In the U.S., the Securities and Exchange Commission (SEC) sets and enforces the reporting and disclosure standards for publicly traded companies. The SEC requires certain financial information to be furnished at least quarterly. Disclosure and transparency are appropriate and necessary, but the sheer volume of available information can be pretty overwhelming. If you want to assess the financial health of a company, where would you even begin?
In this article, we’ll offer a brief description of three important company financial statements without the information overload.
Companies report their quarterly revenues and expenses on an income statement. We expect healthy companies to operate profitably. That means they should be able to consistently generate revenues in excess – or “net” – of expenses. That net income can be reinvested in the company’s future or returned to owners (shareholders) in the form of dividends.
Some companies experience a lot of seasonality – or fluctuation – in their earnings from one quarter to the next. A retail company, for example, might operate at a modest loss for the first three quarters of each year before achieving profitability during the holiday shopping season during the fourth quarter. To account for these fluctuations, most companies report their quarterly earnings in several different ways. They often report quarterly income compared to the prior quarter and compared the same period in prior years.
When comparing investment opportunities, look for companies whose profits are larger, more consistent, or growing more rapidly than their peers.
Of course, net income isn’t the only important data point on an income statement. Red flags include rapidly rising expenses, shrinking profit margins, and frequent instances of “surprise” expenses that erode profits.
The balance sheet takes a “snapshot” of the company at the end of the three month period and shows what the company owns (assets), what they owe (liabilities), and how much the company is worth (shareholders equity … also calculated as assets minus liabilities).
Over time, changes reported on the balance sheet can offer some insight into a company’s management style and priorities. Even if a company’s income statement points to consistent profitability, the balance sheet might reveal trouble brewing in the years ahead. A company with low levels of cash and high levels of debt coming due (in the form of their bonds maturing) could lead them into bankruptcy if they are unable to find money to pay these obligations.
Cash Flow Statement:
“Cash is King” is an appropriate maxim for many investors. For a company to be financially stable, it should have plenty of cash on hand to cover operating expenses, pay off short-term liabilities, and invest in new projects. Healthy companies should also be able to generate positive cash flows over time. The cash flow statement offers a summary of the various sources (inflows) and uses (outflows) of cash during the reporting period. Even a solid company might report occasional net outflows. If a company used a lot of extra cash to pay down debt or invest in a new project, the temporary outflow might actually lead to larger net inflows in the future.
The cash flow statement helps shed light on whether the various inflows and outflows are signs of strength or weakness. Consistent net outflows are always troubling. If a company is not generating cash in the normal course of their business, they might face a vicious spiral where they’re forced to borrow more money to cover upcoming expenses. The cost of servicing additional debt reduces future cash flows and net income, possibly requiring even more borrowing just to stay afloat.