12 Things You Need to Know About Financial Statements (2024)

Knowing how to work with the numbers in a company's financial statements is an essential skill for stock investors. The meaningful interpretation and analysis of balance sheets, income statements, and cash flow statements to discern a company's investment qualities is the basis for smart investment choices.

However, the diversity of financial reporting requires that we first become familiar with certain financial statement characteristics before focusing on individual corporate financials. In this article, we'll show you what the financial statements have to offer and how to use them to your advantage.

Key Takeaways

  • Understanding how to read a company's financial statements is a key skill for any investor wanting to make smart investment choices.
  • There are four sections to a company's financial statements: the balance sheet, the income statement, the cash flow statement, and the explanatory notes.
  • Prudent investors might also want to review a company's 10-K, which is the detailed financial report the company files with the U.S. Securities and Exchange Commission (SEC).
  • An investor should also review non-financial information that could impact a company's return, such as the state of the economy, the quality of the company's management, and the company's competitors.

1. Financial Statement = Scorecard

There are millions of individual investors worldwide, and while a large percentage of these investors have chosen mutual funds as the vehicle of choice for their investing activities, many others are also investing directly in stocks. Prudent investing practices dictate that we seek out quality companies with strong balance sheets, solid earnings, and positive cash flows.

Whether you're a do-it-yourself investor or rely on guidance from an investment professional, learning certain fundamental financial statement analysis skills can be very useful. Almost 30 years ago, businessman Robert Follett wrote a book entitled How To Keep Score In Business. His principal point was that in business you keep score with dollars, and the scorecard is a financial statement. He recognized that "a lot of people don't understand keeping score in business. They get mixed up about profits, assets, cash flow, and return on investment."

The same thing could be said today about a large portion of the investing public, especially when it comes to identifying investment values in financial statements. But don't let this intimidate you; it can be done.

2. Financial Statements to Use

The financial statements used in investment analysisare the balance sheet, the income statement, and the cash flow statement with additional analysis of a company'sshareholders' equity and retained earnings. Althoughthe income statement and the balance sheet typicallyreceive the majority of the attention from investorsand analysts, it's important to include in your analysis the often overlookedcash flow statement.

3. What's Behind the Numbers?

The numbers in a company's financial statementsreflect the company's business,products, services, andmacro-fundamentalevents. These numbers and the financial ratios orindicators derived from themare easier to understand if you can visualize the underlying realities of the fundamentals driving thequantitative information. For example, before you start crunching numbers, it's criticaltodevelopan understanding of what the company does, its products and/or services, and the industry in which it operates.

4. Diversity of Reporting

Don't expect financial statements to fit into a single mold. Many articles and books on financial statement analysis take a one-size-fits-all approach. Less-experienced investors might get lost when theyencountera presentation of accounts that falls outside the mainstream of a so-called "typical" company. Please remember that the diverse nature of business activities results in a diverse setof financial statement presentations. This is particularly true of the balance sheet; the income statement and cash flow statementare less susceptible to this phenomenon.

5. Understanding Financial Jargon

The lack of any appreciable standardization of financial reporting terminology complicates the understanding of many financial statement account entries. This circ*mstance can be confusing for the beginning investor. There's little hope that things will change on this issue in the foreseeable future, but a good financial dictionary can help considerably.

Investopedia's Glossary of Terms provides you with thousands of definitions and detailed explanations to help you understand terms related to finance, investing, and economics.

6. Accounting: Art, NotScience

The presentation of a company's financial position, as portrayed in its financial statements, is influenced by management's estimates and judgments. In the best of circ*mstances, management is scrupulously honest and candid, while the outside auditors are demanding, strict, and uncompromising. Whatever the case, the imprecision that can be inherently found in the accounting process means that the prudent investor should take an inquiring and skeptical approach toward financial statement analysis.

7. Key Accounting Conventions

Generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS)are used to prepare financial statements. Both methods are legal in the United States, although GAAPis most commonly used. The main difference between the two methods is that GAAPis more "rules-based," while IFRS is more"principles-based." Both have different ways of reporting asset values, depreciation, and inventory, to name a few.

8. Non-Financial Information

Information on the state of the economy, the industry,competitive considerations, market forces, technological change, the quality of management and the workforce are not directly reflected in a company's financial statements. Investors need to recognize that financial statement insights are but one piece, albeit an important one, of the larger investment puzzle.

9. Financial Ratios and Indicators

The absolute numbers in financial statements are of little value for investment analysis unless these numbers are transformed into meaningful relationships to judge a company's financial performance and gauge its financial health. The resulting ratios and indicators must be viewedover extended periods to spottrends. Pleasebeware that evaluative financial metrics can differ significantly by industry, company size,and stage of development.

10. Notes to Financial Statements

The financial statement numbers don'tprovide all of the disclosure required by regulatory authorities. Analysts and investorsalikeuniversally agree that a thorough understanding of the notes to financial statements is essential to properly evaluate a company's financial condition and performance. As noted by auditors on financial statements "the accompanying notes are an integral part of these financial statements." Please include a thoroughreview of thenoted comments in your investment analysis.

11. The Annual Report/10-K

Prudent investors should only consider investing in companies with audited financial statements, which are a requirement for all publicly-traded companies. Perhaps even before digging into a company's financials, an investor should look at the company's annual reportandthe 10-K. Much of the annual report is based on the 10-K, but contains less information and is presented in a marketable document intended for an audience of shareholders. The 10-K is reported directly to the U.S. Securities andExchange CommissionorSEC and tends to contain more details than other reports.

Includedin the annual report is theauditor's report,which gives an auditor's opinion on how the accounting principles have been applied.A "clean opinion" provides you with a green light to proceed. Qualifying remarks may be benign or serious; in the case of the latter, you may not want to proceed.

12. Consolidated Statements

Typically, the word "consolidated" appears in the title of a financial statement, as in a consolidated balance sheet. A consolidation of a parent company and its majority-owned (more than 50% ownership or "effective control") subsidiaries means that the combined activities of separate legal entities are expressed as one economic unit. The presumption is thatconsolidation as one entity is more meaningful than separate statements for different entities.

Why are Financial Statements Important?

Financial statements provide investors with information about a company's financial position, helping to ensure corporate transparency and accountability. Understanding how to interpret key financial reports, such as a balance sheet and cash flow statement, helps investors assess a company’s financial health before making an investment. Investors can also use information disclosed in the financial statements to calculate ratios for making comparisons against previous periods and competitors.

What Key Financial Statements Should I Understand When Analyzing a Company?

Investors should start by learning how to interpret key figures on a company's balance sheet, income statement, and statement of cash flows. Those wanting to dig a little deeper may want to consider learning how to analyze reports, such as shareholder’s equity and retained earnings. Investors can find a publicly traded company’s financial statements in its annual report or a 10-K filed with the SEC.

What’s the Difference Between GAAP and IFRS Accounting Conventions?

GAAP sets accounting guidelines and standards that companies must follow when preparing financial statements, whereas IFRS takes a more principles-based approach. Both conventions differ in how they report asset values, depreciation, and inventory. GAAP typically requires more disclosures than IFRS, with the latter providing much less overall detail. Both accounting methods are legal in the United States.

What are Some Key Limitations of Using Financial Statements?

Financial statements only provide a snapshot of a company's financial situation at a specific point in time. They also don't consider non-financial information, such as the health of the broader economy, and other factors, such as income inequality or environmental sustainability. Forward-looking financial statements rely on estimates and assumptions, which may not always be accurate and are subject to change.

The Bottom Line

Understanding the basics of financial statements provides investors with valuable information about a company's financial health. Investors can use key reports, such as a balance sheet, cash flow statement, and income statement, to evaluate a company's performance, helping to make more informed investment decisions. However, it’s also important to understand the limitations of overly relying on financial statements and consider other metrics, such as the impact of non-financial information, when analyzing a company's overall financial position. Financial statements play a vital role in maintaining the integrity of the financial system and promoting trust between companies and investors.

As an enthusiast with extensive expertise in financial analysis and investment, I want to delve into the concepts highlighted in the article about working with a company's financial statements. My hands-on experience and in-depth knowledge in this field allow me to provide valuable insights into the key aspects discussed.

  1. Importance of Financial Statements:

    • The article rightly emphasizes the significance of understanding financial statements for stock investors. I couldn't agree more. It's indeed an essential skill for making informed investment choices.
  2. Sections of Financial Statements:

    • The four main sections of financial statements – balance sheet, income statement, cash flow statement, and explanatory notes – are crucial for a comprehensive analysis. These sections offer a holistic view of a company's financial health.
  3. Robert Follett's Perspective:

    • Referring to Robert Follett's book, "How To Keep Score In Business," reinforces the idea that financial statements are the scorecards of business. Recognizing the mix-up about profits, assets, cash flow, and return on investment is fundamental.
  4. Financial Statements in Investment Analysis:

    • The emphasis on the balance sheet, income statement, and cash flow statement, along with additional analysis of shareholders' equity and retained earnings, aligns with the thorough approach needed for investment analysis.
  5. Understanding the Numbers:

    • The article rightly points out that the numbers in financial statements reflect not just figures but the company's business, products, services, and macro-fundamental events. Visualizing the underlying realities is crucial for meaningful analysis.
  6. Diversity of Reporting:

    • Acknowledging that financial statements may not fit into a single mold due to the diverse nature of business activities is an important reminder. It emphasizes the need for flexibility in analysis.
  7. Accounting Principles:

    • The mention of Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) highlights the legal methods used for financial statement preparation. Understanding the differences between these standards is vital.
  8. Non-Financial Information:

    • Recognizing that financial statements don't capture non-financial information affecting a company's performance is crucial. Investors need to look beyond the numbers to factors like the state of the economy, industry trends, and management quality.
  9. Financial Ratios and Indicators:

    • The article emphasizes that absolute numbers are of little value without transforming them into meaningful ratios. Evaluating financial metrics over extended periods helps in spotting trends and making informed decisions.
  10. Notes to Financial Statements:

    • Stressing the importance of thoroughly reviewing the notes to financial statements is crucial. This section provides essential disclosure required by regulatory authorities and enhances the understanding of a company's financial condition.
  11. The Annual Report/10-K:

    • The recommendation to consider audited financial statements and delve into the 10-K before making investment decisions aligns with best practices. It underscores the importance of transparency and detailed reporting.
  12. Consolidated Statements:

    • Explaining the significance of "consolidated" in financial statements highlights the importance of viewing a company as one economic unit, especially when dealing with majority-owned subsidiaries.

In conclusion, a nuanced understanding of financial statements is essential for investors. It's not just about numbers but about interpreting the underlying realities and considering a holistic approach to investment analysis. The article provides a comprehensive guide for anyone looking to navigate the complex landscape of financial statements and make well-informed investment decisions.

12 Things You Need to Know About Financial Statements (2024)

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