In reality, you may be surprised to find many stocks valuations are far more higher than its' long term ability to create cash profit from invested capital. However, the financial statements are crafted to give its readers a snapshot of how successful this creation of value is being accomplished. In this connection, you will encounter with odd terminology. Hence, you are advised to get a professional accountant to assist you.
Its financial statement explains three major components as listed below:-
1. Income Statement
It attracts the company's stakeholders’ attention because it shows the company's "bottom line": its earnings, or profit. Most of the income statement details the company's operations. Through comparison of its current and preceding year earnings, you will find out whether its earnings is growing or declining. If you find both the figures for sales and operating expenses are also higher, then it is likely indication that the company is growing physically as well. In order to generate more money, it is increasing its capacity to produce more of whatever it sells.
One important thing that the income statement doesn't show is how the company is paying for this growth. To find that, you need to look at the cash flow statement.
2. Cash Flow Statement
The Cash Flow Statement shows how the company is paying for its operations, by detailing the "flow" of cash between the company and the outside world. The positive numbers represent cash flowing in, whereas the negative numbers represent cash flowing out from the company. The operations mean "making" money by selling its goods and services.
Whereas the other two sections of the cash flow statement, Financing, and Investing, reflect the other two ways the company obtain its cash. Financing means "raising" money by issuing shares and bonds. The third section shows how the company is funding its investments for future growth. Usually investors prefer the stock of company who can pay its investment out of its operations rather than turn to "financing". This is because financing will have impacts to the company bottom line. Issuing new stocks will lower the value of each individual share whereas issuing bonds commits them to making interest payments which will punish future earnings.
This company has a very "healthy" cash flow if its operations cash inflow is more than sufficient to cover cash used for investing.
Here it begins with "net" earnings from the income statement and then adjusting it by removing all components that do not entail actual cash flow. For instance depreciation, which is a "paper" expense has been taken out of earnings. So by adding it back in, you're removing its effect.
3. Balance Sheet
The balance sheet reflects its assets, which is what a company owns, and its liabilities, which is what it owes. Their difference is the company's net worth, on paper. The catch here is that the fair market value of many assets can be very different from the "book values" shown here. As such, people looking for "value" stocks need to do more research, beyond the balance sheet.
Generally, investors prefer its current assets are greater than current liabilities by a comfortable margin. To be more conservative, they often exclude inventory from current assets when they calculate this computation. This indicates that the company is likely to suffer a cash shortage during the following year, which may force the company to issue new stocks or bonds to survive.
In short, Assets - Liabilities = Equity or Net Worth, just by the definition of equity. A balance sheet will also show how equity has actually been "built up" over the years, from stock sales and retained earnings.
However, another important issue which the balance sheet does not take into consideration is its human assets such as the relationship between its management and its employees.
Having said the above, the notes to the accounts should not be ignored as they formed part of the financial statement. The note will tell you about the principal accounting standards adopted by the company. Material litigation and contingency liabilities of the company are also stated in the notes of the accounts.
Hope the above discussion gives you a good insight as how to read financial statements. Please do not hesitate to contact me should you need any clarification.
Wishing you have a fruitful investment and look forward to hearing from you again,