Why Accounting Matters for Investors
Financial statements tell the story of a company's health. While you don't need to become an accountant, understanding the basics helps you:
- Evaluate whether a company is profitable and growing
- Assess the company's financial stability
- Compare companies within the same industry
- Identify potential red flags or warning signs
- Make more informed investment decisions
The Three Main Financial Statements
Balance Sheet
A snapshot of what a company owns (assets) and owes (liabilities) at a specific point in time.
Key question: How financially stable is this company?
Income Statement
Shows revenue, expenses, and profit over a period of time (quarter or year).
Key question: Is this company profitable?
Cash Flow Statement
Tracks actual cash moving in and out of the business.
Key question: Does this company generate real cash?
The Balance Sheet
The balance sheet follows a simple equation: Assets = Liabilities + Shareholders' Equity
Assets (What the Company Owns)
- Current Assets: Cash, accounts receivable, inventory - things that can be converted to cash within a year
- Non-Current Assets: Property, equipment, patents, long-term investments - things held longer than a year
Liabilities (What the Company Owes)
- Current Liabilities: Accounts payable, short-term debt - obligations due within a year
- Long-Term Liabilities: Long-term debt, pension obligations - obligations due beyond a year
Shareholders' Equity
The difference between assets and liabilities - essentially what would be left for shareholders if the company sold everything and paid all debts.
Key Balance Sheet Ratios
- Current Ratio: Current Assets / Current Liabilities (>1.5 is healthy)
- Debt-to-Equity: Total Debt / Shareholders' Equity (lower is generally better)
- Book Value per Share: Shareholders' Equity / Shares Outstanding
The Income Statement
Also called the Profit & Loss (P&L) statement, it shows whether the company made money over a period.
Key Components (Top to Bottom)
- Revenue (Sales): Total money earned from selling products/services
- Cost of Goods Sold (COGS): Direct costs to produce what was sold
- Gross Profit: Revenue - COGS
- Operating Expenses: R&D, marketing, administrative costs
- Operating Income: Gross Profit - Operating Expenses
- Interest & Taxes: Financing costs and tax payments
- Net Income: The "bottom line" - final profit after everything
Key Income Statement Metrics
- Gross Margin: Gross Profit / Revenue (higher is better)
- Operating Margin: Operating Income / Revenue
- Net Margin: Net Income / Revenue
- Earnings Per Share (EPS): Net Income / Shares Outstanding
The Cash Flow Statement
Profit on paper doesn't always mean cash in the bank. The cash flow statement shows actual cash movement, divided into three sections:
1. Operating Activities
Cash generated from the core business operations. This should be positive and growing for healthy companies.
2. Investing Activities
Cash spent on or received from buying/selling assets, acquisitions, etc. Often negative when a company is investing in growth.
3. Financing Activities
Cash from issuing stock, borrowing, paying dividends, buying back shares.
Free Cash Flow (FCF)
Formula: Operating Cash Flow - Capital Expenditures
Free cash flow is the money a company has left after maintaining and expanding its asset base. It can be used for dividends, share buybacks, debt repayment, or acquisitions.
Why it matters: A company can show accounting profit but have negative free cash flow. FCF is harder to manipulate and represents real money the business generates.
Important Valuation Metrics
| Metric | Formula | What It Measures |
|---|---|---|
| P/E Ratio | Stock Price / EPS | How much you pay per $1 of earnings |
| P/B Ratio | Stock Price / Book Value per Share | Price relative to company's net assets |
| P/S Ratio | Market Cap / Revenue | Price relative to sales (useful for unprofitable companies) |
| PEG Ratio | P/E / Earnings Growth Rate | P/E adjusted for growth |
| ROE | Net Income / Shareholders' Equity | How efficiently company uses equity to generate profit |
Red Flags to Watch For
Warning Signs in Financial Statements
- Declining revenue: Especially over multiple quarters
- Rising debt levels: Especially if faster than revenue growth
- Negative operating cash flow: Despite showing profit (earnings quality issue)
- Accounts receivable growing faster than sales: May indicate collection problems
- Inventory buildup: Products not selling
- Frequent "one-time" charges: May be hiding ongoing problems
- Changing accounting methods: Could be masking issues
- High executive turnover: Especially CFO departures
Where to Find Financial Statements
- SEC.gov: EDGAR database has all public company filings (10-K annual, 10-Q quarterly)
- Company Investor Relations: Usually on the company's website
- Financial websites: Yahoo Finance, Google Finance, Morningstar
- Brokerage platforms: Most provide financial data for research
Tips for Reading Financial Statements
- Look at trends: Compare multiple years, not just one snapshot
- Compare to peers: Industry benchmarks matter - a 10% margin is great in grocery, poor in software
- Read the footnotes: Important details and risks are often buried there
- Start with the cash flow statement: Cash is harder to manipulate than earnings
- Be skeptical of non-GAAP metrics: Companies sometimes create flattering adjusted numbers
Frequently Asked Questions
Do I need to analyze financial statements for index fund investing?
No. If you're investing in broad index funds, you're automatically diversified across hundreds of companies and don't need to analyze individual statements. This matters more for picking individual stocks.
What's the difference between GAAP and non-GAAP earnings?
GAAP (Generally Accepted Accounting Principles) earnings follow standard rules. Non-GAAP or "adjusted" earnings exclude certain items companies consider non-recurring. Be cautious - companies often use non-GAAP to make results look better.
How do I compare companies in different industries?
Use ratios and margins rather than absolute numbers. Compare to industry averages. A software company and a retailer will have very different normal margins - compare each to its peers.
What should beginners focus on first?
Start with: revenue growth, net income, free cash flow, and debt levels. These four items give you a quick health check. As you learn more, add more detailed analysis.
