How to Read Financial Statements

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Learning to read financial statements is as easy as reading "a nutrition label or a baseball box score," according to a Securities and Exchange Commission (SEC) guide on the subject. Financial statements include an income statement, a balance sheet, a cash flow statement, accompanying notes, a management discussion and analysis section and, for audited statements, an auditor's report. As the SEC guide says, financial statements "show you the money," and learning how to read them is important.

Learn the components of the balance sheet. This document offers a snapshot of the company’s assets, such as current and fixed assets; liabilities, including short-term loans and long-term bonds; and shareholders’ equity, such as common stock and retained earnings. Assets are always equal to liabilities plus shareholders' equity.

Review the income statement, which the SEC guide compares to a flight of stairs. You start at the top with sales, and then you make a deduction for various costs and expenses at each step down. For example, deducting cost of goods sold leads to gross profit, and deducting overhead expenses (e.g., marketing and administrative expenses) leads to operating profit. The bottom step is your bottom line or net profit.

Look through the cash flow statement, which uses and reorders the information from a company’s balance sheet and income statement. The cash flow statement shows the cash coming into (inflows) and leaving (outflows) the company as a result of operating, investing (buying new equipment) and financing (selling stocks or bonds) activities.

Pay attention to the accompanying notes which can get technical at times. These notes are usually placed after the financial statements, often under a separate heading "Notes to Financial Statements." They elaborate on one or more financial statement line items, including inventory valuation methodology, consolidation or the sale of divisions, and details of employee benefit and retirement plans.

Scan through the management discussion and analysis section. Look for an explanation on changes from the previous statement. Pay attention to the business outlook, which is management’s expectation of sales and profits in the quarters and years ahead.

Look for an unqualified auditor's statement indicating a clean bill of health. A qualified or adverse auditor's opinion could result from concerns over how the financial statements were compiled and presented. Note that publicly traded companies often publish unaudited financial statements every three months and release audited versions at year-end.

Figure out what the key business drivers are so that you can focus on the corresponding financial statement line items. For example, the key business driver for a start-up technology company may not be the profit or sales numbers, but rather the trend. If the company is showing steady progress in driving sales quarter-over-quarter, then you can look for the reasons in the management discussion section, such as their product fulfilling a key customer need.