When you’re looking for a company to invest in, you’ll want to do some research. Typically, you’ll have two options, technical analysis or fundamental analysis. Personally, I use fundamental analysis, so today we’re going to go over the most important financial statements you need to look at when conducting your research.
There are three financial statements you need to pay attention to, income statement, balance sheet, and the statement of cash flow.
The income statement is also known as the profit and loss statement. It shows the revenues and expenses for a given time period, typically on a per quarter basis.
You’ll gain some unique insights from an income statement, including an overview of operations, management efficiency, comparison to peers, and net income. Net income = (revenue + gains) – (expenses + losses).
There are two types of income statements. Single-Step and Multiple-Step. Single-step is one simple calculation ((revenue + gains) – (expenses + losses)). Multiple-step separates operating “net income” from non-operating “net income”.
The balance sheet is just as straight-forward as the income statement, except it shows assets and liabilities instead of revenues and expenses.
That means a balance sheet displays what a company owns and owes. It also shows how much is invested by the shareholders.
Statement of cash flow
The cash flow statement provides data that shows a company’s operations, where the money is being spent, and how that money is being spent.
This data is broken down into three categories: operating activities, investing activities, and financing activities.
Operating activities will show the following information:
- Accounts receivable
- Accounts payable
- Income tax
- Cash receipts
Investing activities are any money spent on the future of the company, which could include equipment, R+D, property, and other assets.
Financing activities include debt issuance, stock issuance, dividends, interest payments, and stock buybacks.
As I mentioned in the beginning, when doing research, you’ll fall into two camps. Technical analysis or fundamental analysis.
Technical analysis views everything as a security. A technical analyst will use charts and trading information to identify investment opportunities.
Fundamental analysis views everything as a business. A fundamental analyst will use the above financial statements to pass judgment on companies.
What to look for
If you are doing fundamental analysis and you are looking at these financial statements, there are certain things you want to see.
- Balance sheet, income statement, and cash flows should be positive – Negative numbers either means they’re making less than they spend or they owe more than they own (in the case of the balance sheet).
- Efficient operations – theoretically, you could see this on all three statements, but it will be most prevalent on the statement of cash flows. The operating revenues should be significantly higher than operating expenses (at least that’s preferable). However, this should be cross-referenced with the company’s peers (certain industries have higher margins than others).
- Low outstanding liabilities – Less future earnings going towards interest and paying off debt, and more going to investing activities. This is especially favorable near the end of the business cycle, as revenues typically drop. Fewer liabilities could mean healthy margins even when revenues dip.
You’re investing in a business. You want to see that management is using capital effectively, and they’re not biting off more than they can chew. Positive financial statements and healthy margins.