Correctly reading a business's financial statements—including profit and loss reports, balance sheets, cash flow statements, and statements of shareholders' equity—can tell you if investing is a good decision.
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Interested in playing the stock market? You're not alone: around 55% of US citizens own stock in a publicly traded company. 1 But out of the thousands of companies on the New York Stock Exchange, which one offers the best investment?
Publications like U.S. News, Forbes, and Investopedia recommend stocks to invest in each month. But while you should definitely take professional stock recommendations into account, it's best to read a company's financial documents yourself before putting any money into their business. Below, we explain how to understand the financial documents that are required reading for any investor.
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An income statement showcases a business's profitability over a specific time period, usually over the course of a fiscal year. You might also hear income statements referred to as profit and loss (P&L) statements, statements of earnings, or statements of operations.
At the top, the statement breaks the company's revenue down by source—for most businesses, that means the sales of goods, services, or both. A detailed statement lists revenue by month as well, showing you not just how the company earns income but when the business is most profitable. The revenue section ends by totaling each source of income to show the company's net profit.
The next section lists the company's direct costs, or costs of goods sold (COGS), which covers all costs that stem directly from creating and selling a product. For instance, a tech company's COGS would include the cost of manufacturing each component of a phone, computer, or tablet, from the screen to the keyboard. The section ends by totaling the direct costs, which are subtracted from the net profit to calculate a company's gross profit.
A company's gross profit shows, in dollar amount, how much a company earns from product sales after accounting for the direct costs of product production. The gross profit margin isn't usually listed on the statement itself, so you'll likely need to calculate the percentage yourself. The formula for gross profit is as follows:
gross profit = revenue – direct costs
In contrast, the gross profit margin represents a company's gross profit as a percentage point. The formula for gross profit margin looks like this:
gross profit margin = (revenue – direct costs)/revenue
The higher the gross profit margin, the more a company is making on each sale. To understand a company's profitability, you need to look at both numbers—a business might have a positive gross profit but a low profit margin, which could mean the company is neither efficient nor particularly profitable.
After the gross profit, you'll see a list of the company's indirect expenses, or non-production costs. These expenses could include the following:
Depreciation refers to the way physical assets lose value over time while amortization refers to the way intangible assets like copyrights also lose value over time. Companies list depreciation and amortization (D&A) as part of their cost of goods sold if, for example, they rely on machinery to directly create a product. Other companies list D&A under their operating expenses if pieces of equipment impact day-to-day expenses but aren't used to directly manufacture goods.
Businesses should also list their interest expense, or the money they pay on loans, and interest income, or the money they earn from interest-bearing business bank accounts. A company also lists how much it pays in income taxes.
The statement then (at last!) tallies up the expenses, which are subtracted from the gross profit to show you the net profit, a.k.a. the bottom line. If the company is losing money, it lists a net loss instead.
Finally—you're nearing the end of this statement, we promise—the P&L report should list the company's earnings per share (EPS). That's the amount each shareholder would make per share of stock if the company paid out all its net earnings today.
A balance sheet covers three essential financial categories: a business's assets, liabilities, and equity.
A balance sheet lists the company's assets on one side (usually the left half) and its liabilities and equity on the other (usually the right half). The two halves of the sheet must equal each other for the sheet to be balanced.
The asset side of the sheet lists assets by how quickly they could be liquidated, starting with current assets like cash and inventory. Current assets also include anything that could either be liquidated or yield returns within a year, such as short-term investments and accounts receivable.
The sheet then lists non-current assets like long-term investments, intangible assets like copyrights, and fixed assets that would take over a year to sell and liquidate—for instance, warehouses or heavy machinery necessary to daily operations.
The liability side of the sheet lists liabilities by how soon each payment is due, starting with current liabilities that are due within a year. Long-term liabilities, which come due more than a year after the balance sheet is created, are listed next.
Shareholders' equity is listed beneath liabilities on the same side of the sheet. This section includes retained earnings, which is income the company reinvests for growth and uses to pay down debt. It should also show the stock invested in the company.