How to Read Financial Statements

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Companies whose stock is publicly traded issue an annual report consisting of three sections: the letter to shareholders; the business review; and the financial statements.

Each section contains information that is important to investors for deciding on making an investment in the company’s stock. Understanding how to read the audited financial statements is essential for an investor to get the information needed to make a sound investment decision. The financial statements include a balance sheet, an income statement, a statement of changes in stockholders equity and a statement of cash flows.

Audited Financial Statements

When financial statements are audited an independent auditor issues an opinion as of the reliability of the financial statements. That opinion discloses weather or not financial statements are fairly stated in accordance with generally accepted accounting standards. The opinion lets investors know if the financial statements can be relied upon to make sound investment decisions. If there is a qualified opinion, adverse opinion or a disclaimer of opinion then there are problems with the financial statements that investors need to consider.

Balance Sheet

The balance sheet is a snap shot of the company’s financial position at a certain point in time. It shows what the company owns and what the company owes at the date of the report. The balance sheet is divided into two halves, assets and liabilities on one half and stockholders equity on the other. The basic formula for the balance sheet is assets = liabilities + stockholders equity. The two halves are always in balance which is why it is called a balance sheet. From an economic point of view each dollar of assets must be funded by a dollar of liabilities or equity. Each section of the balance sheet has a group of similar accounts with a dollar amount or balance. Analysts compare ratios of different balances to determine if a company will be able to satisfy its obligations when the time comes.

Income Statement

The income statement shows how a company performed during the period presented and shows whether the company had a profit or a loss. An income statement matches the revenues earned against all the costs and outlays incurred to operate the company. An analyst will determine the company’s operating margin, that is, the net sales minus operating expenses and then compare that figure with prior years and also compare that to other companies in the industry. Another key ratio examined is the earnings per share which tells investors how much a share value increased or decreased for the period.

Statement of Changes in Shareholders Equity

The statement of changes in shareholders equity reconciles changes in ownership of the company from one period to another. Changes occur because of profits and losses, stock dividends and/or stock issuances. Profits and losses will add or reduce retained earnings. Stock dividends will increase the number of shares outstanding and since they are given out as a dividend the overall value per share will change. Stock issuances raise capital for the company and change the number of shares outstanding.

Statement of Cash Flows

The statement of cash flows reports on the company’s sources and uses of cash during the period, separating them by operating, investing and financing activities. Cash flow analysis is important to investing decisions because it is an indication of the company’s ability to continue operating during a period of losses.

Footnotes

The footnotes are an integral part of the financial statements. They provide a more detailed narrative explanation of the numbers and often disclose very important information that can not be derived from the numbers alone.

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