by Joe Lan, CFA

Understanding financial statements is key to fundamental stock analysis and overall investment research. Financial statements provide an account of a companys past performance, a picture of its current financial strength and a glimpse into the future potential of a firm.

This is the first in a new AAII Journal series on financial statement analysis. The goal is to enhance your ability to make a sound judgment about a companys financial strength and future prospects by showing you the benefits of using financial statements in your personal investment research.

Given the varied financial knowledge of our readers, I will address many topics that some may find very basic. However, to build a strong understanding of advanced topics, you need a solid foundation. As we progress through this series, I expect to touch on more advanced topics when explaining how I personally use financial statements to analyze a firm. In this introductory article, I explain the major components of each financial statement and why they matter in security analysis.

Financial Statements and Their Key Elements

The role of financial reporting for companies is to provide information about their fiscal health and financial performance. As investors, we use financial reports to evaluate the past, current and prospective performance and financial position of a company. These statements allow us to compare one firm to another and form the basis of valuing the worth of a stock.

Several financial statements are reported by companies. The most important three, and the three used most often by investors, are:

• the income statement,
• the balance sheet and
• the cash flow statement.

Income Statement

The income statement reports how much revenue the company generated during a period of time, the expenses it incurred and the resulting profits or losses. The basic equation underlying the income statement is:

revenue expenses = income

All companies use a reporting period of one year, which can start and end at the same time as a calendar year, or could start and end at different point in the year (the firms fiscal year).

There are several important pieces of information on the income statement that are relevant to stock analysis. Investment analysts use the income statement to monitor revenues, expenses and profits and their trends over time. The direction and rate of change in not only profits but also top-line revenue influence the valuation of the firm. The rate of growth, and whether it is accelerating or decelerating, for both revenue and net income, is a critical component in stock valuation. Investors often reward high-growth companies with a higher valuation.

Near the bottom of the income statement is earnings per share. Earnings per share is simply the earnings the company generated per share of outstanding company stock. This is the figure used in the denominator of the price-earnings ratio, a key ratio used frequently in investment analysis.

Source: 2010 Kellogg Company Form 10-K.

An example of an income statement can be seen in Figure 1. This is a consolidated statement from cereal maker Kellogg Company (K), meaning that results from the companys divisions and subsidiaries are included in the results. The statement is also condensed, meaning that some line items have been grouped together for the purpose of brevity.

You can conduct a preliminary analysis by looking the very top and near the bottom of the statement. The first line reports revenue (labeled net sales on Kelloggs statement). Near the bottom you see the net income line and the earnings per share section (labeled per share amounts on Kelloggs statement). You want to see these numbers increasing over time.

Balance Sheet

Although the income statement may be the most popular financial statement, the balance sheet provides vital information on a companys financial position. In contrast to the income statement, which provides revenue and earnings data over a period of time, the data contained in the balance sheet is a snapshot for a specific date.

The balance sheet provides information on what a company owns (assets), what it owes (liabilities), and the shareholder ownership interest (equity). The equation underlying the balance sheet is:

assets = liabilities + equity

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Analysts use balance sheets to determine trends in assets and liabilities and to ascertain how adequately the firm is financed. For example, trends in inventory (an asset) and supplier invoices (accounts payable, a liability) can provide insight on product demand and the ordering patterns of the firm. An increase in inventory can suggest that a company is gearing up for an expected increase in product demand. However, analysts must be cognizant that holding too much inventory can be problematic.

In addition, the balance sheet shows changes in a firms debt and provides clues as to whether the firm is becoming too highly levered. The shareholders equity determines the valuation of a firm by providing the book value (which is used as the denominator in the price-to-book ratio), or theoretical value left for the shareholders in event of liquidation.

An example of a balance sheet is presented in Figure 2. (Again, Kellogg is using a consolidated statement.) The top half is always assets, led with the cash balance on the first line. The second half shows liabilities, including long-term debt. At the very bottom is equity. As the company grows, so should equity. Small fluctuations will occur from year to year, however, because the balance sheet tabulates assets and liabilities for a single day.