Two Types of Financial Statements
For investors considering whether to purchase stock in a company, two essential types of financial statements to analyze are the balance sheet and the income statement. While becoming familiar with the statement of cash flow and statement of owner’s equity is also valuable, the balance sheet and income statement supply fundamental information to provide an overview of a business’s current financial position and profitability.
The U.S. Securities and Exchange Commission provides free access to public company financial information in its online database called EDGAR (Electronic Data Gathering, Analysis and Retrieval). Major stock exchanges such as the New York Stock Exchange and NASDAQ also have quarterly and annual reports for listed companies available on their websites.
The balance sheet, also called a statement of financial position, will contain information about assets and liabilities. A balance sheet typically categorizes assets and liabilities as current or long term. Long-term components are frequently referred to as fixed assets and fixed liabilities. Some examples of current assets are cash, accounts receivable and inventory. Fixed assets can include real estate, vehicles and equipment. Liabilities are considered current if due within one year and fixed if over one year. Following the assets and liabilities on a balance sheet is a section for owner’s equity. Owner’s equity is calculated by subtracting liabilities from assets.
The first section of an income statement typically contains revenues, defined as income from normal business operations. Next, costs of earning revenues are tallied. Common examples of these costs include manufacturing costs, freight and sales commissions paid. Basically, revenues minus costs equal profit. Keep in mind that terminology used on financial statements can change over time and also may vary for different business types.
After reading a company's balance sheet and income statement, how does an investor determine if the company is a solid investment? Industry averages are a common guideline used to determine how well a company is doing compared to others in their industry. Industry averages are computed by organizations that collect business information and calculate averages for key data points. Industry averages are available online at major financial news reporting web sites such as Reuters or the Wall Street Journal.
Building on the fundamentals of these two forms of financial statements, here are a few other important factors to consider.
Financial statements that have been audited by a reputable accounting firm provide assurance that the information presented is fair and accurate. The auditor’s opinion statement should be prominently displayed. If not, this is an area of concern.
Also keep in mind that financial statements show past results, which are not always an accurate predictor of future performance.
Reading financial statement footnotes is vital. Footnotes contain a more detailed explanation of financial statement items as well as other key points for understanding business results.