How to Read Financial Statements and Quickly Understand Financial Results
Reading financial statement can be tricky to someone with little or no knowledge of financial statements.
Even the seasoned professionals require reminder on how to read financial statements. The facts about reading financial statements helps one grasp an idea of what is contained in company annual reports, this helps one become a better investor. There are those who wish to learn how business works and get informed about the companies they trade with or work for.
Annual reports contain three sections:
- Executive letter
- Business review
- Financial review
In the executive letter the company elaborates in broad an overview of a company’s financial and business performance.
While a company’s recent developments, trends, and objectives are discussed in Business review.
The quantification of performance of the business in dollars is contained in the financial review section.
The Financial Review section is divided into two main parts:
- Discussion and analysis
- Audited financial statements
There is also a part which contains supplemental information on the financial statements.
A company’s management explains changes in yearly operating results under discussion and analysis. Charts and graphs are used in this discussion to highlight comparisons and mainly presented in narrative form. Numerical expressions are used to present operating results in the financial statements.
Balance sheet, footnote, income statement, statement of changes of shareholders’ equity, and the cash flow statement makes up financial statements.
The balance sheet had two divisions:
- on the left where assets are listed and
- the right side where liabilities are listed with shareholders’ equity
The left and the right side are always balanced.
All the goods and owned are listed in the asset column while the debts due are listed under liabilities.
Under assets current assets, which include cash and those assets that will be converted to cash within a year are listed first.
Next is the listing of fixed assets which include those assets like property, plant and equipment that are not intended for sale but used over and over again. Under these assets depreciation is calculated on machinery and other properties. Intangible assets purchased from other companies which contain assets with no physical existence but hold a substantial value to the company are also listed here.
Liabilities are also listed starting with current liabilities which include debts that fall due within 12 months. Current liabilities consists of accounts payable items containing what the company owes to its regular business creditors.
Also notes payable, accrued expenses and income tax payable are all listed under current liabilities. Then long-term liabilities containing debts due after one year from the date of financial report are listed.
Most common long-term liabilities include deferred income taxes and debentures. Shareholder’s equity contains sum total of stock, additional paid-in capital, retained earnings and adjustments from foreign currency translation.
The balance sheet figures can be analyzed by looking at certain financial ratios.
The net working capital equals to:
Current Assets – Current Liabilities.
Current ratio equals to:
Current assets / Current liabilities.
This helps investors determine sound working capital of a company. Assets that can be quickly converted to cash in case of emergency are called quick assets which equals to the difference between current assets minus inventories and prepaid expenses.
Most investors look into debt equity of a company to establish whether the debt level is acceptable.
The debt to equity ratio is equal to:
Total liabilities / Total Shareholders’ Equity
Companies normally operates safely on higher ratios.