How to Interpret and Profit from Financial Statements

by: Peter Leeds

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 pinksheets.com wsrn.com, bigcharts.com, 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?