Fundamental Analysis: Introduction to Financial Statements
By Ben McClure
The massive amount of numbers in a company's financial statements can be bewildering and intimidating to many investors. On the other hand, if you know how to analyze them, the financial statements are a gold mine of information.
Financial statements are the medium by which a company discloses information concerning its financial performance. Followers of fundamental analysis use the quantitative information gleaned from financial statements to make investment decisions. Before we jump into the specifics of the three most important financial statements - income statements, balance sheets and cash flow statements - we will briefly introduce each financial statement's specific function, along with where they can be found.
The Major Statements
The Balance Sheet
The balance sheet represents a record of a company's assets, liabilities and equity at a particular point in time. The balance sheet is named by the fact that a business's financial structure balances in the following manner:
|Assets = Liabilities + Shareholders\' Equity
Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business - including retained earnings, which is the profit made in previous years.
The Income Statement
While the balance sheet takes a snapshot approach in examining a business, the income statement measures a company's performance over a specific time frame. Technically, you could have a balance sheet for a month or even a day, but you'll only see public companies report quarterly and annually.
The income statement presents information about revenues, expenses and profit that was generated as a result of the business' operations for that period.
Statement of Cash Flows
The statement of cash flows represents a record of a business' cash inflows and outflows over a period of time. Typically, a statement of cash flows focuses on the following cash-related activities:
The cash flow statement is important because it's very difficult for a business to manipulate its cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it's tough to fake cash in the bank. For this reason some investors use the cash flow statement as a more conservative measure of a company's performance.
- Operating Cash Flow (OCF): Cash generated from day-to-day business operations
- Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets
- Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds
10-K and 10-Q
Now that you have an understanding of what the three financial statements represent, let's discuss where an investor can go about finding them. In the United States, the Securities And Exchange Commission (SEC) requires all companies that are publicly traded on a major exchange to submit periodic filings detailing their financial activities, including the financial statements mentioned above.
Some other pieces of information that are also required are an auditor's report, management discussion and analysis (MD&A) and a relatively detailed description of the company's operations and prospects for the upcoming year.
All of this information can be found in the business' annual 10-K and quarterly 10-Q filings, which are released by the company's management and can be found on the internet or in physical form. (For more information, see Where can I find a company's annual report and its SEC filings?)
The 10-K is an annual filing that discloses a business's performance over the course of the fiscal year. In addition to finding a business's financial statements for the most recent year, investors also have access to the business's historical financial measures, along with information detailing the operations of the business. This includes a lot of information, such as the number of employees, biographies of upper management, risks, future plans for growth, etc.
Businesses also release an annual report, which some people also refer to as the 10-K. The annual report is essentially the 10-K released in a fancier marketing format. It will include much of the same information, but not all, that you can find in the 10-K. The 10-K really is boring - it's just pages and pages of numbers, text and legalese. But just because it's boring doesn't mean it isn't useful. There is a lot of good information in a 10-K, and it's required reading for any serious investor.
You can think of the 10-Q filing as a smaller version of a 10-K. It reports the company's performance after each fiscal quarter. Each year three 10-Q filings are released - one for each of the first three quarters. (Note: There is no 10-Q for the fourth quarter, because the 10-K filing is released during that time). Unlike the 10-K filing, 10-Q filings are not required to be audited. Here's a tip if you have trouble remembering which is which: think "Q" for quarter.
Fundamental Analysis: Other Important Sections Found in Financial Filings