Learning how to read financial statements of a company is essential for investors, business owners, managers, and anyone interested in understanding how a business performs financially. Financial statements provide important information about a company’s income, expenses, assets, liabilities, cash flow, and profitability. By understanding these reports, you can assess whether a company is financially healthy, identify potential risks, and make informed business or investment decisions.
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Understand the Three Main Financial Statements
Most companies prepare three important financial statements that provide different information about their financial performance.
- Income statement: Shows the company’s revenue, expenses, and profit or loss over a specific period.
- Balance sheet: Shows what the company owns, what it owes, and the value belonging to shareholders at a particular date.
- Cash flow statement: Shows how money enters and leaves the business through operating, investing, and financing activities.
Reading these three statements together gives you a clearer picture of the company’s financial position.
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Read the Income Statement
The income statement helps you determine whether a company is making money or operating at a loss.
Pay attention to the following figures:
- Revenue: The total money earned from selling products or providing services.
- Cost of sales: The direct costs involved in producing goods or delivering services.
- Gross profit: Revenue minus the cost of sales.
- Operating expenses: Costs such as salaries, rent, marketing, and administration.
- Operating profit: Profit generated from the company’s main business activities.
- Net profit: The amount remaining after expenses, interest, and taxes.
Compare revenue and profit across several years to determine whether the business is growing or experiencing financial difficulties.
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Examine the Balance Sheet
The balance sheet provides a snapshot of a company’s financial position at a particular date.
It contains three main components:
- Assets: Resources owned by the company, including cash, buildings, equipment, and inventory.
- Liabilities: Amounts the company owes, including loans, unpaid bills, and other obligations.
- Shareholders’ equity: The value remaining for shareholders after liabilities are deducted from assets.
The basic accounting equation is:
Assets = Liabilities + Shareholders’ Equity.
Check whether the company has sufficient assets to meet its financial obligations.
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Analyse the Cash Flow Statement
A profitable company can still experience financial difficulties if it does not have enough cash to pay its bills.
The cash flow statement has three sections:
- Operating activities: Cash generated or used by normal business operations.
- Investing activities: Money spent on or received from investments, equipment, and property.
- Financing activities: Cash received from loans, share issues, repayments, and dividends.
Pay particular attention to operating cash flow. Consistently positive operating cash flow can indicate that the company’s core business generates cash.
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Calculate Important Financial Ratios
Financial ratios help you evaluate a company’s performance and compare it with competitors.
Some useful ratios include:
- Current ratio = Current assets ÷ Current liabilities. It measures the company’s ability to meet short-term obligations.
- Net profit margin = Net profit ÷ Revenue × 100. It shows how much profit the company retains from its sales.
- Debt-to-equity ratio = Total debt ÷ Shareholders’ equity. It helps assess how much the business relies on borrowing.
- Return on equity = Net profit ÷ Average shareholders’ equity × 100. It measures how effectively the company uses shareholders’ funds.
Compare these ratios with previous years and similar companies rather than relying on one figure alone.
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Compare Financial Performance Over Time
Do not rely on a single financial statement when evaluating a company. Review at least three to five years of financial information where available.
Look for trends such as:
- Increasing or declining revenue.
- Improving or falling profit margins.
- Growing debt levels.
- Changes in operating cash flow.
- Increasing or decreasing shareholders’ equity.
Also read the notes accompanying the financial statements because they explain accounting policies, outstanding loans, significant transactions, and other important details.
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