How to Read Financial Statements

Financial Statements - How to read them

Financial statements, essentially, describe the profitability and value of any business. A standard set of financial statements comprises of four components. While it is important to understand the similarities between these, it is also important to know the difference.

Knowing what these statements represent and why they should be considered together could be valuable to you now and in the future. It is important to know how to read financial statements.

1. Balance Sheet

This can be described as the critical “what does the company have” financial statement. The balance sheet shows what the company owns and what it owes. Any remaining difference between these two amounts shows what belongs to the owners as their interest. This document is a permanent statement—its numbers present an aggregate of the company’s financial history from the day the company began up to the present. When reading a balance sheet, you can find key information in the working capital, fixed assets and owners’ (shareholders’) equity etc.

2. Income Statement

Also known as the Profit and Loss financial statement, this is the “what did the company do” statement. This document shows how the company performed during its course of operations during a fixed period of time. Unlike the balance sheet, the income statement is a temporary statement. It accumulates information over a set period (usually monthly or quarterly) at the end of which its numbers are reset to zero in order to start tracking activity of the next period. Key elements of the income statement include revenue and expenses. Together, these numbers yield the net income (or loss).

3. Retained Earnings Statement

The statement of retained earnings shows the changes in retained earnings over the course of the tracking period. The retained earnings statement is important since it is a measure of the assets of the company’s operations that have been generated through profitable activity, retained by the business and have not paid out to shareholders as dividends. Stakeholders (such as investors or potential investors) in the company will be interested in reading this statement to better understand how their (potential) dividends are compare to the reported profits of the company. Generally, a large amount of retained earnings is regarded as a sign that the company has done well and is reinvesting its profits in itself. However, it is important to keep in mind that a young company often faces reporting negative retained earnings as it takes time to build the business and become profitable.

4. Cash Flow Statement

This statement shows the details about the cash that moved through the business during the tracking period—how it came in, and how it left. Money can come into the company through channels such as operating income, sale of assets or equity or by borrowing funds. And it can leave, for example, through operating losses, purchase of assets, or paying off of loans or interest. The statement of cash flow does not contain new information in the financial statement—it is derived from what is provided on the balance sheet and income statement. This statement of cash flow informs investors and creditors about the solvency of the business.

When reading and comparing financial statements, you need to consider both the difference in the balance sheet and P&L. Also, understand the industry the companies are in. For example, you read a strong balance sheet, with numerous "hard" assets (land, buildings, equipment) and then read another with modest hard assets, but many "soft" assets (accounts and loans receivable). You could quickly and erroneously assume that one company is better than another. You may also compare two P&L statements where one company shows a profit margin of 18 percent while another indicates net income of only 5 percent. But, suppose the second P&L is that of a supermarket, where 2 percent net profit is acceptable, but the first is in an industry where 22 percent is the norm. Carefully consider statements as they compare to other similar companies and industry standards.

One should not just look at a company's balance sheet without looking at the P&L. Because of the difference in the two statements, they should be analyzed together. A strong P&L combined with a weak balance sheet might indicate short-term success, but potential long-term problems. A strong balance sheet matched with a troubling P&L might show some stability, but weak sales or profits may also indicate poor management, products, pricing or expense controls. Understanding the difference between a balance sheet and a profit and loss statement and how they interrelate will help you to make better management and investment decisions.