When the stock market boomed in the 1920s, investors essentially had to fly blind in deciding which companies were sound investments because at the time, most businesses had no legal obligation to reveal their finances. After the 1929 market crash, reforms were enacted to help prevent a repeat disaster. To this day these reforms require publicly traded companies to regularly disclose certain details about their operations and financial position.
The income statement, balance sheet, and statement of cash flows are required financial statements and informative tools that traders can use to analyze a company’s financial strength and provide a quick picture of a company’s financial health and underlying value.
This section will provide a quick overview of the information that you can glean from these important financial statements without requiring you to be an accounting expert.
Statement #1: The income statement
The income statement makes public the results of a company’s business operations for a particular quarter or year. Through the income statement, you can witness the inflow of new assets into a business and measure the outflows incurred to produce revenue.
Profitability is measured by revenues (what a company is paid for the goods or services it provides) minus expenses (all the costs incurred to run the company) and taxes paid.
The income statement is read from top to bottom, starting with revenues collected. Expenses and costs are subtracted, followed by taxes. The end result is the company’s “net income”—or profit—before paying any dividends.
Example Income statement for YYZ Corp.* for the year ending Dec. 31, 2013 (in millions)
|Cost of goods sold||(250)||(190)|
|Taxes on income||(15)||(20)|
|Average common shares outstanding (in millions)||25||25|
|Earnings per share (EPS)||$3.00||$2.00|
|Dividends declared per common share||$.050||$.045|
* YYZ Corp. is a hypothetical example used for illustrative purposes only
As you can see, in this example, net income declined from $75 million to $50 million.
The next line in the income statement after Net Profit displays the average number of common shares of the company’s stock actually held by investors. Next comes the firm’s earnings per share, which is calculated simply by dividing net income by the number of shares outstanding.
Finally, the last line shows the dividends declared per common share, or the cash payment per share the company makes to stockholders. The payment and amount of dividends are made at the discretion of the company’s board of directors.
Statement #2: The consolidated balance sheet
Whereas the income statement is a record of a company’s revenue stream over a given time period, the balance sheet is a snapshot of a company’s financial position at a given point in time. In other words, the balance sheet shows what a company owns (assets) and owes (liabilities) and the difference between the two (stockholders' equity). This difference represents the book value of the stockholders’ stake in the company. It’s called a balance sheet because both sides of the equation have to be balanced as follows: Assets = liabilities + stockholders’ equity.
The balance sheet lists assets held by the company and displays:
- The portion of those assets financed with debt (liability).
- The portion of equity (retained earnings and stock shares).
- Assets listed in order from the most liquid to the least liquid (i.e., assets that can be most quickly converted to cash are listed first).
- Liabilities listed in order of immediacy (i.e., those that have the most senior claim on a firm’s assets are listed first).
Balance Sheet for YYZ Corp. for the year ending Dec. 31, 2013 (in millions)
|Assets||Liabilities and owners' equity|
|Current assets||Current liabilities|
|Accounts receivable||$50||Short-term debt||$20|
|Total current assets||$172||Total current liabilities||$50|
|Long-term assets||Long-term liabilities|
|Total long-term assets||$320|
|+Additional paid-in capital||$148|
|=Total shareholders' equity||$242|
|Total assets||$492||Total liabilities and owners' equity||$492|
The amount by which assets exceed liabilities is listed as “Total stockholders’ equity” and represents the net worth of a company, or the book value of the stockholders’ stake in the firm. Stockholders’ equity includes common stock, additional paid-in capital and retained earnings.
Statement #3: The statement of cash flows
Much like the income statement, the statement of cash flows reflects a company’s financial activity over a period of time. It shows where a company’s cash comes from and how it’s used to pay for operations and/or to invest in the future. By showing how a company has managed the inflow and outflow of cash, the statement of cash flows paints a better picture of a company’s liquidity (the ability to pay bills and creditors and fund future growth) than the income statement or the balance sheet.
Statement of cash flows for YYZ Corp. for the year ending Dec. 31, 2013 (in millions)
|Plus decrease in receivables (less increase)||$(20)|
|Less increase in inventories||$(10)|
|Plus increase in accounts payable (less decrease)||$0|
|Net increase (decrease) in cash from operations||$15|
|Less purchase of equipment||$(150)|
|Net increase (decrease) in cash||$(35)|
|Cash at beginning of year||$127|
|Cash at end of year||$92|
Cash flow from operations
Cash flow from operations starts with net income and adjusts out all non-cash items. Income and expenses on the income statement are recorded when a company earns revenue or incurs expenses, not necessarily when cash is received or paid. To figure out how much cash a company received or spent, adjust net income for any sales or expenditures made on credit and not yet paid with cash. Similarly, the depreciation of owned assets is added back to net income, as this expense is not a cash outflow.
Cash flow from investing and financing
Cash flow from investing includes cash received from or used for investing activities, such as buying stock in other companies or purchasing additional property or equipment. Cash flow from financing activities includes cash received from borrowing money or issuing stock and cash spent to repay loans.
Sizing up operating performance
Of the main sources of cash flow, analysts look to flow from operations as the most important measure of performance. Also, a decrease in cash flow due to a sharp increase in inventory or receivables can signal that a company is having trouble selling products or collecting money from customers.
The stock price for a given company can advance or decline based on a wide variety of factors. However, companies that perform well financially by increasing their earnings, net worth, and cash flow are typically rewarded with a higher stock price over time. When it comes to trading, knowledge is power. As a result, even traders who generally rely on technical factors to make their trading decisions may benefit from learning to use standard financial statements to zero in on companies that are experiencing strong and/or improving fundamentals.