opportunities.

Pay close attention to the net change in cash and cash equivalents on a company’s statement of cash flows. This figure reflects the increase or decrease in the company’s cash and cash equivalents during the period. It can provide valuable insights into the company’s financial health and ability to meet its financial obligations and invest in future growth.

Stockholders’ Equity:

The statement of stockholders’ equity provides valuable insights into a company’s financial health and its ability to generate profits and distribute them to shareholders. It is important because it represents the portion of the company that belongs to shareholders. The statement is divided into two sections:

• The beginning balance shows total equity at the beginning of the period
• The changes during the period include all transactions that have occurred since the beginning of the period

The statement of stockholders’ equity includes the following items:

• Common stock: This is the amount of capital that has been contributed by the company’s shareholders in exchange for common stock
• Additional paid-in capital: The amount of capital that has been contributed by shareholders in excess of the par value of common stock
• Retained earnings: The amount of earnings the company has retained since its inception, after deducting dividends paid to shareholders
• Net income (or loss): This is the company’s net income (or loss) for the period, which is determined by subtracting the company’s expenses from its revenues
• Dividends: This is the amount of cash that the company has paid to its shareholders as dividends

To analyze stockholders’ equity, compare the company’s equity to its assets to get a sense of the company’s financial leverage. High levels of debt can increase a company’s financial risk and make it more vulnerable to economic downturns. When analyzing stockholders’ equity, it is important to look for two key things:

• Equity growth: Is the company’s equity increasing or decreasing over time? This can be a good sign of the company’s financial health and growth prospects
• Financial leverage: Is the company heavily reliant on debt financing? If so, this can increase the company’s financial risk and make it more vulnerable to economic downturns

Understanding financial statements is an important aspect of successful investing. Warren Buffett, known for his expertise in investing, emphasizes the importance of understanding financial statements in making successful investment decisions. Understanding the four financial statements and how to analyze them will help you make better-informed decisions that lead to better investment outcomes.

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