June 2, 2020
How to Read Company Financial Statements
An important part of analysing a company for a potential investment is understanding their past, current and potential future financial situation.
There are a number of different ways to analyse the financial statements, but before you get to that stage, you need to know how to read them so you know what you’re looking at.
In this article, we’ll go through the basics of a financial statement and explain the key sections so you can see how straightforward it really is. Each line item within the section will be relatively self explanatory once you know how the overall structure works.
As an example for this article, we’ll be looking at the latest quarterly results from Tesla.
It’s important to note that financial statements may differ slightly depending on the company or the country they report in. However, for US listed companies like Tesla the financial statements would be included in the 10-K and 10-Q filings which are mandatory for all publicly traded companies in the US by the SEC.
The 10-K is an annual statement and the 10-Q is quarterly. The 10-K will provide more information about the company and it is audited, so the information you see in it will be more dependable and accurate.
The financial statements of a company are usually made up of three main statements: the balance sheet, the income statement and the cash flow statement.
The balance sheet is typically the first statement to appear and gives a snapshot of the company’s assets, liabilities and shareholders equity at a specific point in time. These three aspects make up what is known as the Balance Sheet Equation, also known as the accounting equation.
The balance sheet is split into five sections;
- Current assets
- Non-current assets (also known as long-term assets)
- Current liabilities
- Non-current liabilities (also known as long-term liabilities)
- Equity (also known as shareholders’ equity or shareholders funds)
Let’s start by looking at the assets. These will be listed in order of how liquid they are, which means how easily they can be changed into cash.
Current assets are assets that are expected to be either used or sold within the next year. This will include things such as cash, cash equivalents, money owed by customers, inventory, and goods and services that have been paid for but not yet used.
Non-current assets are assets that are not expected to be sold or used within the next year. Tesla includes things such as lease vehicles and solar energy systems but there are more common items also listed such as Property, Plant and Equipment along with leases, intangible (in other words, non-physical) assets and goodwill.
The next section shows the liabilities. We have current liabilities which are obligations due within the next year and includes things like money owed to suppliers, money that has been paid but the goods or service is yet to be delivered and the portion of long-term debt that’s due to be repaid this year.
Then we have non-current liabilities, obligations not due within the next year which includes long-term debt and money received for goods or services not yet delivered.
The last section is equity, which is often referred to as shareholders' equity or shareholders' funds.
You can think of this as being whatever would be left over for shareholders if all assets were liquidated and all liabilities met. Therefore, if the figure is positive it means the company has enough assets to cover its liabilities. If it’s negative it doesn’t.
Shareholders' equity will include information about shares that were issued, any capital paid-in by shareholders paying for shares in the company and retained earnings, which is money accumulated from the company’s earnings.
The next financial statement is the income statement, this is also known by many other names including Statement of Operations and Profit and Loss Statement.
This statement is going to show us the earnings and expenses of a company over a specific period of time.
This is important to keep in mind: the balance sheet was a snapshot at a particular point in time, whereas the income statement is looking at what happened over a specific period of time. So the income statement is helping us see a company’s financial performance.
Companies will structure the income statement differently but listed companies like Tesla will typically follow a multi-step income statement which separates the operating revenue and expenses from those coming from non-operating activity.
So we’re looking at:
- Gross profit
- Operating income or loss
- The income or loss before taxes
- The income or loss after taxes.
To get to the gross profit we would typically look at total revenue minus the cost of that revenue.
We can then look at operating expenses. Things like Research and Development for creating new products, Selling, General and Administrative expenses, which are all the costs not directly involved in production of a product or service but needed for the day to day business operations including rent, salaries for executives and other management expenses, admin staff and basically any non-salespeople.
We can then look at any interest paid or received to find out income or loss before taxes.
Then finally the income or loss after taxes.
Cash Flow Statement
The third of the three major parts of a financial statement is the cash flow statement. The income statement that we just looked at may show us the profit or loss generated during a period, but that doesn’t necessarily equal cash.
A company will need cash to survive. So the cash flow statement is going to help by giving information about a company’s liquidity and solvency.
The cash flow statement will tell us the amount of cash or cash equivalents coming into the company or leaving the company, therefore showing us how much cash is on hand for a company.
The cash flow statement is usually split into three sections.
- Cash from operations
- Cash from investing activities
- Cash from financing activities.
Cash From Operations
The first section shows us the cash flow from the primary revenue-generating activities of a company. So this includes the company’s products or services. Things like cash from sales, rent payments, salary payments and so on. Cash flows from current assets and current liabilities.
Cash From Investing Activities
The focus here is on acquiring or getting rid of long-term assets. This will show us outflows due to investments made in things like property and inflows when assets are sold. However, this statement doesn’t detail the investments and so the quality of them can’t be assessed.
Cash From Financing Activities
This shows us cash coming in or going out due to any equity capital or borrowings. It tracks cash flow between the company, its owners, creditors and lenders, including stockholders.
So there you have it. Simple isn’t it?
Those are the main sections of the three main statements that make up a company’s financial statements. The balance sheet, income statement and cash flow statement.
I’d recommend downloading the financial statements of companies from different industries and seeing how they differ from one another and whether you can read them now and get a better understanding of what’s going on.