An essential skill that every stock investor needs to have is the ability to work with numbers in a company’s financial statements. The meaningful analyses and interpretation of balance sheets, cash flow statements, and income statements to distinguish a firm’s investment qualities are necessary for smart investment choices.
But, the financial reporting diversity requires that a person first becomes familiar with certain financial statement characteristics before diverting attention to individual corporate financials. Let us look at what the financial statements have to offer and how one can use them to their advantage.
1. Using Financial Statements as a scorecard
There are millions of individual investors globally; even though most of them have chosen mutual funds for their investing activities, many also invest directly in stocks. Well-judged investment practices dictate that we seek quality companies with solid earnings, strong balance sheets, and positive cash flows.
2. Which Financial Statements should you use?
The financial statements used in the analysis of investment are the income statement, cash flow statement, and the balance sheet, apart from additional analysis of a firm’s shareholders’ equity and also the retained earnings.
Even though investors and analysts usually pay more attention to the income statement and the balance sheet, including the cash flow statement, which is often overlooked, is also very important.
3. Look beyond the Numbers
The numbers in a firm’s financial statements processing reflect the company’s business, services, products, and macro-fundamental events. These numbers and financial indicators derived from them can be understood in an easy way if one can easily visualize the realities behind the fundamentals driving the quantitative information.
For instance, before starting to crunch the numbers, it is important to understand what the company does what kind of products and services it offers, and the wider industry it operates in.
4. Reporting diversity
Financial statements processingcan never fit into a single mold; these kinds of expectations should be eliminated at the earliest. There are several books and articles based on financial statement analysis that talk about the one-size-fits-all approach.
Non-experienced investors can be misled while encountering a presentation of accounts that actually don’t fall into the mainstream of a “typical” company.
Remember that diversified business activities make for a diverse financial statement presentation. This holds true particularly for the balance sheet; the cash flow statement and the income statement are less vulnerable to this phenomenon.
5. Financial Jargon understanding
Due to the lack of standardization of financial reporting terminology, it becomes hard to understand various financial statement account entries. New investors can especially get confused during these circumstances. There’s some hope that things might change on this issue in the near future; however, a good financial dictionary can be a significant help to this problem.
6. Accounting is an Art and not a Science
The presentation of a firm’s financial position, as shown in its financial statements, is directly influenced by the management’s judgments and estimates. Even in the best of scenarios, the management can be seen to be thoroughly honest and candid, whereas the outside auditors seem to be strict, demanding, and uncompromising.
No matter the circumstances, the lack of accuracy that can be inherently found in the process of accounting conveys that a wise investor should never fail to be inquiring or skeptical towards financial statement analysis.
7. Vital Accounting Conventions
In order to prepare financial statements, either GAAP (Generally accepted accounting principles) or IFRS (International Financial Reporting Standards) are used. Both these modes are legal in the US; however, GAAP is most commonly used. Both the methods have their own ways to report asset values, inventory, and depreciation, to name a few.
8. Financial Indicators and Ratios
Unless transformed into meaningful relationships to justify a firm’s financial performance and assess its financial health, the absolute numbers in financial statements can only add little value for investment analysis.
Therefore, in order to witness trends, the resulting indicators and ratios should be seen over extended periods. Remember that evaluative financial metrics may hugely vary from company size, development stage, and the overall industry.
9. Financial Statement Notes
The financial statement figures may not necessarily provide all of the disclosure which are required by regulatory authorities. Likeminded investors and analysts universally agree a detailed understanding of the financial statement notes is important in order to evaluate a company’s financial performance and condition.
10. Consolidated Statements
The word “consolidated” typically appears in the financial statement’s title, like a consolidated balance sheet. If there’s a consolidation of a parent firm and its majority-owned (more than 50% ownership), it means that the combined activities of different legal entities are conveyed as a single economic unit.
It is presumed that the consolidation as one entity has more meaning as compared to separate statements for different entities.
As a wise investor, you should never get overwhelmed by the game of numbers. Understanding the financial statement processing with a calm mind is important as it can have a significant impact on your investing options.