Financial Statements 101: Target the Insights, Skip the Confusion

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You’ll want to put down that novel or toss that magazine because there’s a much more exciting read—a company financial statement. Yes, of course we’re joking. Financial statements have never been thought of as edge-of-your-seat page-turners, but they can give you important insights to help make you a more informed investor.

In this article, we’ll help you interpret and understand statement basics—without the need for a
secret decoder ring.

Why you should care about company financial statements? The primary reason is that financial statements are the money trail and answer important questions such as: “Where did Company XYZ get, spend, or invest its money?” and “What is its financial picture right now?”

When you invest in a company’s stock (or the stocks of many companies in a mutual fund), you should do your homework to see if the company aligns with your investment strategy and goals. You can start to explore a company’s financial picture using three main statements: balance sheets, income statements and cash flow statements. Since many companies operate on a calendar year accounting schedule, many release their year-end financial statements in the first quarter of the year.

It’s a pretty intense topic, but this introduction to these statements provides you with a quick understanding of the basics. It also includes some good discussion points for a consultation with a financial professional.

Balance sheets

For a specific point in time, balance sheets tell you how much a company owns (its assets), and how much the business owes (its liabilities). What a company owns and owes needs to balance each other. Looking at assets is fairly straightforward. These can be obvious items such as cash, property and accounts receivable.

What is owed breaks down into liabilities and equity, and further broken down in each of those categories. How are liabilities defined? They are what the business owes to a third party, from a simple electric bill to the mortgage on the company headquarters. How is equity defined? In general, you can think of equity as ownership in any asset after all debts associated with that asset are paid off. For example, if the company locked its doors today, the equity is what is left after paying what is owed—and the equity would go to the business owners.

Make sure to read between the lines. A balance sheet can be very informative and worth a closer look. Even if Company XYZ has triple the amount in assets as it has in liabilities it isn’t an automatic, slam-dunk investment. If the assets are light on cash and big on accounts receivable, that could be a problem. You can’t pay your bills with receivables—you need cash.

Alternatively, if the company has a stockpile of cash that can be a good thing, but perhaps not for investors. You’ll need to know if the business plans to use the funds in ways that strengthen the company’s market position or if the company is just sitting on its profits. If a business isn’t making a distribution to its investors on a regular basis, you may want to choose a company where you’ll see a more definitive return on investment in a clear timeframe.

Income statements

For a specific time period, income statements tell you how much a company made and spent. An income statement illustrates how much it costs the business to earn its revenue, if the business is spending more than it is earning, and net earnings—or the bottom line.

While a balance sheet pinpoints an exact moment, an income statement (sometimes called a profit and loss statement) can cover a period of time ranging from three months to a year. You can see where the business is spending its money, and what lines of business or products are moneymakers—and which ones may be clunkers.

In a simple world, an income statement showing expenses that are higher than profits would seem perfectly straightforward. But it’s important to dive deeper and ask “why” to see what those numbers really mean:

• Look at past income statements to see if this is a new development or if the business has been in this loss pattern for a considerable length of time.
• Explore whether the expenses seem justified. Some businesses that are very successful now lost money for years due to high expenditures during their development stage.

Cash flow statements

For a specific time period, cash flow statements tell you how much actual cash went in and out of the company. Cash flow statements look at the cash the business made or spent on:

• Operations – Is the business income coming from sales?
• Investments – Does the business make money from investments?
• Financing – Is the cash flowing to the business coming from loans or other borrowed funds?

The cash flow statement looks at a business’s net income, subtracts amounts like money spent on inventory and accounts receivable, and adds back items that don’t have an impact on the company’s actual cash (e.g., depreciation expenses) but do get reflected in its bottom line. Why is the amount spent on inventory (an asset) subtracted? Because the cash has been spent. Likewise for accounts receivable—the company is owed the money but the business does not yet have it in hand.