Understanding Financial Statements
- Types of Statements
- Formula: Assets
- Formula: Net Income
- Formula: Ending Equity
- What to Look For on the Statements
When you get involved with investing , it’s important to understand some basic information about how to read. and understand financial statements especially if you are a do-it-yourself type.
Knowing what they mean can help you make sound decisions about your investment choices.
Types of Statements
There are four basic financial statements that every business should have:
- The Balance Sheet – A report of the financial position of a business entity at any point in time. The balance sheet gives a sort of snapshot of the health of the business during a specific time period, ending today.
Formula: Assets = Liabilities + Equity
- The Income Statement – This is the financial statement that most banks and accountants want to see because it essentially shows the net earnings or net profit of the business during a period of time, usually a year.
Formula: Net Income = Revenue Expenses or Net Income = Revenue – Expenses + Gains – Losses
- The Statement of Retained Earnings – This statement is completed after dividends are paid, usually yearly. This amount is carried over to the financial statements staring the New Year. For example, if at the year ending 2009 the business’s net earnings showed at $100,000, that is before dividends are paid.
- If the business then pays out $5,000 in dividends and the retained earnings from last year (2008) was $4,000, this year it’s $5,000 + $4,000 for a total of $9,000. This number is carried over next year, too.
Formula: Ending Equity = Beginning Equity + Investments – Withdrawals + Income
* The Statement of Cash Flows – Revenue doesn’t always mean that you have cash, and the statement of cash flows is a good example of why that is true. Sales on credit, sales that have not been paid yet, as well as work being performed and not billed yet, won’t appear on the statement of cash flows. This statement only shows received money and money that has gone out during the period count.
Learning about each of these statements is essential to your financial future so that you can invest properly. You’ll want to see all of these statements for any business that you want to invest in. Taken all together you can assess the health of any business.
For public-ally traded companies, all of these statements are available for public view.
What to Look For on the Statements
What you want look for are financials that make sense, plus you want to see a profitable business that has room for growth. Some key things to look for are:
- Poor Cash Flows – If a business has poor cash flows even if they are earning money overall, this can indicate some trouble with collecting which can indicate many problems. Very good business ideas fail all the time due to bad cash flow.
- High Dividends – On the statement of retained earnings, if a business is paying out high dividends even if they’re not that profitable, that is cause for concern. They are likely trying to attract investors because they are short on funds.
- Footnotes – Often you can get a lot more information reading the footnotes on any financial document than you can look at the document. Read all the footnotes so that you can find out the information they may not want you to notice.
Once you learn what to see on each statement you’ll have no trouble looking at any business and knowing their situation. From this you will be able to make a good choice in a matter of an hour or two per business.