For stock investors, it is essential to work with the numbers in a company’s financial statements. To make investment choices, investors need to discern balance sheets, cash flow statements, and income statements.
In this article, you will learn some important insights about financial statements that will help you understand them better and much faster.
Financial Statements are Scorecards
Most wise investors use financial statements as scorecards. In order for them to decide whether they want to invest in a, say, mutual fund, they seek out quality companies that have strong balance sheets, solid earnings, and positive cash flows.
Which Financial Statements to Use
The financial statements in investment analysis are the balance sheet, the cash flow statement, and the income statement. There is also the additional analysis of a company’s shareholders’ equity and retained earnings.
Even though income statement and the balance sheet usually receive a huge chunk of the attention from investors and analysts, it is very important to include the cash flow statement, which is often overlooked.
What the Numbers Tell
The numbers you see in a company’s financial statement reflect the company’s business. This includes the products, services, and macro-fundamental events.
The numbers and the financial ratios or indicators coming from them are easier to understand if you can visualize the underlying realities of the fundamentals that drive the quantitative information.
For instance, before you start analyzing numbers, you must understand what the company does, what it offers as products and services, and in which industry it operates.
Diversity of Reporting
Financial statements do not ever fit into a single mold. Investors with less experience get lost when faced with a presentation of accounts that aren’t under the mainstream or a so-called “typical” company.
Keep in mind that the diverse nature of businesses and business activities result in a diverse set of financial statement presentations. This is particularly true in terms of the balance sheet, while the income statement and the cash flow statement are less prone to this phenomenon.
There is no standardized financial reporting terminology, and this complicates the interpretation of many financial statement account entries.
This can be confusing for a newbie investor. Of course, it’s not possible to learn the jargon overnight, but a good financial dictionary can be helpful.
Accounting is an Art, not Science
The way the company financial status is presented is affected by the management’s estimates and judgments.
In the best case, the management is honest and candid. Outside auditors are more demanding, stricter, and less compromising.
Regardless, there will always be imprecision to be found in any financial statement. That means the wise investor should have a probing and inquisitive approach toward the financial statement.
Then there is also information that isn’t reflected in the company’s financial statement. These include the industry, competitive considerations, market forces, technological advancements, management quality, and workforce.
Wise investors should know that financial statement insights are but one piece, although an important one, of the larger puzzle.