Understanding the Financial Statements
Join the growing ranks of intelligent investors who understand the financial statements and can recognize a profitable and sustainable company. These are the quality companies that make investors wealthy over the long-term.
Developing the skills to understand the financial statements is what made the famous investor Warren Buffett extremely wealthy.
You don't need any accounting experience to understand the financial statements. It's the accountant's job to prepare the financial statements so that ordinary investors can read them. In other words, the financial statements are specifically prepared for those individuals without accounting qualifications.
As a general rule, most savvy investors do not have any accounting qualifications; they simply learnt how to interoperate the data within the financial statements. This is something most people with an interest in making money can easily learn to do.
The true value in the financial statements is that it shows up trends over a period of years. One single set of financial statements does not paint a complete picture; it's the trend over the years that paint a complete picture.
Some companies show a trend or consistency over the years. These tend to be the profitable companies which are the desirable companies that the savvy investors seek out.
A trend occurs when the data plotted on a graph moves in a general direction - this can be in a straight line or a curve. An example of a trend is with revenue that increased at say 10% every year over the last five years.
Consistency refers to how stable the data is over the years. An example of consistency is where the profit margin (profit to revenue ratio) has been stable at around 20% per year for the last fives years. Consistency can also refer to the stability in the increase in revenue. The above 10% revenue trend is another example of consistency - the 10% every year means that the increase is at a stable rate.
Intelligent investors use the financial statements to locate companies that show an increasing trend that is consistent with such data as revenue and profit. They also look for stability and consistency with data such as profit margin and return on equity.
The financial statements are typically prepared for each quarter and another for the full-year. The financial statement actually consists of three separate statements - the Income statement, the Balance Sheet statement and the Cash Flow statement.
Income statement: This used to be referred to as the Profit and Loss statement. This statement reveals how much money the company earned over the quarter or full-year. Common information obtained from the income statement is reported data such as revenue and profits (earnings) and calculated data such as the profit margin (profit to revenue ratio).
Balance Sheet statement: Shows what the company owns and what the company owes at the end of each quarter or the full-year. This statement is a snap shot on a specific day. What the company owns is referred to as its assets and what the company owes is referred to as its liabilities. The net worth of the company is determined by subtracting the liabilities from its assets. The net worth is typically referred to as the company's book value and is also known as the stockholders' equity.
Cash Flow statement: Tracks the cash that flows in and out of the company. The cash flow statement is required where companies use the Accrual Method of accounting - which is common for most businesses. The income statement shows how much revenue (sales) the company generated during the period, but if these companies give credit to their purchases the company may not receive payment during that period. The cash flow statement shows how much cash was received within a period whereas the income statement shows what was sold during the period. The same concept applies to what the company bought during the period.
The financial statements are lodged with the SEC (U.S. Securities and Exchange Commission) where the actual statements can be viewed. The quarterly statements are filed as '10-Q' and the full-year statements are filed as '10-K'.
There's a wide variety of websites where investors can obtain the financial statements. It is a good idea for investors to actually look at some financial statements themselves to see what they entail. Once the investor has a general feel with the statements they will probably find that it is quicker to use a financial website such as Yahoo or Morning Star that displays the data in a summarized format. Check the Resources Page for further information.
The following articles will point out what investors should look for in the financial statements. These will help investors differentiate between good quality companies and companies that are under financial stress.
Stock Analysis for Finance Students and Investors