How to read financial statements: The basics

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A company’s financial statements are like a report card that tells investors how much money a company has made, what it spends on and how much money it currently has. Knowing how to read a financial statement and understand the key performance indicators that it includes is essential for evaluating a company. Any investor conducting fundamental analysis will pull much of the information they need from past and present financial statements when valuing a stock and deciding whether to buy a stock.

 

Each publicly traded company in the United States must produce a set of financial statements every quarter. These include a balance sheet, income statement and cash flow statement. In addition, companies produce an annual report. Together with the company’s earnings call, these statements tell a fairly complete story about a company’s financial health. Reading financial statements can give investors clues about whether or not it’s a good idea to invest in a given company or perhaps to short it.

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Related: Explaining the shareholder voting process

Understanding Each Section of a Financial Statement

1. Balance Sheet

A company’s balance sheet is a ledger that shows its assets, liabilities and shareholder equity at a given point in time. Assets are anything the company owns with quantifiable value. This includes tangible items, such as real estate, equipment, and inventory, as well as intangible items like patents and trademarks. The cash and investments a company holds are also considered assets.

 

On the other side of the balance sheet are liabilities — the debts a company owes, including rent, taxes, outstanding payroll expenses and money owed to vendors. When liabilities are subtracted from assets, the result is shareholder value, or owner equity. This figure is also known as book value and represents the amount of money that would be left over if a company shut down, sold all its assets and paid off its debt. This money belongs to shareholders, whether public or private.

2. Income Statement

The income statement, also known as the profit and loss (P&L) statement, shows a detailed breakdown of a company’s financial performance over a given period. It’s a summary of how much a company earned, spent and lost during that time. The top of the statement shows revenue, or how much money a company has made selling goods or providing services.

 

The income statement subtracts the costs associated with running the business from revenue. These include expenses, costs of goods sold and asset depreciation. A company’s revenues less its costs are its bottom-line earnings.

 

The income statement also provides information about net income, earnings per share, and earnings before interest, taxes, depreciation and amortization (EBITDA).

3. Cash Flow Statement

A cash flow statement is a detailed view of what has happened with regards to a business’ cash over the accounting period. Cash flow refers to the money that’s flowing in and out of a company, and it is not the same as profit. A company’s profit is the money left over after expenses have been subtracted from revenue. The cash flow statement is broken down into three sections:

  • Cash flow from operating activities is cash generated by the regular sale of a company’s goods and services.
  • Cash flow from investment activity usually comes from buying or selling assets using cash, not debt.
  • Cash flow from financing activity details cash flow that comes from debt and equity financing.

At established companies, investors typically look for cash flow from operating activities to be greater than net income. This positive cash flow may indicate that a company is financially stable and has the ability to grow.

4. Annual Report and 10-K

Public companies must publish an annual report to shareholders detailing their operations and financial conditions. Look for an annual report to include the following:

  • A letter from the company’s CEO that gives investors insight into the company’s mission, goals and achievements. There may be other letters from key company officials, such as the CFO.
  • Audited financial statements that describe financial performance. This is where you might find a balance sheet, income statement and cash flow statement. A summary of financial data may provide notes or discussion of financial statements.
  • The auditor’s report lets investors know whether the company complied with generally accepted accounting principles as they prepared their financial statements.
  • Management’s discussion and analysis (MD&A).

In addition, the Securities and Exchange Commission (SEC) requires companies to produce a 10-K report that offers even greater detail and insight into a company’s current status and where it hopes to go. The annual report and 10-K are not the same thing. They share similar data, but 10-Ks tend to be longer and denser. The 10-K must include complete descriptions of financial activities. It must outline corporate agreements, an evaluation of risks and opportunities, current operations, executive compensation and market activity. They must be filed with the SEC 60 to 90 days after the company’s fiscal year ends.

5. MD&A

The management’s discussion and analysis provides context for the financial statements. It’s a chance for company management to provide information they feel investors should have to understand the company’s financial statements, condition and how that condition has changed or might change in the future. The MD&A also discloses trends, events and risks that might have an impact on the financial information the company reports.

6. Footnotes

It can be really tempting to skip footnotes as you read financial statements, but they can reveal important clues about a company’s financial health. Footnotes can help explain how a company’s accountants arrived at certain figures and help explain anything that looks irregular or inconsistent with previous statements.

 

Financial Statement Ratios and Calculations

Financial statements can be the source of important ratios investors use for fundamental analysis. Here’s a look at some common examples:

1. Debt-to-Equity

To calculate debt-to-equity, divide total liabilities by shareholder equity. It shows investors whether the debt a company uses to fund its operation is tilted toward debt or equity financing. For example, a debt-to-equity ratio of 2-to-1 suggests that the company takes on twice as much debt as shareholders invest in the company.

2. Price-to-earnings (P/E)

Calculate price-to-earnings by dividing a company’s stock price by its earnings per share. This ratio gives investors a sense of the value of a company. Higher P/E suggests that investors expect continued growth in earnings, but a P/E that’s too high could indicate that a stock is overvalued compared to its earnings.

3. Return on equity (ROE)

Calculated by dividing net income by shareholder’s equity, return on equity (ROE) shows investors how efficiently a company uses its equity to turn a profit.

4. Earnings per share

Calculate earnings per share by dividing net earnings by total outstanding shares to understand the amount of income earned for each outstanding share.

5. Current Ratio

This metric measures a company’s ability to pay off its short-term liabilities with its current assets. Find it by dividing current assets by current liabilities.

6. Asset turnover

Used to measure how well a company is using its assets to generate revenue, you can calculate asset turnover by dividing net sales by average total assets.

The Takeaway

The financial statements that a company provides are all related to one another. For instance, the income statement reflects information from the balance sheet, while cash flow statements will tell you more about the cash on the balance sheet.

 

Whether you’re opening your first IRA or you’re an experienced investor, understanding financial statements can give you clues that will help you determine whether a stock is a good value and whether it makes sense to buy or sell.

 

Learn More:

This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

 

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Tips for teaching your kids about investing

 

People talk about improving financial literacy for kids, but few seem ready to do much about it.

According to the Council for Economic Education, only one-third of states require their students to take a personal finance class. And its most recent Survey of the States, performed in 2018, “reflects no growth in personal finance education in recent years and little improvement in economic education.”

While states and school districts are still struggling with the idea of adding financial literacy to the curriculum for middle- and high-school students, what are parents of younger children supposed to do?

If you’re thinking about taking matters into your own hands, here are a few ideas:

Related: 6 investing basics to know

 

Aleem_khan / istockphoto

 

If you’re a parent (or grandparent), you know how hard it can be to find just the right gift for the child in your life — something that won’t be lost or quickly forgotten. Many of us turn to toys we hope will be fun and educational, but finding toys related to stock market investing for kids can be tough.

Which means you might have to move on to the real world and actually give your child control of some stocks.

If you want to make it official, you can open a custodial account and either make some picks yourself or let your child do the choosing.

One way to make the lesson more meaningful might be to think about the things that are important to the child at each stage of life and pick a stock that represents it (the company that makes your child’s diapers, for example, a favorite toy brand or toy store).

As the child ages, they can have more input, and you can talk about dividends, compounding, diversification and what it means to buy and hold. If your kiddo can’t make up their mind between two companies, you can work together to do some research.

Older kids also can look for news stories that summarize analysts’ reports on Google FinanceYahoo Finance, or MarketWatch, where the writers typically decipher analysts’ jargon.

It’s important to note that there are pros and cons to the different types of investing accounts available to minors, so you’ll likely want to check out any consequences related to future taxes and when the child applies for financial aid for college.

Another, more personal, consequence is that the child you love might not be thrilled with a share of stock when what they really want is the latest game. But if your child is truly intrigued, you might even find them eventually investing money of their own.

 

SolisImages / istockphoto

 

Not quite ready to put real money into a kid-centric portfolio? You and your children can still follow the markets together and track how they’d do if they were invested.

You could even make it a bit of a competition between siblings (kind of like making picks at a horse race without placing any bets). You can do it on your own or sign up for an online game.

Either way, you can teach your child about how the markets work without any actual losses (or crushing disappointments).

 

fizkes / istockphoto

 

This might sound like an old-school, boring way to explain investing for kids, but there are books out there that include plenty of illustrations, fun language and important lessons, including these highly-rated offerings from Amazon.

  • What All Kids (and adults too) Should Know About … Savings and Investing, by Rob Pivnick — covers saving, budgeting and investing.
  • Go! Stock! Go!: A Stock Market Guide for Enterprising Children and Their Curious Parents, by Bennett Zimmerman — follows the Johnson family as they learn the fundamentals of stocks and bonds, the mechanics of investing and the ups and downs of risk and reward.
  • How the World REALLY Works: Asset Management 2018: A Children’s Guide to Investing, published by the Guy Fox History Project Limited — takes a big topic and breaks it down into terms kids can understand.
  • I’m a Shareholder Kit: The Basics About Stocks — For Kids/Teens, by Rick Roman — a spiral-bound book that was recently updated (May 2018) and designed to appeal to kids who want to know about investing and managing their money.

 

romrodinka/istockphoto

 

If your child is more into screen time than reading books, you might want to check out Warren Buffett’s Secret Millionaires Club to inspire the investing and entrepreneurial spirit.

This animated series includes 26 four- to five-minute webisodes, and there are parent guides to download for each one (in English and Spanish). Sorry, there are no stock tips, but an animated version of the “Oracle of Omaha” does serve as a mentor on the show.

Want to teach your child about the magic of compounding interest? It’s missing the bells and whistles that generally appeal to kids, but the Compound Interest Calculator on the U.S. Securities and Exchange Commission’s investor.gov website is easy to use and understand.

Just plug in an initial investment, how much you expect to add each month and the interest rate you expect to earn. The calculator will chart out an estimate of how much your child’s initial savings would grow over time.

 

SeventyFour / istockphoto

 

Whether it’s a success story or a cautionary tale, kids can learn a lot from their own family history.

For example, you could talk about how your parents and grandparents made and saved their money vs. how it’s done today in a conversation about the value of investing and goal-setting.

You can focus on storytelling instead of lecturing and encourage questions, which may keep them more involved.

 

imtmphoto / istockphoto

 

No matter which platform you choose to teach your kids about investing, consider trying to make it as pain-free and uncomplicated as possible.

If you decide you’re ready to do some real-world investing, for example, you could look for an account that makes it easier — and as hands-on or hands-off as you want it to be.

Keep it fun and keep the effort going, and someday your adult children might be telling tales around the dinner table about how your lessons helped advance their financial savvy.

Learn more:

This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
SoFi Invest
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA/SIPC. The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
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