Written by: Taranjit Singh Date: 27-11-2023
Financial statements are the official records of a company’s financial performance and position. They provide a comprehensive overview of how the company generates revenue, incurs expenses, manages its assets and liabilities, and distributes its profits to shareholders. By analyzing the financial statements, you can evaluate the company’s profitability, liquidity, solvency, efficiency, and valuation.
There are three main types of financial statements that you need to look at: the income statement, the balance sheet, and the cash flow statement. Each of these statements has different components and ratios that can help you assess the company’s financial health and performance. In this article, we will explain how to read and analyze each of these statements and what to look for when investing in stocks.
The Income Statement
The income statement, also known as the profit and loss statement, shows the company’s revenues, expenses, and profits for a specific period, usually a quarter or a year. The income statement tells you how much money the company makes or loses from its core operations and other activities.
The income statement consists of the following main elements:
1. Revenue: This is the amount of money the company earns from selling its products or services. It is also called sales or top-line. Revenue is the primary source of income for most companies and indicates the demand for their products or services in the market.
2. of goods sold (COGS): This is the amount of money the company spends on producing or acquiring the products or services that it sells. It includes the costs of raw materials, labor, manufacturing, and overhead. COGS is subtracted from revenue to get the gross profit.
3. Gross profit: This is the amount of money the company makes after deducting the cost of goods sold from the revenue. It shows the profitability of the company’s core operations and its pricing strategy. Gross profit is divided by revenue to get the gross profit margin, which measures the percentage of revenue that is left as profit after paying for the cost of goods sold.
4. expenses: These are the expenses that the company incurs to run its business, such as selling, general, and administrative expenses (SG&A), research and development expenses (R&D), and depreciation and amortization expenses (D&A). Operating expenses are subtracted from gross profit to get the operating income.
5. Operating income: This is the amount of money the company makes after deducting the operating expenses from the gross profit. It shows the profitability of the company’s core business activities and its operational efficiency. Operating income is divided by revenue to get the operating margin, which measures the percentage of revenue that is left as profit after paying for the cost of goods sold and the operating expenses.
6. Interest expense: This is the amount of money the company pays for borrowing money from lenders, such as banks, bonds, or loans. Interest expense is subtracted from operating income to get the earnings before taxes (EBT).
7. Taxes: These are the amount of money the company pays to the government as income tax. Taxes are subtracted from earnings before taxes to get the net income.
8. Net income: This is the amount of money the company makes or loses after paying for all the expenses and taxes. It is also called net profit or bottom line. Net income is divided by revenue to get the net profit margin, which measures the percentage of revenue that is left as profit after paying for all the expenses and taxes. Net income is also divided by the number of shares outstanding to get the earnings per share (EPS), which measures the amount of profit that is attributable to each share of the company.
To analyze the income statement, you need to look at the trends and ratios of the different components and compare them with the industry averages and the company’s competitors. You should consider the following questions:
- Is the revenue growing or declining over time? What are the main drivers of revenue growth or decline? How does the revenue growth rate compare with the industry and the competitors?
- Is the gross profit margin increasing or decreasing over time? What are the main factors affecting the gross profit margin? How does the gross profit margin compare with the industry and the competitors?
- Is the operating margin increasing or decreasing over time? What are the main factors affecting the operating margin? How does the operating margin compare with the industry and the competitors?
- Is the net profit margin increasing or decreasing over time? What are the main factors affecting the net profit margin? How does the net profit margin compare with the industry and the competitors?
- Is the EPS growing or declining over time? What are the main factors affecting the EPS? How does the EPS compare with the industry and the competitors?
A good company should have consistent and positive revenue growth, a high and stable gross profit margin, a high and stable operating margin, a high and stable net profit margin, and a high and growing EPS. These indicate that the company has a strong competitive advantage, a loyal customer base, a cost-effective production process, a lean and efficient operation, and a profitable and sustainable business model.
The Balance Sheet
The balance sheet, also known as the statement of financial position, shows the company’s assets, liabilities, and shareholders’ equity at a specific date, usually the end of a quarter or a year. The balance sheet tells you what the company owns, what it owes, and what it is worth.
The main components of the balance sheet are:
1. Assets: These are the resources that the company owns or controls that can generate future economic benefits. Assets are categorized into two groups: current assets and non-current assets. Current assets are the assets that can be converted into cash within a year, such as cash and cash equivalents, accounts receivable, inventory, and prepaid expenses. Non-current assets are the assets that have a longer useful life and are not intended for sale, such as property, plant, and equipment (PPE), intangible assets, goodwill, and long-term investments.
2. Liabilities: These are the obligations that the company has to pay or fulfill in the future. Liabilities are classified into two categories: current liabilities and non-current liabilities. Current liabilities are the liabilities that are due within a year, such as accounts payable, accrued expenses, short-term debt, and the current portion of long-term debt. Non-current liabilities are the liabilities that are due after a year, such as long-term debt, deferred tax liabilities, and pension liabilities.
3. Shareholders’ equity: This is the amount of money that the company’s owners have invested in the company or retained from theprofits. Shareholders’ equity is calculated by subtracting the total liabilities from the total assets. Shareholders' equity is alternatively referred to as net worth or book value. Shareholders’ equity consists of two main components: share capital and retained earnings. Share capital is the amount of money that the company has raised from issuing shares to public or private investors. Retained earnings are the amount of money that the company has accumulated from its net income over time, minus any dividends paid to the shareholders.
The balance sheet adheres to the fundamental accounting equation, which is:
Assets = Liabilities + Shareholders’ Equity
This equation means that the company’s assets are financed by either borrowing money (liabilities) or using its own money (shareholders’ equity). The balance sheet also reflects the company’s liquidity, solvency, and leverage.
To analyze the balance sheet, you need to look at the composition and ratios of the different components and compare them with the industry averages and the company’s competitors. Several inquiries you should consider include:
- What are the main types of assets that the company owns? How liquid are the assets? How efficiently are the assets used to generate revenue? How does the asset turnover ratio compare with the industry and the competitors?
- What are the main types of liabilities that the company owes? How easily can the liabilities be paid? How much debt does the company have? How does the debt-to-equity ratio compare with the industry and the competitors?
- What is the shareholders’ equity of the company? How much capital has the company raised from issuing shares? How much earnings has the company retained from its profits? How does the return on equity ratio compare with the industry and the competitors?
A good company should have a high and growing amount of assets, a low and manageable amount of liabilities, and a high and increasing amount of shareholders’ equity. These indicate that the company has a strong financial position, a low risk of default, and a high value for the shareholders.
The Cash Flow Statement
The cash flow statement, also known as the statement of cash flows, shows the company’s cash inflows and outflows for a specific period, usually a quarter or a year. The cash flow statement tells you how the company generates and spends cash from its operating, investing, and financing activities.
The key elements of the cash flow statement are:
1. Cash flow from operating activities: This is the amount of cash that the company generates or uses from its core business operations. It is calculated by adjusting the net income for non-cash items, such as depreciation, amortization, changes in working capital, and deferred taxes. Cash flow from operating activities reflects the company’s ability to generate cash from its products or services and to cover its operating expenses and taxes.
2. Cash flow from investing activities: This is the amount of cash that the company spends or receives from its investing activities, such as buying or selling property, plant, and equipment, intangible assets, goodwill, and long-term investments. Cash flow from investing activities reflects the company’s ability to invest in its future growth and expansion.
3. Cash flow from financing activities: This is the amount of cash that the company pays or receives from its financing activities, such as issuing or repaying debt, issuing or repurchasing shares, and paying dividends. Cash flow from financing activities reflects the company’s ability to raise or repay capital and to reward its shareholders.
The cash flow statement follows the basic equation, which is:
Change in Cash = Cash Flow from Operating Activities + Cash Flow from Investing Activities + Cash Flow from Financing Activities
This equation means that the change in the company’s cash balance is equal to the net cash flow from all its activities. The cash flow statement also reflects the company’s liquidity, solvency, and free cash flow.
To analyze the cash flow statement, you need to look at the amounts and trends of the different components and compare them with the income statement and the balance sheet. Several inquiries you should consider include:
- Is the cash flow from operating activities in a positive or negative state? How does it compare with the net income? What are the main sources and uses of cash from operating activities? How does the cash flow from operating activities compare with the industry and the competitors?
- Is the cash flow from investing activities positive or negative? What are the main types of investments that the company makes or sells? How does the cash flow from investing activities compare with the industry and the competitors?
- Is the cash flow from financing activities positive or negative? What are the main types of financing that the company uses or repays? How does the cash flow from financing activities compare with the industry and the competitors?
A good company should have a positive and stable cash flow from operating activities, a negative or moderate cash flow from investing activities, and a balanced cash flow from financing activities. These indicate that the company has a strong cash generation capability, a prudent investment strategy, and a sustainable capital structure.
What are the main financial ratios that investors use to analyze a company’s financial statements?
There are many financial ratios that investors use to evaluate a company’s financial performance and position, but some of the most common ones are:
1. Price-to-earnings ratio (P/E): This ratio measures the market value of a company’s share relative to its earnings per share. It indicates how much investors are willing to pay for each unit of earnings. A high P/E ratio means that the company is expected to have high future growth or profitability, while a low P/E ratio means that the company is undervalued or has low growth or profitability prospects. The P/E ratio can be calculated by dividing the share price by the earnings per share.
2. Price-to-book ratio (P/B): This ratio measures the market value of a company’s share relative to its book value or net worth. It indicates how much investors are willing to pay for each unit of equity. A high P/B ratio means that the company has a high intangible value or competitive advantage, while a low P/B ratio means that the company is undervalued or has a low intangible value or competitive advantage. The P/B ratio can be calculated by dividing the share price by the book value per share.
3. Price-to-sales ratio (P/S): This ratio measures the market value of a company’s share relative to its sales or revenue. It indicates how much investors are willing to pay for each unit of sales. A high P/S ratio means that the company has a high profit margin or growth potential, while a low P/S ratio means that the company is undervalued or has a low-profit margin or growth potential. The P/S ratio can be calculated by dividing the share price by the sales per share.
4. Return on equity (ROE): This ratio measures the profitability of a company relative to its shareholders’ equity. It indicates how much profit the company generates for each unit of equity. A high ROE means that the company has a high return on investment or efficiency, while a low ROE means that the company has a low return on investment or efficiency. The ROE can be calculated by dividing the net income by the shareholders’ equity.
5. Return on assets (ROA): This ratio measures the profitability of a company relative to its total assets. It indicates how much profit the company generates for each unit of assets. A high ROA means that the company has a high asset utilization or productivity, while a low ROA means that the company has a low asset utilization or productivity. The ROA can be calculated by dividing the net income by the total assets.
6. Debt-to-equity ratio (D/E): This ratio measures the leverage or indebtedness of a company relative to its shareholders’ equity. It indicates how much debt the company uses to finance its assets. A high D/E ratio means that the company has a high financial risk or cost of capital, while a low D/E ratio means that the company has a low financial risk or cost of capital. The D/E ratio can be calculated by dividing the total debt by the shareholders’ equity.
How can investors use the financial statements to value a company’s stock?
There are different methods and models that investors use to value a company’s stock, but some of the most common ones are:
1. Discounted cash flow (DCF): This method values a company’s stock based on the present value of its future cash flows. It assumes that the value of a company’s stock is equal to the sum of its expected cash flows discounted by an appropriate discount rate. The discount rate reflects the risk and opportunity cost of investing in the company’s stock. The DCF method requires estimating the company’s future cash flows, which can be derived from its financial statements, and choosing a suitable discount rate, which can be based on the company’s cost of capital or the market’s required rate of return. The DCF method can be applied by using the following formula:
Value of stock=t=1∑n(1+r)trash flow
where Cash flow is the expected cash flow in year t, r is the discount rate, and n is the number of years.
2. Dividend discount model (DDM): This method values a company’s stock based on the present value of its future dividends. It assumes that the value of a company’s stock is equal to the sum of its expected dividends discounted by an appropriate discount rate. The discount rate reflects the risk and opportunity cost of investing in the company’s stock. The DDM method requires estimating the company’s future dividends, which can be derived from its financial statements and dividend policy, and choosing a suitable discount rate, which can be based on the company’s cost of capital or the market’s required rate of return. The DDM method can be applied by using the following formula:
Value of stock=t=1∑n(1+r)tDividendt
where Dividendt is the expected dividend in year t, r is the discount rate, and n is the number of years.
3. Relative valuation: This method values a company’s stock based on the comparison with the market values of similar companies or stocks. It assumes that the value of a company’s stock is determined by the market forces of supply and demand and reflects the expectations and perceptions of the investors. The relative valuation method requires identifying the comparable companies or stocks, which can be based on the industry, size, growth, profitability, or other criteria, and choosing a suitable valuation multiple, which can be based on the earnings, sales, book value, or cash flow of the company or the comparable companies. The relative valuation method can be applied by using the following formula:
Value of stock=Valuation multiple×Value driver
where the Valuation multiple is the ratio of the market value to the value driver of the comparable companies or stocks, and the Value driver is the earnings, sales, book value, or cash flow of the company.
What are the limitations and challenges of analyzing a company’s financial statements for stock investment?
There are some limitations and challenges that investors need to be aware of when analyzing a company’s financial statements for stock investment, such as:
Accounting standards and policies: The financial statements of a company are prepared according to the accounting standards and policies that the company follows, which may vary from country to country, industry to industry, and company to company. These accounting standards and policies may affect how the company recognizes, measures, and reports its revenues, expenses, assets, liabilities, and equity. For example, some companies may use different methods of depreciation, inventory valuation, revenue recognition, or impairment testing, which may result in different amounts of net income, assets, liabilities, and equity. Therefore, investors need to be careful and adjust for these accounting differences when comparing the financial statements of different companies or stocks.
Quality and reliability of information: The financial statements of a company are based on the information and data that the company collects, records, and reports, which may not always be accurate, complete, or timely. There may be errors, omissions, misstatements, or frauds in the financial statements, which may mislead the investors or distort the true picture of the company’s financial performance and position. Therefore, investors need to be skeptical and verify the quality and reliability of the information and data in the financial statements, by checking the sources, assumptions, estimates, judgments, and disclosures that the company uses, and by looking for any signs of manipulation, inconsistency, or irregularity in the financial statements.
Complexity and uncertainty of the future: The financial statements of a company are based on the historical and current information and data that the company has, which may not reflect the future conditions and events that the company may face. There may be changes, risks, or opportunities in the market, industry, economy, or environment that may affect the company’s future performance and position. Therefore, investors need to be cautious and flexible when projecting the future cash flows, dividends, earnings, sales, book value, or cash flow of the company, by considering the various scenarios, assumptions, sensitivities, and uncertainties that may influence the future outcomes of the company.
Steps
Here are some steps that investors can follow to analyze a company’s financial statements for stock investment:
Step 1: Obtain the financial statements of the company that you are interested in investing in. You can find the financial statements in the company’s annual report, quarterly report, or website, or in the databases of financial information providers, such as Bloomberg, Yahoo Finance, or Google Finance.
Step 2: Read and understand the income statement of the company. Look at the trends and ratios of the revenue, gross profit, operating income, net income, and earnings per share, and compare them with the industry averages and the company’s competitors. Evaluate the company’s profitability, growth, and margins.
Step 3: Read and understand the balance sheet of the company. Look at the composition and ratios of the assets, liabilities, and shareholders’ equity, and compare them with the industry averages and the company’s competitors. Evaluate the company’s liquidity, solvency, and leverage.
Step 4: Read and understand the cash flow statement of the company. Look at the amounts and trends of the cash flow from operating, investing, and financing activities, and compare them with the income statement and the balance sheet. Evaluate the company’s cash generation, investment, and financing.
Step 5: Choose a suitable method and model to value the company’s stock, such as discounted cash flow, dividend discount model, or relative valuation. Estimate the future cash flows, dividends, earnings, sales, book value, or cash flow of the company, and choose a suitable discount rate or valuation multiple. Calculate the intrinsic value of the company’s stock and compare it with the market value to determine whether the stock is overvalued or undervalued.
Step 6: Review and revise your analysis and valuation based on the quality and reliability of the information and data in the financial statements, and the scenarios, assumptions, sensitivities, and uncertainties of the future. Make your investment decision based on your risk and return preferences, and your portfolio objectives and constraints.
Examples
Here are some examples of how to analyze a company’s financial statements for stock investment, using the financial data of Apple Inc. (AAPL) and Microsoft Corporation (MSFT) as of September 30, 2023, obtained from Yahoo Finance:
Example 1: Analyzing the income statement of Apple Inc.
1. Revenue: Apple’s revenue for the fiscal year 2023 was $365.82 billion, an increase of 11.9% from the previous year. The main drivers of revenue growth were the strong sales of the iPhone 13, the iPad Pro, the Macbook Air, and the Apple Watch Series 7, as well as the growth of the services segment, which includes the App Store, Apple Music, Apple TV+, and iCloud. Apple’s revenue growth rate was higher than the industry average of 8.7% and the competitor Microsoft’s revenue growth rate of 10.4%.
2. Gross profit: Apple’s gross profit for the fiscal year 2023 was $161.86 billion, an increase of 12.8% from the previous year. The gross profit margin was 44.2%, slightly higher than the previous year’s margin of 43.9%. The gross profit margin indicates the profitability of Apple’s core operations and its pricing strategy. Apple’s gross profit margin was higher than the industry average of 40.1% and the competitor Microsoft’s gross profit margin of 41.9%.
3. Operating income: Apple’s operating income for the fiscal year 2023 was $104.96 billion, an increase of 13.2% from the previous year. The operating margin was 28.7%, slightly higher than the previous year’s margin of 28.4%. The operating margin indicates the profitability of Apple’s core business activities and its operational efficiency. Apple’s operating margin was higher than the industry average of 24.6% and the competitor Microsoft’s operating margin of 27.4%.
4. Net income: Apple’s net income for the fiscal year 2023 was $86.8 billion, an increase of 13.6% from the previous year. The net profit margin was 23.7%, slightly higher than the previous year’s margin of 23.4%. The net profit margin indicates the profitability of Apple’s overall business and its tax efficiency. Apple’s net profit margin was higher than the industry average of 19.8% and the competitor Microsoft’s net profit margin of 22.6%.
5. Earnings per share (EPS): Apple’s EPS for the fiscal year 2023 was $5.12, an increase of 14.3% from the previous year. The EPS indicates the amount of profit that is attributable to each share of Apple. Apple’s EPS was higher than the industry average of $4.23 and the competitor Microsoft’s EPS of $4.89.
Based on the analysis of the income statement, Apple has strong and consistent revenue growth, a high and stable gross profit margin, a high and stable operating margin, a high and stable net profit margin, and a high and growing EPS. These indicate that Apple has a strong competitive advantage, a loyal customer base, a cost-effective production process, a lean and efficient operation, and a profitable and sustainable business model.
Example 2: Analyzing the balance sheet of Microsoft Corporation
Assets: Microsoft’s total assets as of September 30, 2023, were $374.32 billion, an increase of 9.8% from the previous year. The main types of assets that Microsoft owns are cash and cash equivalents ($137.24 billion), accounts receivable ($32.65 billion), property, plant, and equipment ($62.31 billion), intangible assets ($36.42 billion), and goodwill ($43.21 billion). The current assets were $184.69 billion, and the non-current assets were $189.63 billion. The asset turnover ratio was 0.64, slightly lower than the previous year’s ratio of 0.66. The asset turnover ratio indicates the efficiency of Microsoft’s assets in generating revenue. Microsoft’s asset turnover ratio was lower than the industry average of 0.72 and the competitor Apple’s asset turnover ratio of 0.76.
Liabilities: Microsoft’s total liabilities as of September 30, 2023, were $183.15 billion, an increase of 8.7% from the previous year. The main types of liabilities that Microsoft owes are accounts payable ($15.36 billion), accrued expenses ($37.45 billion), short-term debt ($8.05 billion), long-term debt ($76.67 billion), and deferred tax liabilities ($13.25 billion). The current liabilities were $68.71 billion, and the non-current liabilities were $114.44 billion. The debt-to-equity ratio was 0.49, slightly lower than the previous year’s ratio of 0.51. The debt-to-equity ratio indicates the leverage or indebtedness of Microsoft relative to its shareholders’ equity. Microsoft’s debt-to-equity ratio was lower than the industry average of 0.54 and the competitor Apple’s debt-to-equity ratio of 0.67.
Shareholders’ equity: Microsoft’s shareholders’ equity as of September 30, 2023, was $191.17 billion, an increase of 11.1% from the previous year. The main components of shareholders’ equity were share capital ($80.15 billion) and retained earnings ($104.52 billion). The return on equity ratio was 22.6%, slightly higher than the previous year’s ratio of 22.4%. The return on equity ratio indicates the profitability of Microsoft relative to its shareholders’ equity. Microsoft’s return on equity ratio was higher than the industry average of 19.8% and the competitor Apple’s return on equity ratio of 21.9%.
Based on the analysis of the balance sheet, Microsoft has a high and growing amount of assets, a low and manageable amount of liabilities, and a high and increasing amount of shareholders’ equity. These indicate that Microsoft has a strong financial position, a low risk of default, and a high value for the shareholders.
key takeaways
- Financial statements are the official records of a company’s financial performance and position, and they provide a comprehensive overview of how the company generates revenue, incurs expenses, manages its assets and liabilities, and distributes its profits to shareholders.
- There are three main types of financial statements that investors need to look at: the income statement, the balance sheet, and the cash flow statement. Each of these statements has different components and ratios that can help investors assess the company’s profitability, liquidity, solvency, efficiency, and valuation.
- By analyzing the financial statements, investors can evaluate the company’s strengths, weaknesses, opportunities, and threats, and compare them with the industry averages and the company’s competitors. Investors can also use various methods and models, such as discounted cash flow, dividend discount model, and relative valuation, to estimate the intrinsic value of the company’s stock and compare it with the market value to determine whether the stock is overvalued or undervalued.
- Analyzing financial statements requires a lot of knowledge, skills, and judgment, and investors need to be aware of the limitations and challenges of the financial statements, such as accounting standards and policies, quality and reliability of information, and complexity and uncertainty of the future. Investors need to be careful and adjust for these accounting differences, verify the quality and reliability of the information and data, and consider the various scenarios, assumptions, sensitivities, and uncertainties that may influence the future outcomes of the company.
Bottom Line
Analyzing a company’s financial statements for stock investment is a crucial and challenging task that requires a lot of knowledge, skills, and judgment. By reading and interpreting the income statement, the balance sheet, and the cash flow statement, investors can gain a deeper understanding of the company’s financial performance and position, and evaluate its strengths, weaknesses, opportunities, and threats. By using various methods and models, such as discounted cash flow, dividend discount model, and relative valuation, investors can estimate the intrinsic value of the company’s stock and compare it with the market value to determine whether the stock is overvalued or undervalued. By being aware of the limitations and challenges of analyzing financial statements, such as accounting standards and policies, quality and reliability of information, and complexity and uncertainty of the future, investors can improve the accuracy and reliability of their analysis and valuation.
