The Guide to Understanding Financial Statement - How to Read a Financial Statement

Income statements and balance sheets are two common annual financial statements. These reports contain information about a company’s performance that year and present a snapshot of the health of the company at a given point in time. Publicly traded companies are required to file them to the SEC and they are available to the public through EDGAR. Understanding the information contained in them can help an investor make better decisions. An income statement will always contain figures for revenue, cost of goods sold (COGS), selling, general, and administrative expense (SG&A), and earnings.

Revenue is gross income. It is the total income before any deductions are made for taxes, etc. COGS is the cost of purchasing raw materials and production costs. This is where accurate inventories are important because COGS equals the beginning inventory plus the cost of produced goods during the previous year, less the previous inventory. COGS figures show the cost of producing goods. These costs can show how well managed a firm is. SG&A expenses are the sum of salaries, commissions, and traveling costs for management and salespeople, advertising costs, and payroll costs. These figures also need to be controlled by management because, if they get out of control, they affect the profitability of the firm. Finally, earnings are the company’s revenue less expenses (COGS, SG&A, and taxes).

On the income statement these figures are easy to see because they are labeled just as described. Sometimes firms may refer to COGS as cost of sales, however.

The balance sheet is a snapshot of the firm’s health at a given point in time. The balance sheet has two parts: assets and liabilities. Asset items on the balance sheet are listed in the order of their liquidity or availability for use as company funds. Commonly listed asset items on the balance sheet are cash, accounts receivable, current assets, and fixed assets. We all know what cash is. Accounts receivable are debts owed to the firm. Accounts receivable are a current asset in that they are expected to be converted to cash within the year. Other current assets are cash, inventory, marketable securities, and prepaid expenses (rent, for example). Fixed assets are depreciated over time and are tangible, long-lived resources like plants and machinery. Liabilities are current liabilities (debts owed within the year), long term debt (payments over years), and equity (total value of shares owned by shareholders).

What’s most important to investors about the balance sheet is the book value of a stock can be determined from these lists of assets. Stockholder equity, or book value, represents the amount shareholders would theoretically receive if a firm went immediately out of business. Market value of the company is generally higher as firms do tend to make money. How much higher this market value is can help the investor determine if a stock is overvalued or, perhaps, undervalued.

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