Take time to study financial statements before investing

Jul 14, 2009 | | Posted in Finances Invest

The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.

In order to invest in a company, you should understand and be familiar with the various financial statements of the company to know where it stands. Like Cuba Gooding Jr. once said “Show me the money” in one of his movies, you must ask the company the same question and be satisfied with the answer before you pour your hard-earned money into it.

There are four major financial statements that you should know about.

Balance sheet
A company owns (assets), owes (liabilities) and is owned (shareholders’ equity). A balance sheet puts them together in the form of a formula:

Assets = Liabilities + Shareholders’ Equity

The accountants and financial gurus must balance them out.

Income statement
The company has revenues and expenses. An income statement puts them together in the form of a formula:

Net worth = Revenue – Expenses

Revenue is frequently known as top line and net worth as bottom line. If net worth is negative – expenses are more than revenue – then the company is in the red, meaning it loses money. To be in the black, its expenses must be less than its revenue.

The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time.

Cash flow statement
The cash can travel in two directions – cash coming in and cash going out. There is a third direction called black hole where cash disappears. There are also non-cash transactions on this statement, for example, depreciation or write-offs on bad debts.

Statements of shareholders’ equity
Shareholders’ equity is the investment and usually comes from two sources:

External investments in the company.
Internal retained earnings through its operations.

In a Nutshell
There are other things you must consider before investing in a company. For example,

Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity
Debt is good as long as it’s manageable even if it is more than the shareholder’s equity.
price-to-earnings ratio (P/E)
A higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.

So before you talk to your financial adviser, educate yourself, understand as much as you can about a company before investing in it.

Information contained herein is general in nature, and is provided for informational and educational purposes only. Past performance is no guarantee of future results. Talk to your financial adviser.