Successful investing has no secret formula. A good strategy and a basic understanding of the rules of the game are required to do well in the long run. Since financial statements are basic tools of fundamental analysis, it is important to be able to read and analyze them.
Financial statements provide the means to measure the performance of the company and its management. These statements allow investors to compare one company's performance to other companies and industry norms. Items reported in the financial statements, such as sales, earnings, and cash flow, help value and growth investors gauge the worth of the stock price.
The amount of emphasis you place on various parts of financial statement analysis depends upon your viewpoint. A credit analyst extending a short-term, unsecured loan to a company might emphasize the firm's cash flow and liquidity. An investor with a growth strategy looking at stock may look closely at items that impact a firm's ability to produce future earnings. A value investor examining a distressed company may also concern himself with the financial structure of a firm to identify whether it has the resources to work its way through a difficult period. When working with financial statements, you must keep in mind that they are historical records and public information. Spending a great deal of time scrutinizing financial statements with the hope of finding hidden assets is generally not a productive use of spare time.
There are three primary financial statements—the balance sheet, the income statement, and the cash flow statement. The balance sheet indicates the current financial position of the firm. The income statement summarizes the sales and profit performance over a period of time, while the cash flow statement details the use and generation of cash over a period of time.
Annual and quarterly reports remain the best, most readily available sources of financial statements. Companies produce formal reports for two main groups—shareholders and the Securities and Exchange Commission (SEC). Although the reports sent to shareholders are similar to those filed with the SEC—the annual report is similar to the Form 10-K filed with the SEC, and the quarterly shareholder report is similar to Form 10-Q—there are some differences.
Under the Securities Exchange Act of 1934, public companies are required to file with the SEC a number of very informative reports, including 10-Qs and 10-Ks. The SEC specifies the contents of each report and the frequency with which each report must be filed. In contrast to the slick reports produced for shareholders, the SEC reports may seem very drab. However, the financial statements presented for both the shareholder reports and SEC reports will be the same. For example, the annual report must include audited financial statements (balance sheets for the two most recent fiscal years, and income and cash flow statements for the three most recent years), selected quarterly data for the two most recent years, and a summary of selected financial data for the five most recent years. Most professionals choose to read the SEC-filed reports, because they are typically more detailed in describing the company's line of business and competitive environment, and they present data in an order mandated by the SEC.
You can request copies of a firm's 10-K and 10-Q filings directly from the company, but now that companies are required to file the forms electronically, they can also be retrieved from the SEC Web site at www.sec.gov. Companies must file their quarterly 10-Q reports within 45 days of completing a quarter and within 90 days after their fiscal year end. A firm's fiscal year may or may not correspond to the calendar year. Companies also typically release their quarterly performance figures to the public prior to filing their statements with the SEC. Normally these announcements come about a month after completing a quarter, and publications such as the Wall Street Journal provide an Earnings Digest section to summarize these announcements.
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