Many investors have heard the terms “income statement,” “balance sheet statement” and “cash flow statement,” but have no idea what each of these are and how they might be able to use them to their advantage. These three statements comprise what are known as the “financial statements” of a company. Every publicly traded company is required to disclose these financial statements at least once a quarter (every three months) to provide transparency and insight into the company’s operations. This article is intended to dig into the first two statements to help the average investor discover how financial professionals use them to make more sound investing decisions.
The income statement is the best-known of the three financial statements. This statement’s purpose is to look at the profitability of a company over a given period. From a basic overview, the statement starts with a company’s sales and reduces those sales by the company’s expenses to arrive at the income. To break it down even further, expenses are divided into the categories of operating expenses, interest expenses and taxes. Operating expenses include cost of goods sold; selling, general and administrative expenses; and depreciation. “Cost of goods sold” are costs associated with the physical production of the product being sold. “Selling, general and administrative expenses” refer to marketing, labor, overhead expenses and other costs associated with the operations but not the production of the product. Reviewing a basic income statement online is a great way to familiarize yourself with the layout. This statement is usually used in the valuation process of a company to determine the appropriate price an investor is willing to invest.
The balance sheet statement is the next financial statement that also garners a lot of scrutiny from investors. Generally, the balance sheet is used to evaluate the financial condition of a company as of a certain date and breaks out a company’s assets and liabilities. The difference between the assets and liabilities are a company’s net worth, also referred to as shareholders’ equity. Assets are broken down into current assets (items that are either cash or easily converted into cash) and fixed assets (investments, property). Liabilities are divided into current liabilities (items that need to be paid within a year) and long-term debt. Shareholders’ equity can be complicated to understand for the average investor, and often not important to a financial professional. The balance sheet statement is typically used to evaluate a company’s ability to pay its debts using its assets.
These two statements are typically used to evaluate a company’s investment worthiness at a basic level. To recap, the income statement shows the profit/loss generated by a company, and what the investor is willing to pay to invest in the company. The balance sheet shows a company’s assets and liabilities. Most investors will assess multiple quarters/years of income and balance sheet statements, and participate in analyst calls, investor meetings and sometimes even personal meetings with a company’s management to better understand the company before investing. This article just scratches the surface of what financial analysts and other financial professionals do on a daily basis to evaluate an investment for their clients.
Hunter Larson joined D.A. Davidson in 2015 as a research associate before accepting a position as financial adviser in Aberdeen.