As an investor, it is essential for you to understand how to read, and analyse financial statements so you can get a full and accurate understanding how much money there is, how much debt is owed, the income coming in each month, and the expenses going out the door before investing in any stocks. To help you do that, here is a general look at financial statements.
The Annual Report
At the end of a company’s financial year, which may or may not follow a calendar year, the company will publish their financials.
Many of the financial statements you need to understand a company are contained in the annual report. These reports are free and can easily be accessed on the company’s website or the stock exchange site on which it trades.
Sheet #1: Balance Sheet
Of the three important statements, the balance sheet is the one that provides a snapshot in time of what is owned (assets), what is owed (liabilities), and what is left over (net worth or book value).
Sheet #2: Income Statement
The second of the three statements is the income statement. Sometimes called the profit and loss, the income statement shows you money coming in the door (revenue), money going out the door (expenses), and what’s left over afterwards (income, or profit). The income statement is important because you can use it, along with the balance sheet, to calculate the return you are earning on your investment.
Sheet #3: Pro Forma Financial Statements
If you read an annual report and you see something called “Pro Forma” reports, you should stop, take a moment, and seriously consider whether or not you can trust management. Pro forma means that the financial statements do not comply with the GAAP rules.
The main reason to learn how to read financial statements is so that you can calculate financial ratios. Financial ratios let you know how a company is doing, how profitable it is, whether management is taking on too much debt, potential problems investors could face down the road, and much more.
Sometimes, you need to look beyond the financial statements to understand what is going on and the dangers threatening your investments. Imagine, for a moment, that you are looking at the financial statements of a horse and buggy manufacturer in the early 20th century. No matter how cheap the business appeared, you wouldn’t want to buy shares because the automobile was going to decimate the entire industry soon.
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