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The Basics of Financial Statement Analysis

When it comes to investing in publicly listed companies, one of the leading skills to have is the ability to understand and interpret a firm’s financial statements. The financial statements give you information about a company’s financial performance in a particular time period.

It is similar to a report card for businesses and these statements help us decide whether a company is healthy or otherwise and provides transparency to investors.

From an investor’s perspective, financial statements are important as you can study these statements to decide whether you want to buy stocks of a particular company. 

There are three types of financial statements that are the balance sheet, income statement, and cash flow statement. All of these are equally important to understand the finances of a company. Let’s take a look at each one of them.

Balance Sheet

According to Investopedia, the balance sheet is a report of a company's financial worth in terms of book value. This is also known as a company’s statement of financial position as it summarizes that at a point in time. A company’s balance sheet consists of three parts i.e. assets, liabilities, and shareholder’s equity.

  • Assets are anything that the company owns. It includes cash, inventory, cash equivalents, and marketable securities. In general, assets are measurable resources from which the company anticipates to generate more benefits (read: sales) in the future.
  • Liabilities include anything that a company owes. This includes debt, short-term and long-term loans, accounts payable balance, payroll expenses, etc. Usually, the lower a company’s debt, the better is the overall health of the company, however, there are exceptions to this widely accepted rule.
  • Equity is the overall net worth of the business or the remaining claim on assets after the liabilities have been paid off. Shareholder’s equity is the difference between the company’s total assets and total liabilities. This is also considered as the book value of the company.

The balance sheet helps us understand if the company is capable of paying off any debt or loans, its liquidity position, working capital, and several other metrics.

Income Statement

According to Motley Fool, an income statement tells us the profitability of a business at a given point in time. It includes information about the amount of money a company spent to run and operate its business and the amount it earned through revenue. In a nutshell, the company reports its revenue, expenses, and net income in the income statement.

The income statement is also known as the Profit and Loss statement of a company. It provides necessary information about the profit earned or loss incurred by a company. It also lets us know the reason behind the profit or loss of a company which can be associated with either increased revenue, lowered expenses, one-time gains, impairment charges, or a combination of these metrics.

An Income statement is divided into the following parts:

  • Sales are the revenue or money the business has earned only by selling its products or services to customers or other companies.
  • Cost of goods sold tells you the amount a company spent to produce or manufacture the goods and services sold. It includes all the expenses from the cost of labor, raw materials, etc., related to the cost of production.
  • Operating expenses states the amount required to run the whole business. It is also known as the cost of doing business and expenses such as rent, utilities, and maintenance are included here. It also includes salary and other overhead expenses.
  • Gross profit tells you how profitable your products and services after accounting for the cost of production. It is simply the profit a company makes after deducting the cost required for manufacturing and selling the product or service and is the difference between sales and the cost of goods sold. Generally, a company manufacturing a product will have a lower gross margin compared to a company providing a service.
  • Net Profit is also referred to as the bottom line or net income of the company. It is the amount a company has after all the expenses are paid. In short, it tells you how much profit your overall business makes.

Cash Flow Statement

According to GetSmarterAboutMoney, the cash flow statement of a company reports the movement of cash for a particular period. This is useful for smaller businesses that operate with limited cash on hand. The cash flow statement is also divided into three parts:

  • Cash flows from operating activities– This is the cash flow generated from principal revenue-generating activities or from operating the business. It includes inventory, accounts payable, accounts receivable, depreciation, etc.
  • Cash flows from investing activities– This includes the cash flow that comes from buying and selling assets and other investments.
  • Cash flows from financing activities– This includes cash flow from debt and equity financing. It is the amount received from or paid to capital providers.

Cash Flow Statements gives us information about how a company utilizes its cash. A healthy company should have enough cash to pay its employees, suppliers, and creditors. It should also generate enough cash to pay dividends or lower its debt or reinvest for future expansion and revenue growth.

The Bullish takeaway

Financial statements tell us a lot about a company and play an important role in deciding the overall performance of a company. You can also analyze and compare the financial statements of competitors to get an idea about which company would be a better investment.

Financial statement analysis is one of the most important tools for investors to make a decision. You can easily come to know if a company has a healthy balance sheet, strong profit margins, and robust cash flows by analyzing the three statements mentioned above.

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