Things you need to know about Financial Statements

Knowing how to work with the numbers in a company’s financial statements is an essential skill for 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.

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.
• 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

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.

2. Financial Statements to Use

The financial statements used in investment analysis are the balance sheet, the income statement, and the cash flow statement with additional analysis of a company’s shareholders’ equity and retained earnings. Although the income statement and the balance sheet typically receive the majority of the attention from investors and analysts, it’s important to include in your analysis the often-overlooked cash flow statement.

3. What’s Behind the Numbers?

The numbers in a company’s financial statements reflect the company’s business, products, services, and macro-fundamental events. These numbers and the financial ratios or indicators derived from them are easier to understand if you can visualize the underlying realities of the fundamentals driving the quantitative information. For example, before you start crunching numbers, it’s critical to develop an understanding of what the company does, its products and/or services, and the industry in which it operates.

4. Understanding Financial Jargon

The lack of any appreciable standardization of financial reporting terminology complicates the understanding of many financial statement account entries. This circumstance 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.

5. Accounting: Art, Not Science

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 circumstances, 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. 

6. 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

7. Notes to Financial Statements

The financial statement numbers don’t provide all of the disclosure required by regulatory authorities. Analysts and investors alike universally 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 thorough review of the noted comments in your investment analysis.