How to Analyze Financial Statements for Beginners

One essential step in being able to understand a company’s profitability is being able to understand and analyze the financial statements that they publicate. Specifically, these documents are able to provide a snapshot of a company’s financial health and recent performance in order to educate potential investors on whether or not the company is worth investing in. In this section, we will break down the key elements of financial statements and how they should mold your investment portfolio now and in the future. 

What Are Financial Statements?

Financial statements are formal records of the financial activities of a business, organization, or individual. They provide a summary of the financial position and performance over a specific period. The three main types of financial statements are:

• Balance Sheet: This shows what a company owns (assets) and owes (liabilities) at a specific point in time.

• Income Statement: Also known as the profit and loss statement, it summarizes revenues and expenses over a period, showing how much profit or loss the company made.

• Cash Flow Statement: This details the inflow and outflow of cash, highlighting how well a company manages its expenses to fund current ventures and expand their profits in the future. 

Understanding these statements is the first step in analyzing a company's financial health.

The Balance Sheet

The balance sheet provides a snapshot of a company's financial position at a specific moment. It is divided into three main sections: assets, liabilities, and equity.

Assets

Assets are everything a company owns that has value. They are typically classified into two categories:

• Current Assets: These are assets that can be converted into cash within a year, such as cash, accounts receivable, and inventory. Some may even describe these assets as "liquid" because they are easily convertible to cash. 

• Non-Current Assets: These are long-term investments that cannot be easily converted into cash, such as property, equipment, and assets that don't physically exist such as patents that prevent other companies from stealing ideas from the originator.

Liabilities

Liabilities are what a company owes to others. Like assets, they are also divided into two categories:

• Current Liabilities: These are obligations due within a year, such as goods or services payed through credit and short-term loans.

• Long-Term Liabilities: These are debts that are due beyond one year, such as bonds payable (debts issued by a company to investors that must be repaid in the future) and long-term loans.

Equity

Equity represents the owner's claim on the assets after all liabilities have been deducted. It includes common stock, retained earnings, and additional paid-in capital. (In short: assets of a company after their liabilities are payed off)

Analyzing the Balance Sheet

To analyze a balance sheet, consider the following ratios:

• Current Ratio: This measures a company's ability to pay short-term obligations. It is calculated by dividing current assets by current liabilities.

• Debt-to-Equity Ratio: This indicates the proportion of debt to equity in financing the company's assets. It is calculated by dividing total liabilities by total equity.

  These ratios help assess the company's liquidity and financial leverage.

  In a nutshell: Balance Sheets are important in order to understand if a company is able to pay off all of their expenses reasonably; also, they show if a company can expand with their remaining assets after they are able to securely pay-off their liabilities with current assets if need be.

  
  

  The Income Statement

  The income statement provides a summary of revenues and expenses over a specific period, usually a quarter or a year. It shows how much profit or loss a company made during that time.

  Key Components

  • Revenue: This is the total income generated from sales of goods or services.

  • Cost of Goods Sold (COGS): This represents the direct costs of the product that the company sells. 

  • Gross Profit: This is calculated by subtracting COGS from revenue.

  • Operating Expenses: These are the costs required to run the business, excluding COGS. They include selling, general, and administrative expenses.

  • Net Income: This is the profit after all expenses, taxes, and costs have been deducted from total revenue.

  
  

  Analyzing the Income Statement

  Key metrics to analyze include:

  • Gross Margin: This is calculated by dividing gross profit by revenue. It shows how efficiently a company produces its goods.

  • Operating Margin: This is calculated by dividing operating income by revenue. It indicates how well a company controls its operating costs.

  • Net Profit Margin: This is calculated by dividing net income by revenue. It shows how much profit a company makes for every dollar of revenue.

  These metrics provide insight into a company's profitability and operational efficiency.

  In short: The income statement is essential for investors to know because it shows if a company is cuurently, which is when the business makes more money than they spend. So, by understanding how net income, expenses, and revenue relate, you are able to analyze whether the company is producing a surplus (making more than they spend) or whether they produce a deficit (spend more than they make)

  
  

  The Cash Flow Statement

  The cash flow statement tracks the flow of cash in and out of a business. It is divided into three sections:

  • Operating Activities: This section reports cash generated or used in the core business operations.

  • Investing Activities: This section shows cash used for investments in long-term assets, such as property and equipment.

  • Financing Activities: This section reports cash flows related to borrowing and repaying debt, as well as equity transactions.

  Analyzing the Cash Flow Statement

  Key aspects to consider include:

  • Cash Flow from Operations: Positive cash flow from operations indicates that a company can generate enough cash to sustain its operations.

  • Free Cash Flow: This is calculated by subtracting capital expenditures from cash flow from operations. It shows how much cash is available for expansion, dividends, or debt repayment.

  • Cash Flow Trends: Analyzing cash flow trends over time can provide insights into a company's financial stability and growth potential.

  
  

  Putting It All Together

  When analyzing financial statements, it is essential to look at them collectively rather than in isolation. Here are some steps to follow:

  1. Review the Balance Sheet: Start by assessing the company's assets, liabilities, and equity. Look for trends in the current ratio and debt-to-equity ratio.

  2. Examine the Income Statement: Analyze revenue, expenses, and profit margins. Look for consistent growth in revenue and manageable expense levels.

  3. Evaluate the Cash Flow Statement: Check for positive cash flow from operations and healthy free cash flow. This indicates that the company can fund its operations and growth.

  4. Compare with Industry Peers: Benchmark the company's financial ratios against industry averages to gauge its performance relative to competitors.

  5. Look for Trends Over Time: Analyze financial statements over multiple periods to identify trends in performance, growth, and stability.

  
  

  Common Mistakes to Avoid

  When analyzing financial statements, beginners often make several common mistakes:

  • Focusing on One Statement: Relying solely on one financial statement can lead to an incomplete understanding of a company's financial health.

  • Ignoring Context: Financial performance should be evaluated in the context of industry trends, economic conditions, and company-specific factors.

  • Neglecting Footnotes: Footnotes in financial statements provide essential details and explanations that can impact the interpretation of the numbers.

  Overlooking Non-Financial Factors: Factors such as management quality, whether there is a market for the product or service, and whether the market is too competitive to realistically thrive in.

  How to access a company's financial statement: 

  • Most publicly listed companies/stocks have an Investor Relations page if you go on their website. 

  • If you are having difficulties finding it, take a look at these websites: 

  • Yahoo Finance: https://finance.yahoo.com

  • Google Finance: https://www.google.com/finance

  • Morningstar, Bloomberg, MarketWatch, NASDAQ, or Reuters

  
  

  Conclusion

  Analyzing financial statements is a valuable skill for anyone interested in finance, investing, or business management. By understanding the balance sheet, income statement, and cash flow statement, you can gain insights into a company's financial health and make informed decisions.

  Remember to look at the statements collectively, compare and contrast with companies in a similar line of industry, and avoid common pitfalls. With practice, you will become more confident in your ability to analyze financial statements and understand what they reveal about a company's performance.

  Take the next step in your financial education by reviewing a company's financial statements today. The more you practice, the better you will become at spotting trends and making informed decisions.