Investors use financial statements to analyze the financial condition of a company before choosing to invest their money. Common financial statements used to make investment decisions include the income statement, balance sheet and statement of retained earnings. Public companies must make financial statements available to the public according to rules established by the Securities and Exchange Commission. Understanding how to interpret the information presented in financial statements is imperative to making sound investment decisions.
The income statement helps investors evaluate management’s performance and estimate the future earnings of a company. Listed on an income statement is a company’s revenue, expenses, gains and losses for a particular period. Revenue, also called sales, includes money received for the sale of the company’s goods or services. Expenses, commonly referred to as operating expenses, are costs the company incurs related to sales. Revenue minus expenses equals a company’s net income. Gains and losses are increases and decreases in assets, not related to normal business operations.
Items on a company's balance sheet represent the basic accounting formula: assets minus liabilities equal shareholders’ equity. Assets represent items of value that a company can sell for a profit or used to produce items to sell. Common assets on a balance sheet include cash, accounts receivable and equipment. Liabilities include debt the company owes to others, such as the repayment of a loan to the bank. Shareholders’ equity represents the amount of money remaining, which belongs to the shareholders or owners, if the company’s sells all of its assets to pay its liabilities.
Retained earnings represent a portion of net income that the company keeps after dividends are paid to shareholders. The statement of retained earnings shows changes in a corporation’s retained earnings account for a certain period. The statement starts off by listing the beginning balance of retained earnings, which is the ending balance of the previous period. Net income is then added or net loss is subtracted from the beginning balance. The amount of dividends paid is also subtracted from the beginning balance. The total equals the ending balance of retained earnings for the period.
Investors use financial statements to construct financial ratios used for performing analysis. When compared to a company’s competitors, financial ratios can inform investors of the health, viability and overall performance of a company. Common financial ratios used by investors to evaluate stocks include price-to-earnings, debt-to-equity and price-to-book. Understanding how to properly read financial statements is vital to constructing useful financial ratios.
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