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Understanding Financial Statements


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Understanding Financial Statements

understanding financial statementsAs an investor it is crucial for you to understand financial statements. Financial statements are the best way to understand a company’s health and determine how it will perform moving forward. It’s important to remember that past performance does not guarentee future sucess when looking at a financial statement, however, it is the best guage the investor has in their tool kit to measure and project how the company will perform moving forward.

The Statement of Cash Flows

The statement of cash flows helps investors determine how well a company converts its profits to cash they can use to either reinvest in the business, pay dividends to shareholders, pay debts, repurchase stock, and much more. The statement of cash flows is one of the most important financial statements an investor needs to understand.

The statement of cash flows shows a lot of great information about a company once an investor learns how to read it. Click here to learn more about what the statement of cash flows can teach you. Some of the things the statement of cash flows can teach you about a company is how much money they reinvest to purcahse new operating equipment or buildings. This can help investors see if the company is growing. It can also show you how well a company leverages its debt to generate new business for the company. For investors, it also shows how much money they can pay dividends with and their track record with paying dividends.

understanding financial statements income statementThe Income Statement

The income statement helps investors determine how profitable a company is. Investors use the income to see how well the company turns revenue into gross profit and how well it turns gross profit into net income. As an investor you want to compare the company your looking at to other companies with similar operations. By making comparisons you will be able to see if your company is outperforming its competitors.

Some very important measures of the income statement are gross profit percentage (revenue divided by cost of goods sold), operating revenue to operating expenses percentage (operating expenses divided by operating income) and net income percentage (net income divided by revenue). It’s important to compare all these performance measures to similar businesses. For instance a tech company traditionally has a much higher net income percentage then a manufacturing company. So without comparing numbers to close competitors your assessments and assumptions may be misguided or incorrect. To learn more about how to read the income statement click here.

The Balance Sheet

The balance sheet gives investors a snapshot of the company on a particular reporting date. The difference between a balance sheet and the income statement or statement of cash flows is the latter two are cumulative (usually for a period of 3 or 12 months) while the balance sheet shows the company’s position for that specific date.

When looking at the balance sheet there are a number of different ways to access the strength of the company you are looking at. The most common metric for investors to look at is current assets to current liabilities. This tells investors the company currently has enough money to pay its current liabilities. There are many other things investors can learn from the balance sheet, including how fast the company turns over its inventory and how fast they collect accounts receivable. To learn more about how to read the balance sheet click here.

Understanding the Notes Section of the Financial Statements

understanding financial statements notesThe financial statements are good on their own, but when you supplement the numbers with additional information in the notes section of a companies financial reports you can really get a clear picture of the business. The notes section tells the investor how the numbers were created, whate measurements were used and breaks down each category so you can see a more accurate picture of the business. The notes are located at the bottom of a companies 10k or 10q financial reports.

After doing some key metrics and comparing them against the industry its time to look at the notes to get a clear picture. Since financial statements are consolidated there are many things an investor will not understand about a business until the look at the notes. This might include things such as minrity interests in other businesses that have made up a significant portion of the businesses total revenue. In cases such as these it’s important to understand the business of the other company as well.

Buiness Valuation Using Financial Statements

A while back I made a post covering value investing. This post showed investors how to measure a business intrinsically. However, this post is applicable to many other situations especially when looking at financial statements. Click here to read the post I wrote on value investing.

understanding financial statements value investingSome very important notes about this post are how investors can use financial statements to predict the future success of a business. In this post I stressed the importance of fully understand a business before you make an investment including a company’s management. A value investor trys to buy businesses that he/she deems is undervalued by the market. What they are looking for is company’s that are really strong, but due to certain market factors do not have a favorable share price. Personally, I like to use a blend of value investing and speculation because I think its important to predict what will happen in the future, but I also believe it’s important to pick companies that do not have over inflated share prices based solely on hype. Investing in hype is how investors get burned. That’s why I have continually stressed that it is extremely important to truely understand the business you are investing in before buying their stock. This rule is especially true for penny stocks since the potential for return is so great, but (as with anything with great potential) there is also a real possibility of losing a significant amount of money as well. The more you understand about a particular company the better decisions you are going to make as an investor.

One area of value investing I believe is of extreme importance to investors is the businesses management team. Often at the early stages of a business the management team is just as crucial (if not more) then the product or service it is selling. A great management team will guide a company in the right direction and give it the best chance for success. At the penny stock stage of investment you have the advantage of investing in a business with some history. An angel investor solely has the management team and an idea to invest in. But when a company starts selling stock their is already a history for investors to measure the success and failures of a business. This is why it is so imporant as an investor to understand a company’s financial statements.

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