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How to measure a company’s financial strength using the 3 key financial statements
Posted by Grace Townsley
December 2, 2022
Following the massive economic crash that triggered the Great Depression, the government began requiring companies to disclose specific financial information every year. This increased transparency was meant to give investors better insight into the companies they purchased stock in, and to allow for simple comparisons between companies.
Prior to the Great Depression, there was little consistency across companies’ financial documents — if they disclosed financial information at all. But today, every publicly traded company is required to share a specific set of numbers through three publicly available financial statements.
Whether you’re thinking of going public, or want to use these financial documents to determine a company’s financial strength, this quick guide to the three main financial statements offers an overview of the use and benefits of each key document.
What are the three main financial statements?
The three main financial statements that disclose information about every company’s operations and financial health are the income statement, balance sheet and statement of cash flows.
Together, they paint a picture of the company’s current financial standing, debt, revenue, profit, assets and more. They offer an at-a-glance view of the company’s efficiency, health and growth trajectory. They also make it easier to compare companies, even if those businesses are not in the same industry.
In short, these three financial documents standardize the delivery of financial information to investors, potential partners, employees and other stakeholders.
What is an income statement?
An income statement reveals a company’s operations during a specific period of time, typically a quarter or year.
The statement is divided into several sections, with multiple types of transactions listed in each section. The four main sections include:
Revenue: The income the company earns by selling its main products and services.
Gains (also called Other Income): Any additional income generated through nonprimary activities, like selling a company vehicle or unused real estate.
Expenses: All costs, like electricity, labor and inventory costs, are included in this section.
Losses: Any money lost to unusual expenses, like losing a lawsuit or selling real estate at a loss, is recorded in this section.
Income statements vary in their level of detail, but every statement follows this order and structure. For example, under Revenue, a business may report earning $2 million by selling three types of widgets, but isn’t required to report how much revenue was generated by each of the three types. This allows businesses to be transparent without disclosing trade secrets or sensitive information a competitor could use against them.
Income statements are useful for determining how efficiently businesses turn revenue into profit, how well they manage expenses and what areas they focus their efforts on, like research and development, company expansion or labor costs.
The second financial statement is the balance sheet, a snapshot of a business’ financial position on one particular date. Often, the balance sheet refers to the last day of the quarter or year, but a balance sheet can be generated at any time.
A balance sheet records a company’s total assets, liabilities and stockholders’ equity. The assets are recorded along the left side of the document, and equal the liabilities plus stockholders’ equity are listed on the right side.
In the assets column, you’ll see items like cash, accounts receivable, inventory and long-term assets like equipment and buildings. These items are listed in order from most liquid to least.
In the liabilities and owners’ equity section, you’ll see debt, including accounts payable and short-term debt, then long-term debt, and finally, stock and retained earnings. At the bottom of this document, you’ll see that the assets column and liabilities and equity columns always equal out.
The balance sheet is helpful for understanding how much debt a company has taken on, as well as how much it holds in assets. Usually, the higher the cash and accounts receivable, compared to the debt section, the stronger that company’s financial position.
What is a cash flow statement?
The third key financial statement is the cash flow statement, also called a statement of cash flows. The cash flow statement is like a detailed view of the income statement, describing how a company receives and spends its revenue. And like an income statement, it refers to a specific period of time, like a quarter or year.
The top section of a cash flow statement, the cash from operations section, is often considered the most important section of this statement.
It reveals whether the company has a positive cash flow (where income exceeds expenses), or a negative cash flow. It also reveals fluctuations in the company’s financial standing that are difficult to see in the other statements, like a decrease in income with an increase in inventory — which suggests the company is struggling to sell its products.
The best way to analyze a company? Study the three statements together
No single statement paints a full picture of a company’s financial standing. But taken together, the income statement, balance sheet and cash flow statement can describe a company’s efficiency, growth and profitability, practically at a glance.
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