How to Read Financial Statements for Beginners

US Securities Regulator Says Financials Are Not Rocket Science

Jul 17, 2009

Another way of expressing the SEC viewpoint is that company financials are down to earth- not flights of fancy, unless a white-collar crook is cooking the books.

There are four basic financial statements and two add-on features of reports that tell investors how a company is doing, according to the SEC's "Beginners' Guide to Financial Statements." These tools appear in the annual or quarterly reports, and are issued at the close of each fiscal or business period.

Google Used to Illustrate Four Main Financials

The principal financials are explained and illustrated below, using Google Inc. reports. Although separate documents, revealing the progress of a company over a fixed period or its condition at a certain time, they are also interactive. They dovetail together like a slide show. In addition, there are important add-ons accompanying them, which are extremely important.

(1) BALANCE SHEET - The balance sheet is a snapshot of the financial condition of a company, on the last day of a fiscal period. It begins with a tally of the Assets, which are resources used to generate profits. These can be long term, like a manufacturing plant; intermediate, like communications equipment or current or short term, like inventories. Management assigns them a realistic value, usually based on historical cost or current replacement value.

Next are Liabilities, items representing monies or services the company owes to others. Like Assets, they can be due long-term, intermediately or currently.

The last section, Shareholders' Equity, is the portion of the enterprise that belongs to the owners. Common stock, stock warrants and partnership interests represent those interests. Shareholders' Equity is a residual position; and, in liquidation is entitled to the remainder, after assets are sold and liabilities settled.

Balance Sheet Reveals Financial Leverage

In the Balance Sheet equation (Assets - Liabilities = Shareholders’ Equity), Liabilities are subtracted from Assets to produce Shareholders' Equity. Dividing Shareholders’ Equity by common shares outstanding, found in either the Balance Sheet or Shareholders’ Equity sections, provides investors with the book value per share calculation, useful when compared to what the stock costs.

A company’s financial leverage is another important measure found in the Balance Sheet. To determine that, investors calculate how much of the company is owned by debt holders, versus how much shareholders can claim.

The percentage of debt plus equity, or total capitalization, owned by debt holders is the degree of financial leverage in the business. The higher the leverage, the more exposed shareholders are to disproportionately less earnings, when sales drop off, and disproportionately greater earning on upturns. That’s the effect of leverage.

(2) INCOME STATEMENT - The Income Statement explains how much profit an enterprise retains for its owners, over an operating period. Consider the Income Statement as what's left after total revenues or monies coming in have been reduced by the amounts of monies going out. They can represent direct costs of producing and selling products or services, as well as general operating costs, reserves set aside, interest paid and accrued taxes.

Income Statement Tracks Visible and Invisible Costs

Investors calculate many significant measures from the Income Statement. Dividends per share and Earnings per Share are most popular. To calculate these measures, they divide Net Income or the total dividend declared by the board by shares outstanding, to figure earnings or dividends per share.

Probably the most important thing to know about Net Income is that not all the deductions subtracted from revenues are cash disbursements. They can also be accounting allocations against revenues, representing invisible costs of doing business. Reserves to replace assets wearing out, called depreciation, and its cousin to replace natural resources used up, depletion, are examples.

(3) CASH FLOW - On the other hand, a Cash Flow statement shows actual outlays and intakes of cash from transactions. There are no invisible happenings here. At the end of the period, investors learn whether the cash flow was positive or negative. This observation reveals how comfortably the company can pay fixed costs, in difficult times.

Cash Flow is a good indicator of a company's prospects to remain solvent short term, while Net Income is valuable to indicate long-term prospects; since it shows how amply the enterprise is maintaining assets and planning for their replacements, as well as many other future events. This is a very important financial, when an investor wants to gauge whether cash generated comes mostly from operations or borrowing.

(4) SHAREHOLDERS' EQUITY - Shareholders' Equity is a historical accounting of the capital contributions to a corporation's treasury, including:

FOOTNOTES – These should not be ignored because of their pedestrian name, for they discuss information and insert data on the following critical topics:

MD&A is a shortcut for "Management's Discussion and Analysis of Financial Condition and Results of Operations." That's a mouthful but the discussions are full of nourishment for the thoughtful investor. The SEC requires disclosure about trends, events or possible uncertainties that would have a material impact on the company’s future. These are the up-close-and-personal pages.

Transparency in public company transactions and affairs has become the mantra of investing today, after the barrage of stock market fraud and fiascoes hitting Wall Street in recent years. In its role of oversight, the SEC has become a leading advocate of financial literacy by investors, in accomplishing that transparency.

The copyright of the article How to Read Financial Statements for Beginners in Shares/Stocks is owned by Howard Bryan Bonham. Permission to republish How to Read Financial Statements for Beginners in print or online must be granted by the author in writing.

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