Financial statements provide a snapshot of a corporation's financial health at a particular point in time, giving insight into its performance, operations, cash flow, and overall conditions. Shareholders need them to make informed decisions about their equity investments, especially when it comes time to vote on corporate matters.

There are a variety of tools shareholders have at their disposal to make these equity evaluations. In order to make better decisions, it is important for them to analyze their stocks using a variety of measurements, rather than just a few. Some of the metrics available include profitability ratios, liquidity ratios, debt ratios, efficiency ratios, and price ratios.

Key Takeaways

  • Financial statements provide a snapshot of a corporation's financial health, giving insight into its performance, operations, and cash flow.
  • Financial statements are essential since they provide information about a company's revenue, expenses, profitability, and debt.
  • Financial ratio analysis involves the evaluation of line items in financial statements to compare the results to previous periods and competitors.

Understanding the Need for Financial Statements

Financial statements are the financial records that show a company's business activity and financial performance. Companies are required to report their financial statements on a quarterly and annual basis by the U.S. Securities and Exchange Commission (SEC). The SEC monitors the markets and companies to ensure that everyone is playing by the same rules and that markets function efficiently. There are specific guidelines that are required by the SEC when issuing financial reports so that investors can analyze and compare one company with another easily. 

Financial statements are important to investors because they can provide enormous information about a company's revenue, expenses, profitability, debt load, and the ability to meet its short-term and long-term financial obligations. There are three major financial statements.

Balance Sheet

The balance sheet shows a company's assets (what they own), liabilities (what they owe), and stockholders' equity (or ownership) at a given moment. 

Income Statement

The income statement reports the revenue generated from sales, the operating expenses involved in creating that revenue as well as other costs, such as taxes and interest expense on any debt on the balance sheet. The net amount or the bottom line of the income statement is the net income or the profit for the period. Net income is revenue minus all of the costs of doing business. 

Cash Flow Statement

The cash flow statement (CFS) measures the cash generated for a period, including all of the transactions that added to or subtracted from cash. Cash flow is important because it shows how much cash is available to meet short-term obligations, invest in the company, or to pay dividends to shareholders. Dividends are typically cash payments to shareholders as a perk for investing the company. 

Financial Ratios

Financial ratios help investors break down the enormous amount of financial data that's reported by companies. A ratio is merely a metric to help analyze the data and make useful comparisons with other companies and other reporting periods.

Financial ratio analysis analyzes specific financial line-items within a company's financial statements to provide insight as to how well the company is performing. Ratios determine profitability, a company's indebtedness, the effectiveness of management, and operational efficiency.

It's important to consider that the results from financial ratios are often interpreted differently by investors. Although financial ratio analysis provides insight into a company, they should be used in tandem with other metrics and evaluated against the overall economic backdrop. Below are some of the most common financial ratios that investors use to interpret a company's financial statements.

Profitability Ratios

Profitability ratios are a group of financial metrics that show how well a company generates earnings compared to its associated expenses. However, investors should take care not to make a general comparison. Instead, they will get a better sense of how well a company is doing by comparing ratios of a similar period. For example, comparing the fourth quarter of this year with the same quarter from last year will net a better result.

Return on Equity

Return on equity, or ROE, is a common profitability ratio used by many investors to calculate a company's ability to generate income from shareholders' equity or investments. Companies issue shares of stock to raise capital and use the money to invest in the company. Shareholders' equity is the amount that would be returned to shareholders if a company's assets were liquidated, and all debts were paid off. The higher the return or ROE, the better the company's performance since it generated more money per each dollar of investment in the company.

Operating Margin

Operating profit margin evaluates the efficiency of a company's core financial performance. Operating income is the revenue generated from a company's core business operations. Although operating margin is the profit from core operations, it doesn't include expenses such as taxes and interest on debt.

As a result, operating margin provides insight as to how well a company's management is running the company since it excludes any earnings due to ancillary or exogenous events. For example, a company might sell an asset or a division and generate revenue, which would inflate earnings. Operating margin would exclude that sale. Ultimately, the operating profit is the portion of revenue that can be used to pay shareholders, creditors, and taxes.

Liquidity Ratios

Liquidity ratios help shareholders determine how well a company handles its cash flow and short-term debts without needing to raise any extra capital from external sources, such as a debt offering.

Current Ratio

The most commonly used liquidity ratio is the current ratio, which reflects current assets divided by liabilities, giving shareholders an idea of the company's efficiency in using short-term assets to cover short-term liabilities. Short-term assets would include cash and accounts receivables, which is money owed to the company by customers. Conversely, current liabilities would include inventory and accounts payables, which are short-term debts owed by the company to suppliers.

Higher current ratios are a good indication the company manages its short-term liabilities well and generates enough cash to run its operation smoothly. The current ratio generally measures if a company can pay its debts within a 12-month period. It can also be useful in providing shareholders with an idea of the ability a company possesses to generate cash when needed.

Debt Ratios

Debt ratios indicate a company’s debt situation and whether they can manage their outstanding debt as well as the debt servicing costs, such as interest. Debt includes borrowed funds from banks but also bonds issued by the company.

Bonds are purchased by investors where companies receive the money from the bonds upfront. When the bonds come due–called the maturity date–the company must pay back the amount borrowed. If a company has too many bonds coming due in a specific period or time of the year, there may not be enough cash being generated to pay the investors. In other words, it's important to know that a company can pay its interest due on their debt, but also it must be able to meet its bond maturity date obligations.

Debt-to-Equity Ratio

The debt-to-equity ratio measures how much financial leverage a company has, which is calculated by dividing total liabilities by stockholders' equity. A high debt-to-equity ratio indicates a company has vigorously funded its growth with debt. However, it's important to compare the debt-to-equity ratios of companies within the same industry. Some industries are more debt-intensive since they need to buy equipment or expensive assets such as manufacturing companies. On the other hand, other industries might have little debt, such as software or marketing companies.

Interest-Coverage Ratio

The interest coverage ratio measures the ease with which a company handles interest on its outstanding debt. A lower interest coverage ratio is an indication the company is heavily burdened by debt expenses.

Efficiency Ratios

Efficiency ratios show how well companies manage assets and liabilities internally. They measure the short-term performance of a company and whether it can generate income using its assets.

Inventory Turnover

The inventory or asset turnover ratio reveals the number of times a company sells and replaces its inventory in a given period. The results from this ratio should be used in comparison to industry averages. Low ratio values indicate low sales and excessive inventory, and therefore, overstocking. High ratio values commonly indicate strong sales and good inventory management.

Valuation Ratios

Price ratios focus specifically on a company's stock price and its perceived value in the market. The price/earnings (or P/E) ratio is an evaluation metric comparing the current share price of a company’s stock with its per-share earnings. Higher P/E values indicate investors expect continued future growth in earnings. However, a P/E that's too high could indicate that the stock price is too high relative to the earnings or profit being generated. Investors use the P/E ratio to evaluate whether the stock price is fairly valued, overvalued, or undervalued.

The P/E ratio is most helpful when compared to historical P/Es of the same company and companies within the same industry.

Dividend Yield

The dividend yield ratio shows the amount in dividends a company pays out yearly in relation to its share price. The dividend yield provides investors with the return on investment from dividends alone. Dividends are important because many investors, including retirees, look for investments that provide steady income. Dividend income can help offset, at least in part, losses that might occur from owning the stock. Essentially, the dividend yield ratio is a measurement for the amount of cash flow received for each dollar invested in equity.

The Bottom Line

There is no one indicator that can adequately assess a company's financial position and potential growth. That is why financial statements are so important for shareholders and market analysts alike. These metrics (along with many others) can be calculated using the figures released by a company on its financial statements.