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How to Read Financial Statements: A Beginner’s Guide

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The Beginner’s Guide to Reading & Understanding Financial Statements

10 Jun 2020

Tim Stobierski

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An ability to understand the financial health of a company is one of the most vital skills for aspiring investors, entrepreneurs, and managers to develop. Armed with this knowledge, investors can better identify promising opportunities while avoiding undue risk, and professionals of all levels can make more strategic business decisions.

Financial statements offer a window into the health of a company, which can be difficult to gauge using other means. While accountants and finance specialists are trained to read and understand these documents, many business professionals are not. The effect is an obfuscation of critical information.

If you’re new to the world of financial statements, this guide can help you read and understand the information contained in them.

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Understanding Financial Statements

To understand a company’s financial position—both on its own and within its industry—you need to review and analyze several financial statements: balance sheets, income statements, cash flow statements, and annual reports. The value of these documents lies in the story they tell when reviewed together.

1. How to Read a Balance Sheet

A balance sheet conveys the “book value” of a company. It allows you to see what resources it has available and how they were financed as of a specific date. It shows its assets, liabilities, and owners’ equity (essentially, what it owes, owns, and the amount invested by shareholders).

The balance sheet also provides information that can be leveraged to compute rates of return and evaluate capital structure, using the accounting equation: Assets = Liabilities + Owners’ Equity.

Assets are anything a company owns with quantifiable value.

Liabilities refer to money a company owes to a debtor, such as outstanding payroll expenses, debt payments, rent and utility, bonds payable, and taxes.

Owners’ equity refers to the net worth of a company. It’s the amount of money that would be left if all assets were sold and all liabilities paid. This money belongs to the shareholders, who may be private owners or public investors.

Alone, the balance sheet doesn’t provide information on trends, which is why you need to examine other financial statements, including income and cash flow statements, to fully comprehend a company’s financial position.

This article will teach you more about how to read a balance sheet.

2. How to Read an Income Statement

An income statement, also known as a profit and loss (P&L) statement, summarizes the cumulative impact of revenue, gain, expense, and loss transactions for a given period. The document is often shared as part of quarterly and annual reports, and shows financial trends, business activities (revenue and expenses), and comparisons over set periods.

Income statements typically include the following information:

Revenue: The amount of money a business takes in

Expenses: The amount of money a business spends

Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever a business sells

Gross profit: Total revenue less COGS

Operating income: Gross profit less operating expenses

Income before taxes: Operating income less non-operating expenses

Net income: Income before taxes less taxes

Earnings per share (EPS): Division of net income by the total number of outstanding shares

Depreciation: The extent to which assets (for example, aging equipment) have lost value over time

EBITDA: Earnings before interest, taxes, depreciation, and amortization

Accountants, investors, and other business professionals regularly review income statements:

To understand how well their company is doing: Is it profitable? How much money is spent to produce a product? Is there cash to invest back into the business?

To determine financial trends: When are costs highest? When are they lowest?

This article will teach you more about how to read an income statement.

Related: Financial Terminology: 20 Financial Terms to Know

3. How to Read a Cash Flow Statement

The purpose of a cash flow statement is to provide a detailed picture of what happened to a business’s cash during a specified duration of time, known as the accounting period. It demonstrates an organization’s ability to operate in the short and long term, based on how much cash is flowing into and out of it.

Cash flow statements are broken into three sections: Cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.

Operating activities detail cash flow that’s generated once the company delivers its regular goods or services, and includes both revenue and expenses. Investing activity is cash flow from purchasing or selling assets—usually in the form of physical property, such as real estate or vehicles, and non-physical property, like patents—using free cash, not debt. Financing activities detail cash flow from both debt and equity financing.

It’s important to note there’s a difference between cash flow and profit. While cash flow refers to the cash that's flowing into and out of a company, profit refers to what remains after all of a company’s expenses have been deducted from its revenues. Both are important numbers to know.

With a cash flow statement, you can see the types of activities that generate cash and use that information to make financial decisions.

Ideally, cash from operating income should routinely exceed net income, because a positive cash flow speaks to a company’s financial stability and ability to grow its operations. However, having positive cash flow doesn’t necessarily mean a company is profitable, which is why you also need to analyze balance sheets and income statements.

This article will teach you more about how to read a cash flow statement.

4. How to Read an Annual Report

An annual report is a publication that public corporations are required to publish annually to shareholders to describe their operational and financial conditions.

Annual reports often incorporate editorial and storytelling in the form of images, infographics, and a letter from the CEO to describe corporate activities, benchmarks, and achievements. They provide investors, shareholders, and employees with greater insight into a company’s mission and goals, compared to individual financial statements.

Beyond the editorial, an annual report summarizes financial data and includes a company's income statement, balance sheet, and cash flow statement. It also provides industry insights, management’s discussion and analysis (MD&A), accounting policies, and additional investor information.

In addition to an annual report, the US Securities and Exchange Commission (SEC) requires public companies to produce a longer, more detailed 10-K report, which informs investors of a business’s financial status before they buy or sell shares.

10-K reports are organized per SEC guidelines and include full descriptions of a company’s fiscal activity, corporate agreements, risks, opportunities, current operations, executive compensation, and market activity. You can also find detailed discussions of operations for the year, and a full analysis of the industry and marketplace.

Both an annual and 10-K report can help you understand the financial health, status, and goals of a company. While the annual report offers something of a narrative element, including management’s vision for the company, the 10-K report reinforces and expands upon that narrative with more detail.

This article will teach you more about how to read an annual report.

A Critical Skill

Reviewing and understanding these financial documents can provide you with valuable insights about a company, including:

Its debts and ability to repay them

Profits and/or losses for a given quarter or year

Whether profit has increased or decreased compared to similar past accounting periods

The level of investment required to maintain or grow the business

Operational expenses, especially compared to the revenue generated from those expenses

Accountants, investors, shareholders, and company leadership need to be keenly aware of the financial health of an organization, but employees can also benefit from understanding balance sheets, income statements, cash flow statements, and annual reports.

If you don’t have a financial background, the good news is that there are steps you can take to learn about finance and jumpstart your career. Building your financial literacy and skills doesn’t need to be difficult.

Are you interested in gaining a toolkit for making smarter financial decisions and communicating decisions to key stakeholders? Explore our online finance and accounting courses, and download our free course flowchart to determine which best aligns with your goals.

About the AuthorTim Stobierski is a marketing specialist and contributing writer for Harvard Business School Online.

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Table of Contents

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Table of Contents

1. Financial Statement = Scorecard

2. Financial Statements to Use

3. What's Behind the Numbers?

4. Diversity of Reporting

5. Understanding Financial Jargon

6. Accounting: Art, Not Science

7. Key Accounting Conventions

8. Non-Financial Information

9. Financial Ratios and Indicators

10. Notes to Financial Statements

11. The Annual Report/10-K

12. Consolidated Statements

Why are Financial Statements Important?

What Key Financial Statements Should I Understand When Analyzing a Company?

What’s the Difference Between GAAP and IFRS Accounting Conventions?

What are Some Key Limitations of Using Financial Statements?

The Bottom Line

Investing

Investing Basics

12 Things You Need to Know About Financial Statements

Quick tips to help you master the art of reading a financial statement

Richard Loth

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Richard Loth has 40+ years of experience in banking, corporate financial consulting, and nonprofit development assistance programs.

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Updated April 13, 2023

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Marguerita is a Certified Financial Planner (CFP), Chartered Retirement Planning Counselor (CRPC), Retirement Income Certified Professional (RICP), and a Chartered Socially Responsible Investing Counselor (CSRIC). She has been working in the financial planning industry for over 20 years and spends her days helping her clients gain clarity, confidence, and control over their financial lives.

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Knowing how to work with the numbers in a company's financial statements is an essential skill for stock investors. The meaningful interpretation and analysis of balance sheets, income statements, and cash flow statements to discern a company's investment qualities is the basis for smart investment choices.

However, the diversity of financial reporting requires that we first become familiar with certain financial statement characteristics before focusing on individual corporate financials. In this article, we'll show you what the financial statements have to offer and how to use them to your advantage.

Key Takeaways

Understanding how to read a company's financial statements is a key skill for any investor wanting to make smart investment choices.There are four sections to a company's financial statements: the balance sheet, the income statement, the cash flow statement, and the explanatory notes.Prudent investors might also want to review a company's 10-K, which is the detailed financial report the company files with the U.S. Securities and Exchange Commission (SEC).An investor should also review non-financial information that could impact a company's return, such as the state of the economy, the quality of the company's management, and the company's competitors.

1. Financial Statement = Scorecard

There are millions of individual investors worldwide, and while a large percentage of these investors have chosen mutual funds as the vehicle of choice for their investing activities, many others are also investing directly in stocks. Prudent investing practices dictate that we seek out quality companies with strong balance sheets, solid earnings, and positive cash flows.

Whether you're a do-it-yourself investor or rely on guidance from an investment professional, learning certain fundamental financial statement analysis skills can be very useful. Almost 30 years ago, businessman Robert Follett wrote a book entitled How To Keep Score In Business. His principal point was that in business you keep score with dollars, and the scorecard is a financial statement. He recognized that "a lot of people don't understand keeping score in business. They get mixed up about profits, assets, cash flow, and return on investment."

The same thing could be said today about a large portion of the investing public, especially when it comes to identifying investment values in financial statements. But don't let this intimidate you; it can be done.

2. Financial Statements to Use

The financial statements used in investment analysis are the balance sheet, the income statement, and the cash flow statement with additional analysis of a company's shareholders' equity and retained earnings. Although the income statement and the balance sheet typically receive the majority of the attention from investors and analysts, it's important to include in your analysis the often overlooked cash flow statement.

3. What's Behind the Numbers?

The numbers in a company's financial statements reflect the company's business, products, services, and macro-fundamental events. These numbers and the financial ratios or indicators derived from them are easier to understand if you can visualize the underlying realities of the fundamentals driving the quantitative information. For example, before you start crunching numbers, it's critical to develop an understanding of what the company does, its products and/or services, and the industry in which it operates.

4. Diversity of Reporting

Don't expect financial statements to fit into a single mold. Many articles and books on financial statement analysis take a one-size-fits-all approach. Less-experienced investors might get lost when they encounter a presentation of accounts that falls outside the mainstream of a so-called "typical" company. Please remember that the diverse nature of business activities results in a diverse set of financial statement presentations. This is particularly true of the balance sheet; the income statement and cash flow statement are less susceptible to this phenomenon.

5. Understanding Financial Jargon

The lack of any appreciable standardization of financial reporting terminology complicates the understanding of many financial statement account entries. This circumstance can be confusing for the beginning investor. There's little hope that things will change on this issue in the foreseeable future, but a good financial dictionary can help considerably.

Investopedia's Glossary of Terms provides you with thousands of definitions and detailed explanations to help you understand terms related to finance, investing, and economics.

6. Accounting: Art, Not Science

The presentation of a company's financial position, as portrayed in its financial statements, is influenced by management's estimates and judgments. In the best of circumstances, management is scrupulously honest and candid, while the outside auditors are demanding, strict, and uncompromising. Whatever the case, the imprecision that can be inherently found in the accounting process means that the prudent investor should take an inquiring and skeptical approach toward financial statement analysis.

7. Key Accounting Conventions

Generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS) are used to prepare financial statements. Both methods are legal in the United States, although GAAP is most commonly used. The main difference between the two methods is that GAAP is more "rules-based," while IFRS is more "principles-based." Both have different ways of reporting asset values, depreciation, and inventory, to name a few.

8. Non-Financial Information

Information on the state of the economy, the industry, competitive considerations, market forces, technological change, the quality of management and the workforce are not directly reflected in a company's financial statements. Investors need to recognize that financial statement insights are but one piece, albeit an important one, of the larger investment puzzle.

9. Financial Ratios and Indicators

The absolute numbers in financial statements are of little value for investment analysis unless these numbers are transformed into meaningful relationships to judge a company's financial performance and gauge its financial health. The resulting ratios and indicators must be viewed over extended periods to spot trends. Please beware that evaluative financial metrics can differ significantly by industry, company size, and stage of development.

10. Notes to Financial Statements

The financial statement numbers don't provide all of the disclosure required by regulatory authorities. Analysts and investors alike universally agree that a thorough understanding of the notes to financial statements is essential to properly evaluate a company's financial condition and performance. As noted by auditors on financial statements "the accompanying notes are an integral part of these financial statements." Please include a thorough review of the noted comments in your investment analysis.

11. The Annual Report/10-K

Prudent investors should only consider investing in companies with audited financial statements, which are a requirement for all publicly-traded companies. Perhaps even before digging into a company's financials, an investor should look at the company's annual report and the 10-K. Much of the annual report is based on the 10-K, but contains less information and is presented in a marketable document intended for an audience of shareholders. The 10-K is reported directly to the U.S. Securities and Exchange Commission or SEC and tends to contain more details than other reports.

Included in the annual report is the auditor's report, which gives an auditor's opinion on how the accounting principles have been applied. A "clean opinion" provides you with a green light to proceed. Qualifying remarks may be benign or serious; in the case of the latter, you may not want to proceed.

12. Consolidated Statements

Typically, the word "consolidated" appears in the title of a financial statement, as in a consolidated balance sheet. A consolidation of a parent company and its majority-owned (more than 50% ownership or "effective control") subsidiaries means that the combined activities of separate legal entities are expressed as one economic unit. The presumption is that consolidation as one entity is more meaningful than separate statements for different entities.

Why are Financial Statements Important?

Financial statements provide investors with information about a company's financial position, helping to ensure corporate transparency and accountability. Understanding how to interpret key financial reports, such as a balance sheet and cash flow statement, helps investors assess a company’s financial health before making an investment. Investors can also use information disclosed in the financial statements to calculate ratios for making comparisons against previous periods and competitors.

What Key Financial Statements Should I Understand When Analyzing a Company?

Investors should start by learning how to interpret key figures on a company's balance sheet, income statement, and statement of cash flows. Those wanting to dig a little deeper may want to consider learning how to analyze reports, such as shareholder’s equity and retained earnings. Investors can find a publicly traded company’s financial statements in its annual report or a 10-K filed with the SEC.

What’s the Difference Between GAAP and IFRS Accounting Conventions?

GAAP sets accounting guidelines and standards that companies must follow when preparing financial statements, whereas IFRS takes a more principles-based approach. Both conventions differ in how they report asset values, depreciation, and inventory. GAAP typically requires more disclosures than IFRS, with the latter providing much less overall detail. Both accounting methods are legal in the United States.

What are Some Key Limitations of Using Financial Statements?

Financial statements only provide a snapshot of a company's financial situation at a specific point in time. They also don't consider non-financial information, such as the health of the broader economy, and other factors, such as income inequality or environmental sustainability. Forward-looking financial statements rely on estimates and assumptions, which may not always be accurate and are subject to change.

The Bottom Line

Understanding the basics of financial statements provides investors with valuable information about a company's financial health. Investors can use key reports, such as a balance sheet, cash flow statement, and income statement, to evaluate a company's performance, helping to make more informed investment decisions. However, it’s also important to understand the limitations of overly relying on financial statements and consider other metrics, such as the impact of non-financial information, when analyzing a company's overall financial position. Financial statements play a vital role in maintaining the integrity of the financial system and promoting trust between companies and investors.

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Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our

editorial policy.

Robert Fullet. "How to Keep Score in Business," Page 2. FT Press, 2012.

Financial Accounting Standards Board. "Comparability in International Accounting Standards—A Brief History."

U.S. Securities and Exchange Commission. "Form 10-K."

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Financial Statements: List of Types and How to Read Them

Balance Sheet: Explanation, Components, and Examples

Consolidated Financial Statements: Requirements and Examples

Gauging the Impact of Combining GAAP and IFRS

Cash Flow Statement: What It Is and Examples

The Common-Size Analysis of Financial Statements

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Related Terms

Financial Statements: List of Types and How to Read Them

Financial statements are written records that convey the business activities and the financial performance of a company.

Balance Sheet: Explanation, Components, and Examples

A balance sheet is a financial statement that reports a company's assets, liabilities and shareholder equity at a specific point in time.

Consolidated Financial Statements: Requirements and Examples

Consolidated financial statements show aggregated financial results for multiple entities or subsidiaries associated with a single parent company.

What Are Accruals? How Accrual Accounting Works, With Examples

Accruals are revenues earned or expenses incurred that impact a company's net income, although cash has not yet exchanged hands.

Annual Report Explained: How to Read and Write Them

An annual report describes a company's operations and financial condition to stakeholders, and is required by regulators.

Audit: What It Means in Finance and Accounting, and 3 Main Types

An audit is an unbiased examination and evaluation of the financial statements of an organization.

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What is a Financial Statement | Xero PH

is a Financial Statement | Xero PH

Xero homepageBeautiful businessXero homepageBeautiful businessTry Xero for freeLog inXero homepageBeautiful businessFeaturesPricing For small businessFor accountants & bookkeepersSupportTry Xero for freeLog inWhat is a financial statement?Financial statement? (definition)A financial statement is a report that shows the financial activities and performance of a business. It is used by lenders and investors to check a business’s financial health and earnings potential.Financial statements can cover any period of time, although they’re most commonly prepared at the end of a month, a quarter, or a year.Types of financial statementThere are four basic financial statements in accounting:1. Balance sheet: A snapshot of your business’s financial condition at a single point in time, it shows what you own (your assets) vs what you owe (your liabilities). The difference between the two is often used as a starting point for valuing a business.2. Profit and loss statement: Also called an income statement, this report shows your business’s revenues and expenses. Expenses are subtracted from revenues to show your business’s profit or loss figure, also known as net income.3. Cash flow statement: Also called a statement of cash flows, this report shows changes to the cash coming in and out of your business over a period of time. It only records cash (which may not be all of your income), and includes amounts received from lenders and investors. A cash flow statement shows whether you can cover short term expenses like bills and payroll.4. Statement of changes in equity: Also called a statement of owner's (or shareholder’s) equity, or statement of retained earnings, this report shows how much money your business keeps (rather than pays out to shareholders or owners). Often, these retained earnings are used to make debt payments or are reinvested in the business.Combined, these statements provide a good view of the financial health of your business.See related termsCash flow statementFinancial reportingMore termsHandy resourcesAdvisor directoryYou can search for experts in our advisor directoryFind an advisorAccounting templatesDiscover free resources to help you do better businessSee all our free templatesFinancial reportingKeep track of your performance with accounting reportsFind out moreDisclaimerThis glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.FooterAccounting softwareHow Xero accounting software worksSee all Xero featuresExplore the Xero App StorePricingXero forAccountants & bookkeepersMediaInvestorsApp developersResourcesProduct updatesSmall business insightsSmall business guidesSmall business templatesAccounting glossaryBusiness resourcesCustomer storiesCompanyAbout XeroSustainability at XeroGovernance and leadershipBlogOur brandsCareersContact usSupportGet supportTake a courseFind an accountant or bookkeeper© 2024 Xero Limited. All rights reserved. "Xero" and "Beautiful business" are trademarks of Xero Limited.LegalPrivacy noticeAccessibilityThe current region is PhilippinesRegionPhilippines (USD)FacebookYoutubeLinkedinInstagramTwit

Beginner's Guide to Financial Statements | The Motley Fool

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Beginners Guide Financial Statements

3 Most Important Financial Statements

Matthew Frankel, CFP –

Updated

Mar 11, 2024 at 11:30AM

Key Points

Income, Balance Sheet, and Cash Flow statements aid investors in assessing company performance and health.

Income Statement Analysis: Reveals revenue sources, expenses, and net income trends critical for evaluating profitability.

Balance Sheet Overview: Provides insights into assets, liabilities, and equity, aiding in assessing financial stability.

Motley Fool Issues Rare “All In” Buy Alert

All publicly traded companies are required to release financial statements quarterly so investors can get a sense of how the business is doing. There are three main financial statements investors should be aware of: the income statement, the balance sheet, and the cash flow statement. In this article, we'll look at what each one is and the key information investors should pay attention to.

Image Source: Getty Images

What are they?What are company financial statements?Financial statements are documents designed to give investors a snapshot of how a business is performing over a particular period. Financial statements answer some important questions investors should ask before buying a stock, such as:

Financial statements answer these questions:

How does the business make its money?Have the business's revenue and earnings grown or shrunk?How much does the business own?How much does the business owe?Is there more money coming in or going out?

With those questions in mind, here's a quick guide to the three main types of financial statements and what investors should pay close attention to.

Income statementIncome statementA company's income statement tells you how much money a company brought in and how much of a profit (hopefully) it earned from that revenue.The “top-line” number: The first major number on the income statement is a company's net sales or revenues, also known as the top-line number. In many cases a company's income statement will break down different sources of income. For example, Apple's (AAPL 0.24%) income statement breaks its revenue into product sales and service revenue.Net income (earnings): From there, the company's cost of sales is subtracted to produce its gross income. Its operating costs (like research and development) are subtracted to calculate its operating income. Then income tax expenses are subtracted, and the result is the company's net income, also known as its "earnings." Net income is often expressed both as one large number and by share (the latter being earnings per share, or EPS).Depending on the company, there might be other information on the income statement, such as sales broken down by region or product category.

The general takeaway

An income statement starts with the company's sales and shows step by step how it turns them into profit.

It's also worth mentioning that there are typically several columns of numbers on an income statement to show how the current period compares to the same period last year. You'll typically see the latest quarter compared with the same quarter a year before, and the company's year to date (or full year) compared to the same period from the prior year. Comparing the company's current income to the previous year’s provides a good sense of how the business is growing.

Balance sheetBalance sheetA balance sheet gives you a snapshot of a company's financial condition at a given time (typically the end of a quarter). And as with the income statement, the data is typically presented as a comparison between the current period and the same time a year prior.There are three sections on a balance sheet:Assets: What the company owns. This is further broken down into current and noncurrent assets. Current assets include liquid assets and assets that can be expected to become liquid within a year. Examples include cash, short-term Treasuries, accounts receivable, and inventory. Noncurrent assets include long-term investments, real estate, and equipment used in manufacturing, just to name a few.Liabilities: What the company owes. These are also divided into current and noncurrent. Current liabilities include payments a company will have to make within a year, such as accounts payable and short-term debt. Noncurrent liabilities include things like long-term debts.Shareholder's equity: Think of shareholder's equity as what the company would have if it shut down, sold all of its assets, and paid all of its debts. Shareholder’s equity is the difference between assets and liabilities and is the company's net worth.

Cash flow statementCash flow statementA company's cash flow statement shows the money flowing into and out of the business. This is broken down into a few categories:Operating activities: This includes the net income from the company's business, stock-based compensation, receivables collected, accounts payable that were paid, and other business-related items.Investing activities: If a business buys or sells stocks or bonds, this activity is included in this part of the cash flow statement. The same is true if the business buys or sells real estate or equipment.Financing activities: If a company issues new common stock, it is included in this part of the cash flow statement. Dividend payments are a common outflow in this section, as are stock buybacks. And if a company repays debt, that will appear as a line item here.All of these categories added together produce the company's total cash flow. A positive number indicates that the company's cash increased during the period, while a negative number shows that the cash decreased. Just under the cash flow number will be a total of the cash and cash equivalents the company currently has.

FINANCIALS | English meaning - Cambridge Dictionary

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Meaning of financials in English

financialsnoun [ plural ] uk

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/faɪˈnænʃəlz/ us

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FINANCE, STOCK MARKET shares in financial organizations such as banks: You should get out of financials and invest in retailers.

ACCOUNTING, FINANCE a way of referring to a company's financial results, or to the financial matters that affect something: At the start of any project, it's essential to get the financials right.

(Definition of financials from the Cambridge Business English Dictionary © Cambridge University Press)

Examples of financials

financials

The main concern in the boardroom is to get the earnings per share right and to ensure that the three-monthly financials are okay.

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Example from the Hansard archive. Contains Parliamentary information licensed under the Open Parliament Licence v3.0

They state that they have the right financials resources or are backed by their firms.

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Example from the Hansard archive. Contains Parliamentary information licensed under the Open Parliament Licence v3.0

The companys business applications automate back office processes such as accounting and financials, human resources, contract management, payroll, legal and compliance.

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