The Role of Financial Statement Analysis in Making Investment Decisions

Some investors consider the balance sheet the best statement to get a good overall view of a company's financial position. The balance sheet follows the basic accounting equation assets equal liabilities plus owners' equity. The difference between what a company has and what it owes equals equity, or net worth. A high net worth may indicate that a company is relatively debt free, particularly if its owners' equity is higher, expressed as a percentage of assets, than other companies in its industry.

The income statement shows how much profit a company has earned during a given period. The format includes a gross profit calculation, followed by an operating income section. This produces operating income. Non-operating income or losses, including one-time or special sources of revenue or expense, are then added to derive net income. Gross profit is based on revenue minus the cost of producing the goods or services that a company sells, called the cost of goods sold. This shows how efficiently the company generates income from its production. Operating income considers many other costs along with the cost of goods sold, including overhead and depreciation on equipment. This is important in determining the company's basic profitability, especially when compared to prior periods or to other companies in its field. Growing operating income is a good sign. Special items may positively or negatively affect a period's net income, but they are less likely to affect long-term concerns.

The statement of cash flows also reveals useful information when making investment decisions. It shows the net change in the company's cash position during a given period. In general, stable or growing cash flow means the company can cover its short-term debt payments and expenses, while also keeping up with any long-term debt obligations. You can also look over the structure of the cash flow to see how much cash is generated from operating activities versus financing and investing. It is a good sign when a company's cash from operating income routinely exceeds its net income. This shows income is turning into cash. Typically, an effective cash position is favorable in an investment because it shows less risk of loan defaults or bankruptcy.

The statement of owners' equity isolates the equity section of the balance sheet. Its primary purpose is to show the trend in retained earnings for the company. Retained earnings are accumulated profits not paid out in dividends. This is useful in investment decisions because higher retained earnings relative to dividends means you get less dividend income. However, this often means the company is looking to grow and is holding onto income for reinvestment versus paying it out in the near term.