How to Read Financial Statements for Beginners

If you want to determine a company where you want your money to be invested in or you are just being curious on a company performance for your research, then reading financial statements would be the answer. Financial statements will tell you how much money there is, debt, income and expenses are spent by the company. You can read financial statements from company’s annual reports and other financial reports which help you figure the profitability, liquidity ratios and cash flows.

There are several tips to see the big picture of a company through financial statements:

1. Obtain Company’s Annual Reports of Minimum 3-Year Annual Reports

Three years of reports specifically for the latest ones will give an accurate picture of how the company has been doing recently. You need their Profit and Loss (P&L) Statements (also called Income Statements), Balance Sheet and Cash Flow Statements. You should also check the auditor’s report which tell you whether the numbers are accurate or concerns about future business operations. You need to check the details of potential problems with the numbers and management’s discussion and analysis. If the company is family-owned business, ask for their tax returns to be compared with their increase or decrease in owner’s equity section in the Balance Sheet.

2. Pay Attention on Profit and Loss (P&L) Statements

Check where the money comes in and goes out. If the company was unprofitable three years ago but the last two years have been good, then you might be alright to invest. Check also any statement which show a large gap in comparison to other years and analyse the factors or root causes of the alarge gap. Country’s economic and political conditions, inflation rate or changes in goods price may be the factors of the large gap.

3. Check the Cash Flow Statement

Use the Cash Flow Statement to determine how much cash is available for necessary uses, like purchasing inventory, paying current bills, and most importantly, paying your employees. The business can have a lot of assets like inventory and property, but that it is no good when the company can’t run the daily operations.

4. Check the Balance Sheet

The Balance Sheet informs the End-of-Year snapshot of the company. Focus on the assets first whether there is any appropriate growth. Then check the Liabilities section and compare with the Profit & Loss to the Balance sheet whether the company has the ability to pay the debt or not. Lastly, check the Owner’s Equity section. If the amount of Owner’s Equity is decreasing then the business is showing signs of profitability but you must check the alignment with owner’s personal income statements.

Other Tips

1. Check the Profitability Ratios

You can test the way the company makes money by using the following important formulas.

• Price/earnings ratio compares the price of a stock to its earnings. A ratio of 10 means that for every $1 in company earnings per share, people are willing to pay $10 per share to buy the stock.
  • Price/earnings ratio = Market value per share of stock divided by Earnings per share of stock
• Dividend payout ratioshows the amount of a company’s earnings that are paid out to investors. Use it to determine the actual cash return you get by buying and holding a share of stock.
  • Dividend payout ratio = Yearly dividend per share divided by Earnings per share
• Return on salestests how efficiently a company is running its operations by measuring the profit produced per dollar of sales.
  • Return on sales = Net income before taxes divided by Sales
• Return on assets shows you how well a company uses its assets. A high return on assets usually means the company is managing its assets well.
  • Return on assets = Net income divided by Total assets
• Return on equitymeasures how well a company earns money for its investors.
  • Return on equity = Net income divided by Shareholders’ equity
• The gross margingives you a picture of how much revenue is left after all the direct costs of producing and selling the product have been subtracted.
  • Gross margin = Gross profit divided by Net sales or revenues
• The operating marginlooks at how well a company controls costs, factoring in any expenses not directly related to the production and sales of a particular product.
  • Operating margin = Operating profit divided by Net sales or revenues

2. Check the Liquidity Ratios

You can use the following formulas to check whether the company has plenty of liquid assets which is easily converted to cash.

• Current ratiogives you a good idea of whether a company will be able to pay any bills due over the next 12 months with assets it has on hand.
  • Current ratio = Current assets divided by Current liabilities.
• Quick ratioor acid test ratio shows a company’s ability to pay its bills using only cash on hand or cash already due from accounts receivable. It doesn’t include money anticipated from the sale of inventory and the collection of the money from those sales.
  • Quick ratio = Quick assets divided by Current liabilities.
• Interest coverage ratiolets you know whether a company is bringing in enough money to pay interest on whatever outstanding debt it has.
  • Interest coverage ratio = EBITDA divided by Interest expense.

3. Check for Cash Flows

You can use the following formulas to check whether the company has plenty of cash to keep operating.

• Free cash flowshows you how much money a company earns from its operations that can actually be put in a savings account for future use.
  • Free cash flow = Cash provided by operating activities – Capital expenditures – Cash dividends.
• Cash return on saleslooks specifically at how much cash is being generated by sales.
  • Cash return on sales = Cash provided by operating activities divided by Net sales
• Current cash debt coverage ratio lets you know whether a company has enough cash to meet its short-term needs.
  • Current cash debt coverage ratio = Cash provided by operating activities divided by Average current liabilities
• Cash flow coverage ratiofinds out whether a company has enough money to cover its bills and finance growth.
  • Cash flow coverage ratio = Cash flows from operating activities divided by Cash requirements

Sources:
Eipsten L. Reading Financial Reports for Dummies Cheat Sheet. Accessed from https://www.dummies.com/business/accounting/reading-financial-reports-for-dummies-cheat-sheet/
Kennon J. 2018. How to Read and Understand Financial Statements: The Beginners’ Guide to Reading and Understanding Financial Statements. Accessed from https://www.thebalance.com/guide-to-understanding-financial-statements-357512

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