We hope you enjoyed our earlier article where we provided an “overview of stocks” and touched on the purpose of financial statements and how they can help you make better informed investment decisions.
As promised, I want to build on our earlier segment and help you better understand these statements by introducing you to how to read financial statements.
This article will focus on the financial statements, specifically the income statement, balance sheet and cash flow statements.
Let’s dive in….
A financial statement is a written record of financial activity and position of a business. The contents of a financial statement are a collection of various standard reports. Businesses may choose to generate financial statements on monthly, quarterly, or annual basis.
This segment, we will focus on the financial statements required every quarter by the Securities & Exchange Commission (SEC). Remember, all publicity traded companies must release these statements every three months. As they provide invaluable insight, the financial statements are a crucial measurement tool for the financial health and situation of a business so it is important to learn how to properly read them if we are to invest in these companies.
Components of Financial Statements
There are three main types of financial statements that all publicity traded companies must report: the income statement, balance sheet, and cash flow statement.
- Income Statement tells you about the profitability of a company and summarizes all the revenues and expenses to come up with ‘net income’ also known as the ‘bottom line’ of a company. Bottom line is a term used to refer to earnings after the expenses have been deducted.
- Balance Sheet covers assets, liabilities, and equity. Financial viability, liquidity, and risk can all be determined from this ‘snapshot’ of the finances of a given company, making it very useful to creditors and investors.
- Cash Flow Statement provides a summary of payments and receipts – in terms of where the money comes from and where it goes. The cash flow statement consist of three different reports: Operating, financing, and investing.
How to Read Financial Statements
The following are some guidelines that will help you properly read the financial statements:
How to Read an Income Statement
The Income statement is a critical component of the financial statements as it provides the details of how profitable a company is.
An income statement is generally broken down into several parts,
i.e., gross income, cost of sales, net sales, pre-tax income and taxes, operating expenses, operating income, as well as other income and expenses. All of these add up to your net income.
Here I provide you with a simple example of a consolidated income statement to help you better understand the financial position of a respected company. Keep in mind this is a simplified income statement tailored for newcomers but don’t worry, the concept remains the same. If you see the (parenthesis) for example, don’t panic, this just means it is a negative number.
|Humble Hustle Studios||For the year ended May,31,2019||For the Year ended May 31,2018||Difference|
|Cost of sales||15000||12000||3000|
|Gross Income||13000 (Revenues – Cost of Sales)||11000 (Revenues – Cost of Sales)||2000|
|Selling and administrative expense||5000||6000||(1000)|
|Interest expense, net||50||70||(20)|
|Income before income taxes||7950||4930||3020|
Here we are comparing income statements that are one year apart.
You can also compare income statements quarter by quarter (every three months). If the company is new, you may not be able to go back several years, rather, only several months.
Let’s analyze the income statements from 2018 to 2019.
In the first row, we see revenues.
In 2018 revenues were $23000 compared to $28000 in 2019, an increase of $5000.
For those who may be confused between the gross income and net income, don’t worry.
Think of gross income as your entire paycheck before any deductions. Let’s say your paycheck is 2500 before any deductions, consider that your gross income. After you recieve your actual paycheck, you know they will deduct taxes, insurance, 401k and other cost. After the deductions you may only receive 1500, consider this your net income.
The same concept applies here
The gross income (revenues minus cost of sales) has also increased by $2000 and the selling and administrative expenses have dipped with a difference of $1000.
After subtracting the gross income from the selling and administrative expenses, interest, and income taxes, net income has increased by $3010 from 2018 to 2019.
The income statements for both time periods indicate a growth trend for both revenues and net income from one year to the next. As stated in my first article, it is important to look for stocks that show this trend over a long period of time. Sure, you may have a dip every now and then, I’m sure most stocks in 2020 for example have dipped in both net income and revenue because of the Corona Virus, but rest assured many of these companies will rebound and the income statement will correlate when they do.
Here are more helpful tips when reading an income statement:
The key is to read between the lines to get more information:
- If your operating expenses have decreased as a percentage of your sales, then it suggests your company is efficiently being managed.
- If your sales have increased, while the cost of your sales has decreased, then you can be confident that your company is finding efficiencies in its production processes.
- Most income statements generally include information in terms of earnings per share, which divides the earnings of a company by its number of outstanding shares. This offers a better view of the company’s profitability to shareholders.
How to Read a Balance Sheet
The formula that you will need to remember when reading the balance sheet is:
Assets = Liabilities + Shareholder Equity
- Assets refer to anything that offers value to your business, e.g., copyrights or patents, land or buildings, inventory, accounts receivable, and cash.
- Liabilities are the financial obligations of your company. These include accounts payable, interest payments, loans, etc.
- Shareholder Equity is the amount of money left over when the liabilities of your company are subtracted from its assets.
As indicated by the formula above, if your company’s assets are equal to its liabilities plus shareholder equity, then it means your balance sheet is ‘balanced’.
Let’s dive into an example
Baaaaahhh Consulting Company: Balance Sheet
|ASSETS||OCT 2 2019||OCT 3 2018|
|CASH & CASH EQUIVALENTS||20000||18000|
|Property, plant and equipment||50000||45000|
|LIABILITIES AND EQUITY|
|LONG TERM DEBT||15000||14000|
|TOTAL OWNERS EQUITY||45400||35880|
|TOTAL LIABILITIES $ OWNERS EQUITY||90400||75880|
As you can see above, we are comparing two balance sheets for the same company from different point in times.
In the asset’s column, we can see an increase in inventory, prepaid expenses, property plant and equipment and other assets. The biggest increase here is the property plant and equipment from 45000 to 50000 for an increase of 5000.
Total assets overall increased by 14520 for a total increase of 19%. Again, this is a simplified balance sheet, but overall, even the more difficult ones will follow the same logic.
Simply look for growth over a period of time.
Total Liabilities increased by 5000 from 40000 to 45000. The biggest increase here is accounts payable (when a company owes a vendor or supplier money because of goods or services). Although there was an increase in liabilities, this is offset because of the major increase in assets.
Remember the formula at the beginning of this segment: Assets = Liabilities + Shareholder Equity.
Here is the formula with inserting the 2019 values from the balance sheet:
90400 = 45000 + 45400
75880 = 40000 + 35880
Overall, there is a positive trend from one time period to the next, indicating an increase in assets.
Financial Statements: How to Read a Cash Flow Statement
The cash flow statement is used to understand cash coming into the business, and out of the business.
The cash flow statement is created by using the elements from the income statement and the balance sheet from consecutive periods. These elements include cash receipts and payments from operating activities, investing activities, and financing activities.
- Operating cash flow activities includes sales of products and services, payments made to suppliers, interest payments, income tax, rent, and wage payments.
- Investing cash flow activities includes loans made or receive, sale of an asset, and payments made that are related to acquisitions and mergers.
- Financing cash flow activities includes cash that is raised from capital and paid out because of loans, stock repurchases, and dividends.
On the cash flow statement, you will see the above-listed categories divided into ‘additions’ and ‘subtractions. Together, these allow you to learn about the net cash for each specific category.
You can then determine your total net cash flow by adding up the net cash.
Let’s look at an example of a cash flow statement from all three perspectives: Operating, financing, and investing.
|Always Original Clothing Brand||2018||2019|
|CASH FLOWS FROM OPERATING ACTIVIES|
|EARNINGS AFTER TAXES||10000||12000|
|CHANGE IN WORKING CAPITAL REQUIREMENTS||(3000)||(5000)|
|NET CASH FLOW FROM OPERATING ACTIVIES (A)||12000||13000|
|CASH FLOWS FROM INVESTING ACTIVITIES|
|SALES OF FIXED ASSETS||0||1000|
|ACQUISITIONS OF FIXED ASSETS||0||(300)|
|NET CASH FLOW FROM INVESTING ACTIVITIES (B)||0||700|
|CASH FLOWS FROM FINANCING ACTIVIES|
|INCREASE IN LONG-TERM BORROWING||0||200|
|INCREASE IN SHORT-TERM BORROWING||0||10|
|LONG TERM DEBT REPAID||(100)||(100)|
|NET CASH FLOW FROM FINANCING ACTIVITIES (C)||(150)||50|
|TOTAL NET CASH FLOW (A+B+C)||11850||13750|
Cash Flows from Operating Activities
As the cash flow statement indicates, you can see an increase in earnings after taxes from 2018 to 2019 with depreciation expenses increasing by 1000. Change in working capital requirements (assets minus liabilities) increased from 3000 to 5000.
Once you add all the operating activities together:
10000 + 5000 – 3000= 12000 net cash flow from operating activities for 2018.
12000 + 6000 – 5000 = 13000 net cash flow from operating activities for 2019.
Increase in cash by 1000 indicates growth trend.
Cash Flows from Investing Activities
Investing portion is much easier to read here.
In 2018 sales of fixed assets was 0, and acquisitions of fixed assets was also 0, thus, net cash flow from investing activities is 0.
In 2019, they sold a fixed assetfor 1000 but also acquired an asset for 300.
Total net cash flow from investing is 700.
Cash Flows from Financing Activities
Within the financing cash flow statement, both increase in long-term borrowing and short-term borrowing were 0 in 2018 and slightly increased in 2019 to 210 respectively.
Long term debt :
Remains the same however dividends (rewards for shareholders, if you own stocks that provide dividends it is another way to make some extra cash) increased by 10 dollars as a company must pay their investors per share.
Overall, the company took on debt of 210 and now have some cash to spend.
Of course, many big stock companies take out loans all the time, do not be discouraged here if you see some debt.
Net cash from financing activities increased from -150 in 2018 to 50 in 2019.
Total Net Cash Flow
Now its time to add up all the net cash flows from operating, investing, and financing.
Total net cash flow can be calculated with the following formula:
Total Net Cash Flow = A (Operating) + B (Investing) + C (Financing)
Let’s input both the 2018 and 2019 values:
$11850 = 12000 + 0 + (150)
$13750 = 13000 + 700 + 50
When you add up the 2018 totals it equals to $11850.
2019 adds up to 13750 with an increase of 1900 in cash from year to year.
Although this is a simple example of a cash flow statement, we can conclude that the Net Cash Flow is increasing from one year to another and the company does have enough cash to continue funding its operations.
In conclusion, you don’t need to be a mathematical genius to be financially literate. All of these statements are easily accessible online and there are plenty of resources out there to help you build upon these skills.
Like anything in life, all it takes is some practice and application to become better over time. Understanding the different types of financial statements and the information they contain will help you better understand the financial position of particular stock. As a result, you will be able to make more informed investment decisions.
We hope this short guide will help motivate you to become better at reading financial statements. Stay tuned for more content as we dive deeper into the world of stocks in the near future. If you have any questions, concerns, or see something we should improve upon, please reach out to us! Your honest feedback will help us become better, till next time!! – Phan