How to Interpret and Profit from Financial Statements
Financial statements are a useful tool for judging the health of
a company, and for comparing it to its competitors. They show
what the company owes and owns, the profits or loses it has made
over a given period, and how their position has changed since
their last statement. Generally if you can tell which direction
a company is heading in, you can also forecast future stock
prices with some accuracy.
Gaining a basic knowledge of financial statements, and applying
this knowledge when choosing or assessing investments can help
you pick tomorrow's winning stocks, while avoiding tomorrow's
losers. Of course, financial statement analysis will not always
factor in significant news events, unexpected incidents, changes
in management, and other factors which may influence share
prices, but it provides a starting point from which to gauge the
present value of shares, independent of future occurrences.
The following report details some simple financial statement
explanation and analysis methods. Although the topic can get
much deeper and more complex, this article is designed to give
investors the ability to understand the numbers and simpler of
financial ratios, and be able to use that knowledge to assist
them to make better decisions when doing their due diligence.
Balance Sheet
The balance sheet shows a company's financial position at a
specific date, usually the last day of the company's fiscal year
for annual reports. One side of the balance sheet shows what the
company owns and has owing to it, called assets. The other side
represents liabilities, which are what the company owes, and
also has shareholders' equity, which represents the excess of
the company's assets over its liabilities. Shareholder's equity
is often referred to as book value. Total assets are equal to
the sum of the company's liabilities plus the shareholders'
equity. In other words, take away liabilities from assets and
the remainder is what value is owned by the shareholders. The
Balance Sheet can be used to uncover the value of the company,
the debt load, and cash position.
Earnings Statement
Also called the Income Statement or Profit and Loss Statement,
it shows how much revenue a company received during the year
from the sale of its products and services, and the expenses the
company incurred due to wages, taxes, operating costs, etc...
The difference between the two is the company's profit or loss
for the year. The amount left over after taxes is the net
earnings.
Net earnings are basically saying how much money the company
'really' made over the course of the year. Some companies can
have low earnings if they used much of their money for research
and development, to acquire other companies, fuel aggressive
growth, move into new markets, etc, which is much more favorable
than if the company had low earnings because they didn't
generate many revenues, their expenses were too high, etc...
Statements of Changes in Financial Position
This shows how the company's financial position changed from one
year to the next. Also called the cash flow statement, this
details how the company generated and spent its cash during the
year. This statement can be used in evaluating the liquidity and
solvency of a company, and to assess the ability of that company
to generate cash internally, to repay debts, to reinvest in
itself, etc...
Sources of Financial Reports
Certainly you can get financials from the companies themselves.
Most will gladly fax them to you, or mail you their latest
quarterly and annual reports.
However, a faster way to access the information can be by
Internet. For example, go to Yahoo.com and choose stock quotes.
Enter the ticker symbol for the company you are interested in,
and Yahoo will provide its most recent press releases, which
will include past quarterly and annual reports with the
financial statements. You can also check the previous reports to
compare which direction the company is moving in and look for
trends (i.e. increasing debt load, unpredictable earnings,
decreasing revenues, erratic revenues, etc...). There are also
many other Internet resources which provide similar information,
such as wsrn.com, bigcharts.com, (canada-stockwatch.com for
Canadian issues), etc...
Comparison Shopping
To familiarize yourself with some of the numbers, try looking up
the financials of three companies you own or are interested in.
(Balance Sheet) Which of the companies has the greatest long
term debt load? Do any of the companies have greater current
liabilities than current assets? Compare the current share price
to the shareholder's equity (book value): is the share price
much greater or less than the book value?
(Earnings Statement) What were the revenues of the most recent
year (or quarter) and does the number represent an increase or
decrease from the previous period? How much money per share did
the company earn (or lose) in the most recent period?
(Statement of Changes in Financial Position) Has company debt
been increasing or decreasing? What was the greatest expense the
company incurred according to the statement?
Decision Making
Understand that financial statements can provide investors with
a partial fundamental snapshot of a company. They only represent
one piece of the puzzle. Remember that, while financial
statements can help investors compare several companies,
comparison is limited only to the numbers provided.
In other words, you can see that one company made money while
the other lost money, but you don't know which has the better
technical outlook (based on analysis of the trading chart),
which is a potential takeover target, which will have the best
future earnings, etc...
As well, the impact of financial statements tends to be
long-term as it relates to share prices. Four quarterly reports
showing increasing earnings may push the stock into an upward
trend as the market begins to recognize the fundamental
improvements of the underlying company, but one quarter of
increasing earnings may or may not have a significant impact on
shares.
Therefore, most investors use financial statements as part of a
greater overall decision making process. Certainly, though, an
understanding of and familiarization with the data can benefit
any investor who takes the time to make educated trading
decisions.
Important Points
Many growth companies don't need nor are expected to have
positive earnings. Instead, they generally accumulate debt as
they focus on research and development of new technologies,
aggressively move into new markets, fight for market share with
competitors, etc... Other companies with minimal growth
prospects on the other hand, have more importance placed on
actual earnings, lowering operational costs, etc...
Be sure to understand what numbers are important and unimportant
to a specific company based on their situation and the position
they are in. This can be done easily by going to wsrn.com and
doing an industry comparison on the company in question. Do
companies in the same industry seem to have positive earnings,
or is the focus on growth, research, etc... Are they a larger or
smaller company than the industry average, and are they growing
faster than the others? Read the fine print to make sure the
numbers you are reading have been audited, rather than being
just company estimates, or unverified results. This generally is
not something you need to worry about with most exchange-listed
companies, but it is important practice.
Many annual statements will begin with positive news about sales
or revenue increases, or other positive comments, but further
reading reveals that the company actually lost more money,
increased debt, or had a poor quarter or year. For most
companies their financial statements are part of their
promotional material and they need to make the information sound
as impressive and positive as possible, even if the overall
results were disappointing. Be wary of one-time earnings or
loses. For example, a company may win a huge lawsuit settlement
and the influx of money gives them positive earnings for the
quarter. However, how would they have done when the one-time
extraordinary is ignored?