The Balance uses cookies to provide you with a great user experience. Return on equity = Net income divided by Shareholders’ equity. As you know, public companies report net income in their income statements. How do you like that? Return on sales tests how efficiently a company is running its operations by measuring the profit produced per dollar of sales. Here are some questions to focus on: One last point: Put a company’s profit performance in the context of general economic conditions. Return on equity measures how well a company earns money for its investors. Don’t let a financial report bamboozle you. Use the following formulas to make sure a company has plenty of cash to keep operating. To make sense of financial statements, you need at least a rudimentary understanding of financial statement accounting. As opposed to the 10K filings (see below), annual reports are often easier for the average reader to digest. You can find the bottom line in the income statement and compare this profit number with other relevant numbers in the financial statements. Price/earnings ratio = Market value per share of stock divided by Earnings per share of stock. You can read the amount of cash in the balance sheet. The book value per share of a private company is the closest proxy you have for the market value of its ownership shares. Click on the links to dive … The main reason to become informed about the financial performance and condition of a business is because you have a stake in the business. Current ratio = Current assets divided by Current liabilities. In short, financial statements are iffy to some extent. Is there any doubt it can pay its bills on time?”. The income statement is important because you can use it along with the balance sheet to calculate the return you are earning on your investment. By Consumer Dummies . There’s no getting around this limitation of accounting. The operating margin looks at how well a company controls costs, factoring in any expenses not directly related to the production and sales of a particular product. Sometimes called the profit and loss (P&L) statement, the income statement shows you money coming in the door (revenue), money going out the door (expenses), and what's left over (income, or profit). Many income statements start out normally: sales revenue less the expenses of making sales and operating the business. This might do in a pinch. You can compare reading a business’s financial report with shucking an oyster: You have to know what you’re doing and work to get at the meat. This guide will teach you how to sort through all the different forms and entries to find the financial information you're seeking. But cash flow from making profit is the spigot that should always be turned on. Read the last line of the income statement. A ratio of 10 means that for every $1 in company earnings per share, people are willing to pay $10 per share to buy the stock. The higher the EPS, the higher the market value for a public company. Instead, they'd want to calculate the diluted earnings per share, which captures a more complete picture of the company's financial health as it relates to you, the shareholder.. This guide will teach you how to sort through all the different forms and entries to find the financial information you're seeking. Strictly speaking, therefore, the bottom line of a public company is its EPS. Even if a business has a couple billion bucks in the bank, you should ask, “How does its solvency look? Financial statements will tell you how much money the operation has stashed away, how much debt is owed, the income coming in each month, and the expenses going out the door. Be warned, however, that these letters from the top dog often are self-congratulatory and typically transfer blame for poor performance on factors beyond the control of the managers. How to Read Financial Statements for Dummies. The market value of ownership shares of a public company depends mainly on its EPS. Some of the most important ratios to start with include the price-to-cash-flow ratio (and its close relative, the price-to-earnings ratio), the asset turnover ratio, and the current ratio. Of course, when it comes to the annual report, you don’t need to read everything, just the key parts. Reports to the government are more extensive than the glossy reports sent to shareholders. Understanding Your 401(k) Retirement Plan, How to Read and Understand Financial Statements, Formulas, Calculations, and Financial Ratios for the Income Statement, A Beginner's Guide to Income Statement Analysis for Investors. What Is "Income Before Tax" on Income Statements? A business earns profit by making sales and by keeping expenses less than sales revenue, so the best place to start in analyzing profit performance is not the bottom line but the top line: sales revenue. For example, if a company is on the verge of a new merger or acquisition, the earnings per share (EPS) could be a misleading measurement for investors. There’s a lot more to investing than reading financial reports. Now, you would naturally think that if net income increases, say, 10 percent over last year, then EPS would increase 10 percent. However, there are different ways of calculating the same numbers. A high return on assets usually means the company is managing its assets well. Body: This example financial report is designed for you to read from the top line (sales revenue) and proceed down to the bottom line (net income). Free cash flow shows you how much money a company earns from its operations that can actually be put in a savings account for future use. You could blithely assume that these things happen to a business only once in a blue moon and should not disrupt the business’s ability to make profit on a sustainable basis. In contrast, the financial reports of most private companies are significantly smaller; they contain financial statements with footnotes and not much more. Return on assets = Net income divided by Total assets. The financial success or failure of the business makes a difference to you. There’s no way around this demand on financial report readers. It usually includes much more information than the annual report, including both an income statement and a balance sheet. Instead of simply saying how much debt the company has, for example, these statements will break down exactly where each of its debt obligations lies—whether it's in deferred taxes, short-term loans, or overhead costs. Quick ratio = Quick assets divided by Current liabilities. Berkshire Hathaway. Each section gives a brief introduction to a form or concept. You read financial reports to get a sense of a company’s financial position and how viable it is in the marketplace. As you become more familiar with financial statements, you may start catching some of these ways that ratios are more misleading than they may seem at first. Get in the right frame of mind. Heading: Identifies the business, the financial statement title, and the time period summarized by the statement. A business needs this cash flow to make cash distributions from profit to shareowners, to maintain liquidity, and to supplement other sources of capital to grow the business. Get in the right frame of mind. The annual financial reports of public companies contain lots of information: a letter from the chief executive, a highlights section, trend charts, financial statements, extensive footnotes to the financial statements, historical summaries, and a lot of propaganda. Joshua Kennon co-authored "The Complete Idiot's Guide to Investing, 3rd Edition" and runs his own asset management firm for the affluent. Current cash debt coverage ratio lets you know whether a company has enough cash to meet its short-term needs. Part of the test of a viable operation is having enough cash to keep the company going. You can find the bottom line in the income statement and compare this profit number with other relevant numbers in the financial statements. You need a good reason to pry into a financial report.