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8 Min. Read

How to Read a Financial Report?

To get the most out of financial reporting you need to know what you are looking for in the information. The main reason for financial reporting is to stay informed about the financial performance of a business. The people who review usually have some sort of stake in the business like ownership, stock holdings or interest to invest. So, the readers of financial reports usually care about the success or failure of the business.

Here are a few helpful tips when it comes to reading financial statements.

Know What You Are Looking For

If you want more information about a business than you can find online or in news articles, a public company’s annual report should contain a lot of financial information in it, including:

  • A letter from the chief executive
  • Highlights sections
  • Trend charts
  • Financial statements with extensive footnotes
  • Historical summaries
  • And more

On the other hand, private companies have much less reporting to do and their reporting usually just consists of financial statements with footnotes and not much more.

For a quick overview of the company, review the highlights section. To get a better understanding of the financial strategies of a business and future planning to read the letter from the chief executive to shareholders.

Know Accounting Basics

Financial statements – the income statement, balance sheet and statement of cash flows – are the core of financial reporting. You should have at least a basic level of understanding of financial accounting to make sense of these reports. If you don’t have the education yourself to decipher what is on your financial statements you can familiarize with accounting terminology and financial reporting practices online or consult an accountant to help you.

Analyze Profit Performance

A business is run on its ability to make sales and by keeping their expenses less than their sales revenue. Therefore, the best place to start analyzing profit performance is not the bottom line but rather the top line – sales revenue.

Here are some questions to consider when reviewing sales revenue:

  • How does the sales revenue in recent years compare to the previous years’?
  • What is the business’ gross margin ratio?
  • How do the gross margin and the company’s net earning compare to its top line (sales revenue)?

It is also important to note to consider a company’s profit performance in context to the current general economic conditions.

Compare EPS Against In The Bottom Line

Along with net income, public companies report earnings per share (EPS). EPS is the amount of the bottom-line profit for each share of its stock. Therefore, the bottom line of a business is the EPS. While companies don’t have to report their EPS, it is quite easy to calculate the EPS. Simply, divide a company’s bottom line net income by the number of ownership shares held by equity investors in the company.

Investors focus on the EPS as it is the primary driver of the company’s market value. The market value of a public company is higher, the higher the EPS.

The EPS does not increase just because the net income of a company increases. The driver of market value and book value per share may change more or less than 10 percent:

Less than 10 percent: A company might have issued additional stock shares within the year or may have issued additional employee stock options, and this has decreased the EPS.

More than the 10 percent: The company might have bought back some of its own shares, which decreases the number of shares used and increases your EPS. This might be a deliberate strategy to increase the EPS higher than the increase in net income.

Investigate Gains And Losses Patterns

An income statement might start out normally with sales revenue minus the expenses of operating the company. Sometimes, you might notice a section of unusual gains and losses on the way down to the profit line. These can happen once in a while when a business faces an event like a natural disaster or legal circumstance. But when a business reports these gains and loss more frequently, it might be worth investigating further.

Check Cash Flow From Profit

The goal of a business is not just to make a profit but to be able to generate cash flow from that profit as quickly as possible. This cash flow from making profit is the most important stream of cash inflow to a business and keeps a company running. A company needs this cash flow to make cash distribution from its profit to shareholders, to maintain liquidity and to supplement other sources of capital to grow the business.

Investigate Solvency

A company can have good sales revenue and great profit margins but if it can’t pay its bills on time, the company’s profit performance could be doomed.

A company’s ability to pay it’s bills and debts is called solvency. Solvency analysis looks for symptoms of financial distress that could cause a company disruption. A key metric to measure a company’s ability to meet its debt and bills is the solvency ratio. This ratio indicated whether a company has enough cash flow to meet its short-term and long-term liabilities. The lower the solvency rate, the greater the company’s profitability and the better the chance of it meeting its financial obligations.

Solvency ratio is a key metric used to measure an enterprise’s ability to meet its debt and other obligations. The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-term and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.

The formula for the solvency ratio is as follows:

Formula for the solvency ratio
This article will also include information about:

What Are the Four Basic Financial Statements?

What Information Is Contained in an Annual Report?

What Are the Four Basic Financial Statements?

Together these four financial statements give readers an idea of the financial results and condition of a company. Financial statements are comprised of four basic reports.

Income Statement

An income statement shows the generated revenues, expenses and profit & losses over the reporting period. Since it shows the operating results of a company, it is often considered the most important financial statement.

Balance Sheet

A balance sheet shows the assets, liabilities and equity of a company as of the date it is being reported. The information is reported for a specific point time. The format of this report is structured so that the total of all assets equals the total of all liabilities and equity. This is considered the second most important report as it gives readers information about a company’s liquidity and capitalization.

Statement of Cash Flows

The cash inflows and outflows that occur during a reporting period are shown on the statement of cash flows. It can be useful when compared to the income sheet, especially if the amount of profit and loss reported doesn’t reflect the cash flow experienced by the business. This is the statement often presented to outside parties.

Statement of Retained Earnings

The statement of retained earnings shows changes in equity during a reporting period. While the report format varies, it should include the sale or repurchase of stock, dividend payments and changes caused by reported profits or losses. This is the least used financial statement and usually only included with the audited financial statement package.
Internal teams usually only see the income statement and the balance sheet, since these documents are the easiest to prepare for review.

When the financial statements are issued internally, the management team usually only sees the income statement and balance sheet, since these documents are relatively easy to prepare.

What Information Is Contained in an Annual Report?

An annual report is a publication that must be provided by a public corporation must provide annually to its shareholders to describe their operations and financial conditions. The front part might have branded graphics, photos of the company and an accompanying narrative to chronical business activities over the year and the back part of the report contains detailed information about the company’s financial operations.

A company is analyzed by shareholders, potential investors, employees, creditors, analysts and other interested parties by their annual report. This report contains information that can indicate to company’s financial position. The information includes:

  • A company’s ability to pay its debts
  • Profits and losses from the previous fiscal year
  • Business growth over a number of years
  • Retained earnings that can be used to help a company grow
  • The portion of the revenue generated that is spent on operational expenses
  • And more

Typically, an annual report will contain the following sections:

  • General corporate information
  • Operating and financial highlights
  • Letter to the shareholders from the CEO
  • Narrative text, graphics and photos
  • Management's discussion and analysis (MD&A)
  • Financial statements, including the balance sheet, income statement and cash flow statement
  • Notes to the financial statements
  • Auditor's report
  • Summary of financial data
  • Accounting policies