How to Read Financial Statements

Understanding how to read financial statements is key to fundamental stock analysis and overall investment research. Financial statements provide an account of a company’s past performance, a picture of its current financial strength and a glimpse into the potential of a firm.

Financial statements empower the individual investor to effectively evaluate a company’s financial strength and weed out certain securities that are waning over a certain period of time.

In this introductory article, we cover why learning how to read financial statements is crucial for an investor. Additionally, we delve into the three financial statements you need to be aware of, major components of each report and why they matter in security analysis.

What Is a Financial Statement?

The role of financial statements and reporting for companies is to provide information about their fiscal health and financial performance. As investors, we use financial statements and reports to evaluate the past, current and prospective performance of a company. These types of financial overviews allow us to compare one firm to another and form the basis for valuing the worth of a stock. A great way to start, or end, your fundamental research before investing in a company is to thoroughly examine its public financial filings and accounting statements.

Financial statements can help potential investors and current shareholders understand a business’ profitability in the past, present and future, as well as how generated revenue is being used in different areas of the company. As an individual investor, it is your responsibility to look over a company’s financial statements before you decide whether to invest or not. When comparing companies, always make sure you’re comparing “apples to apples” when looking at their financial reports. This is important because accounting statements and practices used to compile these official documents may vary by industry.

Three Financial Statements You Need to Know

As an individual investor, you should be versed in what these three financial statements entail. Companies produce financial statements quarterly for potential investors, regulatory agencies, banks other corporations and shareholders to view. The most important three financial statements, and the ones used most often by investors, are the:

• Income statement: reports how much revenue the company generated during a period of time, the expenses it incurred and the resulting profits or losses.
• Balance sheet: provides a picture of the firm’s assets, debts and net worth at a specific point in time.
• Cash flow statement: tabulates how much cash is coming in and going out of the firm; cash is entirely different from profits or revenue.

Data found in all three financial statements is used to calculate key ratios and metrics that provide insight on the company’s financial status as well as past, present and future performance. Additionally, the three financial statements provide investors insight on potential issues that may need to be addressed within the company. The income statement, balance sheet and cash flow statement all have their own unique details with information that is interconnected, meaning an investor or shareholder should use all three financial statements during their financial overview and analysis.

How to Read Financial Statements

If you’re just starting out your fundamental analysis, you will want to learn how to read financial statements so you can do your own research before investing. But how do you know where to start? These three reports are important for understanding a company’s financial status from multiple angles. By reading financial statements, you can find out how much money the company currently has as well as how much debt it owes or how long it takes for it to pay off those liabilities (and also how it uses the capital raised from a debt offering). With these three financial statements, you can also find out how much income the company makes over a certain time period as well as how much it spends on operations, inventory and other important financial activities.

All three financial statements are linked with one another. Therefore, it is vital to look at all of them for a financial overview when establishing the health of a company. Reading financial statements before you invest can poke holes in a company’s data. For example, a firm could sell its entire inventory on account and never bother to collect the cash. The income statement may look healthy as sales are being made and revenues and expenses are recognized. However, the balance sheet will provide a hint of trouble as the company’s accounts receivable continue to climb. Lastly, this type of outstanding problem can be verified by looking at the cash flow statement, which would show continued outflows of cash from operating activities as cash is spent on raw materials and manufacturing, yet no cash is collected from sales on account. This is one example of how to use these three financial statements together to get the big picture and decide if the company is on solid ground as an investment.

For more resources on how to read a financial statement, you can visit the EDGAR database, which is the official portal for the public to access corporate reports and other financial statements filed with the U.S. Securities and Exchange Commission (SEC). It also provides tools, resources and introductory material on how to read a financial report for beginners.

Why Read Footnotes on Financial Statements?

If you’re new to reading financial statements, you may be wondering what the purpose of footnotes are to these public reports. Footnotes on financial statements provide investors with additional information that can often explain how a company calculated its financial statement figures and any irregularities it may have reported.

As we mentioned above, it’s important to understand how certain accounting statements and practices are completed because industries may include or omit specific data. Therefore, footnotes on financial statements include disclosures, accounting practices as well as upcoming, pending transactions that may affect future profitability. Footnotes on financial statements also provide a space for complex definitions or additional calculations, to keep the official financial statements from becoming cluttered or unreadable.

The Interpretation of Financial Statements

The interpretation of financial statements is a basic step that all investors should be versed in. By providing data through a variety of financial statements and reports, companies provide investors, lenders and shareholders with more power in their decision-making. All three financial statements are public records at your disposal, which allows all investors to complete their due diligence before investing.

Financial statements are important to investors because they provide information and data about a company’s revenue, expenses, profitability, debt load and the ability to meet its short-term and long-term financial obligations.

Warren Buffett, the financial tycoon and investment strategist, fully believes that the interpretation of financial statements is one of the best evaluations you could do before you start investing. He believes that by looking at 10 years of financial statements before investing in a company, you can weed out businesses that could potentially have underlying financial status and health issues. He also believes that analyzing the income statement, balance sheet and cash flow statement together is much more effective than reading only a shareholders’ annual report, which can easily hide important information.

He points out that this is a solid strategy for both introductory and seasoned investors because the data is free and public for investors to take advantage of. The analysis of financial statements allows investors to find inconsistencies over a certain period of time in order to effectively weed out companies that aim to hide information from both shareholders and investors.

How to Find a Company’s Financial Statements

If you’re wondering how to find a company’s financial statements, you’ll be relieved to know that all official reports are filed for free public use. In many cases, you can find a company’s financial reports and other statements located on its corporate website in the investor relations area. The SEC has financial statements and reports available on its website, dating back to 1993.

Because U.S. publicly traded companies are just that, public, they are required to file regular financial statements and disclosures with regulators such as the SEC.

Additionally, as we mentioned above, you can visit the EDGAR database to search a specific company for free access to its financial statements for analysis. The SEC’s EDGAR database is a robust area with a wealth of information. Simply click on “Search for Company Filings.” You can search for financial statements by name, ticker, state or SIC code—a four-digit industry code used by the SEC.

In the latest filings section, EDGAR lists the most recent finance reports that have been received. The website also allows you to search the full text of EDGAR filings and attachments for previous years.

Additionally, each company that files its financial statements with the SEC has a unique identifier assigned to it. Once you look up the identifier using the company search, you can use it to quickly locate specific forms.

Now that you know how to find a company’s financial statements, you can conduct your own research before investing no matter the stock.

Using Financial Overviews and Statements to Invest

Knowing how to read financial statements and analyze them is key to becoming a well-informed individual investor. Just like reading reviews and background information about a product before you purchase, you need to be conducting your own research and reading financial statements before purchasing a stock.

With these three financial statements, you can compare the current reporting period with previous ones to rule out inconsistencies and understand a company’s current assets, how it pays off and manages its debts and so much more. Financial overviews like the balance sheet, income statement and cash flow statement allow investors to regain power against large banks and hedge funds. Lastly, the interpretation of financial statements is helpful to calculate key metrics, ratios and trends to identify potential problems that may not be obvious on the annual report or just one of the financial statements.

If you’re ready to start your analysis of financial statements and invest with confidence, you should have the right tools and resources at your disposal! A+ Investor gives you an entire suite of screening tools to ease into investing at your own pace. At AAII, we aim to help investors take control of their financial destiny with helpful educational resources. If you’d like to learn more about AAII’s extensive selection of educational tools and resources, subscribe to A+ Investor today and get access to countless tools, screens and grades you can use to build a personalized portfolio.