For stock investors, knowing how to work with the numbers in a company’s financial statements is an essential skill. The meaningful interpretation and analysis of the financial statements to determine a company’s investment qualities is the basis for smart investment decisions.
I’ll explain to you what the financial statements have to offer and how to use them for your benefit.
There are individual investors, who choose mutual funds as the vehicle of choice for their investing activities. Also, some individuals directly invest in stocks. Mutual funds are managed by professional fund managers and they decide the allocation of fund’s assets among various stocks based on the investment objectives. Therefore, in mutual funds, you can’t decide in which stock to invest.
But if you invest in stocks directly, you can decide which company to invest and this is where you should understand the financial statements better even though you get the service from an investment professional.
1. Components of Financial Statements
There are six main components of financial statements. They are the statement of financial position (balance sheet), the statement of comprehensive income (income statement and statement of other comprehensive income), the statement of cash flow, the statement of changes in equity, and notes to the financial statements.
- The balance sheet: tells you how strong the financial position of a company.
- The statement of other comprehensive income: shows you the financial performance of a company (whether the company is profitable or not).
- The statement of cash flow: shows you how a company has used cash and cash equivalents during the period.
- The statement of changes in equity: shows you the composition of the owner’s equity.
2. Key Accounting Frameworks
Generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS) are the main frameworks used to prepare financial statements and both are legal in the USA. And, GAAP is the most commonly used framework in the USA. But IFRS is the most commonly used framework across the world. Further, GAAP is more “rules-based,” and IFRS is more “principles-based.
When it comes to investment analysis, you should know how to transform absolute numbers into meaningful relationships and interpret those relationships to determine the financial position and the financial performance of a company.
4. Notes to the Financial Statements
Notes to the financial statements are an integral part of the financial statements. These mainly represent the accounting policies and other disclosure requirements of the reporting framework (GAAP or IFRS). Therefore you need to have a thorough understanding of the notes to the financial statements to analyze financial statements.
5. Consolidated Financial Statements
You can see consolidated financial statements in a group of company financial statements. This is the consolidation of the parent company and the companies in which the parent company has control or significant influence. If you are about to invest in a parent company of a group of companies it more meaningful to analyze the consolidated financial statements rather than analyzing separate financial statements of the parent.