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Unless you’re looking at a small private company with a simple business structure and few assets, their financial statements will look long and complicated to someone not used to reading them. But the great thing about financial statements is that they’re standardized; they all follow a specific set of standards (International Financial Reporting Standards for most public companies, or US GAAP for companies in the United States) which dictate how items should be disclosed, so once you know how to read one set of statements, you mostly know how to read them all. If you’re interested in gaining a high-level understanding of the company, you don’t have to read the financial statements from cover to cover like a book; there’s a much smarter way to do it.
Step 1: Obtain the financial statements.
Public companies will have their financial statements on their website for easy access, usually in an Annual Reports section like the following:
You can also search for the company on SEDAR for Canadian public companies and EDGAR for US public companies. And if you’re looking to compare companies, places like Yahoo Finance will have a Financials section which will provide the main financial statement line items to look for, which we’ll talk about in Steps 2 and 3.
Step 2: Skim the balance sheet/ statement of financial position.
All companies will have this. It should look something like the following:
The most important numbers here are the Assets and Equity of a company. The Assets represents the value of all things the company own, while the Equity represents the value of all things you would own the company, i.e. Assets deducting any Liabilities you owe to people who you have borrowed funds from. Hence, you’ll notice that on a set of financial statements, Assets always = Liabilities + Equity.
Step 3: Skim the income statement/ statement of changes in comprehensive income.
All companies will have this as well. It should look something like the following:
The most important umbers here are Revenue and Net Income. Revenue relates to how much money the business has brought in in terms of total sales value during the year, while Net Income relates to how much money the business gets to put into its pocket at the end of the year, after paying everyone it has to pay.
Items which is not disclosed in the income statement, but which you may wat to calculate for, are EBITDA and EBIT.
EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization
EBIT = Earnings Before Interest and Taxes
The reason EBIT is often considered more useful than simple Net Income is that interest and taxes can differ based on how the firm is financed, so are not reflective of the business’ operational ability. EBITDA takes it a step further by also excluding depreciation and amortization, which are accounting entries to smooth out the value of certain assets over time, rather than cash expenses.
Step 4: Look through the relevant note disclosures.
While the balance sheet and income statement (what are referred to as the “face” of the financial statements) may be only two pages long, the Notes behind the financial statements may be 10 or 20. You don’t have to read all these notes like a novel, but you should probably read Note 1. Note 1 will always be a description of the organization and nature of the business, which will provide you a high-level overview of what the business is all about, including the basic structure it is organized in.
If you are not accounting savvy, I recommend skipping Note 2 entirely; you will likely not care about what accounting policies the business is employing.
For the rest of the notes, pick and choose at your own leisure. A tip is to go back to the face of the financial statements and see if there are any line items you want to know more about. The relevant Notes relating to those line items will be listed next to the line item. For example, if there’s a Subordinated Note you noticed in the Liabilities section of the balance sheet which you’re wondering about, there may be a reference to Note 6, and you can skip right on there in the Notes without reading Notes 2-5.
Step 5: Consider calculating ratios.
So now you’ve essentially gone through the entirety of the financial statements. Is there anything else you should do to get a better understanding of the business? What I usually do is calculate some ratios. Here are the key ones:
|Interest coverage ratio||A ratio used to determine whether a company is making enough money to cover any interest payments. If this ratio is above 1, this means the company is not making enough and will likely default on its loans.||Interest expenses / EBITDA|
|Current ratio||This generally determines whether on a short-term basis the company has more assets than what is owes. A ratio below 1 spells trouble.||Current assets / Current liabilities|
|Quick ratio||An alternative to the current ratio, except inventory is not counted as part of current assets because oftentimes it is not easily liquidated.||(Current assets – Inventory) / Current liabilities|
|Return on equity||Represents the percentage return shareholders would receive on their investment into the company.||Net income / Shareholder’s equity|
|Earnings per share||Represents the dollar amount of the company’s earnings that you would have “earned” if you held one share of the company.||Net income / Number of shares outstanding|
Hopefully this post has made the idea of reading your first set of financial statements less terrifying. Let me know if there are any areas you would like me to clear up, or what other topic you’d want me to write about!