INVESTING

Interview Your Investments: What Are Financial Statements?

From starting your investing journey with your first purchases to considering a new addition to your existing portfolio, determining the value and risk of a new investment may seem complicated. However, there are multiple ways to conduct research about a company, providing an extra layer of confidence in your decisions. One of these methods is reviewing a company’s financial statements.

Public companies are required to file regular reports with the Securities and Exchange Commission (SEC) regarding their financial situation and management discussions. These statements are prepared by accountants adhering to specific rules, such as the Generally Accepted Accounting Principles (GAAP) for U.S. companies, and can be found through a variety of sources, including SEC’s EDGAR database, the company’s website, brokerage firms, and other financial platforms or trade journals.

Throughout these documents, there is numerical data available regarding a company’s financial situation. By reviewing this information, you can effectively gauge the strength and risk of a company, and you may gain insight into whether its stock value is currently overvalued or undervalued. From there, you may decide if the potential investment is best for you and your financial goals.

Let’s review the three main documents comprising a company’s financial statements.

Balance Sheet

A balance sheet breaks down a company’s assets, liabilities and shareholders’ equity. Assets include everything of value that a company owns, covering both tangible assets like inventory and intangible assets like intellectual property. Liabilities refer to everything a company owes, whether to other people, other companies or debt obligations. Shareholders’ equity refers to the value left over after subtracting total liabilities from total assets. In some instances, shareholders’ equity may be referred to as a Statement of Shareholders’ Equity, but it is typically listed as a section within a company’s balance sheet rather than a separate document.

Through reading a company’s balance sheet, you may assess its stability and liquidity. Holding more assets than liabilities may indicate that a company effectively balances its value and obligations, making it more tolerant of any potential risk. On the other hand, holding more liabilities than assets may indicate that a company is not effectively managing its finances, making it more susceptible to financial decline.

Income Statement

An income statement covers a company’s revenue, expenses and profits. Revenue includes all the money a company receives from selling goods and services, as well as gains from other assets and investments. Meanwhile, expenses include all the costs a company pays to produce its goods and services, as well as losses from other assets and investments. Profit is the value left over after subtracting total expenses from revenue. In some instances, companies may also provide comprehensive income information, either as a footnote on the income statement or a separate document. Comprehensive income develops a broader picture of a company’s financial performance by taking income adjustments and unrealized profits into consideration alongside traditional income sources listed on the income statement.

Through reading a company’s income statement, you may assess its profitability and efficiency. Revenue that outweighs expenses may indicate a company manages its operating costs efficiently, ensuring there is positive income remaining for continued performance and growth. On the other hand, expenses that outweigh revenue may indicate poor management of business costs or overextended reach in business operations. This, in turn, may predict future challenges, as overspending may not be sustainable in the long-term.

Cash Flow Statement

A cash flow statement reveals how money moves in and out of a company within a certain timeframe. It is typically comprised of three main categories: cash from operations, cash from investing and cash from financing. Cash from operations includes all funds earned and spent within the company’s main business operations. Cash from investing includes all funds gained or lost from expanding the company’s long-term investments, including current assets, loan collections and business acquisitions. Lastly, cash from financing refers to all funds made or paid from stocks, dividends and debt repayment.

Through reading a cash flow statement, you may assess a company’s security and growth potential. Incoming cashflow may signal the efficiency with which a company can generate cash, while outgoing cashflow may signal a company’s ability to make its necessary payments and invest in further company growth. Furthermore, a cash flow statement is typically regarded as especially crucial among a company’s financial statements, as it may be difficult for company accountants to inflate or manipulate the reporting of actual cash within a business.

Limitations

While financial statements may provide important insights into the health and performance of a company, it can be helpful to remember there are limitations to these documents. When reviewing, the available data is entirely based on previous performance, whether from recent years or the most recent financial quarter. This data can help predict the future success of a company, but it cannot guarantee it. Additionally, the numerical data listed on financial statements does not account for inflation.

Financial statements also lack comprehensive information on non-financial factors. These documents cannot represent considerations such as brand reputation, stockholder and employee morale, and competitive advantages within the industry. Therefore, while conducting research before making investments, it can be helpful to review other overall trends and social influences alongside a company’s financial statements.

Sources:

https://www.investopedia.com/terms/f/financial-statements.asp

(https://www.investopedia.com/terms/i/incomestatement.asp

https://www.investopedia.com/investing/what-is-a-cash-flow-statement/

https://www.investopedia.com/terms/f/fundamentalanalysis.asp