A company’s financial statements include critical data that can be used as part of your fundamental analysis to help you spot investment opportunities. Discover the three pivotal financial statements, what to look for in them, and why they are so important.
Financial statements contain crucial information that can help you to understand a company’s current health and future potential. Balance sheets, income statements and cash flow data are the bedrock of a company’s earnings report, offering valuable insights into how well the business is performing.
Since they are released on a regular basis, these statements also allow you to identify trends that can be traded as part of a strategy for achieving financial independence.
“I call it the Rule of Three. If you read a company’s financial statements three times, and you still can’t figure out how they make their money, that’s usually for a reason.”
James Chanos
Three key financial statements
Financial reports are typically released at the end of each financial quarter and provide a comprehensive level of detail about a company. The headline figures, which offer an immediate indication of whether a stock is trading at fair market value, can be sourced from three financial statements.
Balance sheets
A company’s balance sheet provides important information about the assets it holds, its existing liabilities or debt, and its sources of capital in the form of equity.
This data can help you to evaluate whether a company can finance its short-term operating costs, meet future debt obligations and potentially distribute dividends to shareholders.
Income statements
The income statement section of a financial report provides a clear perspective on a firm’s profitability. It consolidates revenue and capital gains, while subtracting expenses and losses, to produce a net income figure that can help you to gauge the company’s overall financial performance.
Tip: Expressing profit margins as a percentage allows for easy comparison between different companies.
Cash flow
If you want to learn more about the inner workings of a company, a cash flow statement is a great place to start as it provides a thorough breakdown of how much cash is generated by its core operations. It also details other forms of income and spending, such as the sale or acquisition of capital assets, and various forms of investments and borrowing.
Tip: Regardless of how they are presented by different companies, financial statements are all based on standardised accounting principles.
What should investors look for in financial reports?
There are a number of key metrics to which analysts and investors pay particular attention when studying financial statements. Knowing what the other big players in the market are basing their decisions on — and why — can help you to anticipate an increase or decrease in interest related to a particular stock.
Checking a firm’s balance sheet and cash flow is a crucial part of an investor’s due diligence; it helps to determine if the company has enough capital to sustain its operations. On the other hand, the income statement offers insights into the company’s current profitability and growth potential.
Where can investors find financial statements?
Financial statements can usually be accessed by visiting the “Investor Relations” section of a company’s website. This information source will provide the most detailed insights available, and the data may also be complemented by additional commentary from the company’s management team. Some companies even provide recordings of Q&A sessions held with analysts and company officers.
Given how important earnings reports are to investors, news agencies and brokers often provide user-friendly breakdowns of their key elements, alongside value-added insights from industry experts.
For those interested in the thoughts of other traders regarding earnings reports, online discussion forums can serve as platforms for ideas and viewpoints to be openly shared and discussed.
Tip: An earnings report calendar can be used to track the date and time of a company’s regular financial updates.
Why are quarterly reports so important to investors?
Given the valuable insights that can be gained from earnings reports, the time during which they are released is commonly referred to as “earnings season.”
During this time, individual companies may outperform their sector, earning them the label of a “hot stock pick,” which can lead to a further rally in their stock price. Moreover, investors can gain a broader perspective on a stock sector by evaluating the overall performance of multiple companies within a specific sector.
It is also possible to use these reports to compare a company’s earnings with previous quarters. This can help investors to evaluate a company’s trajectory and potentially witness the formation of any trends.
Tip: News released during the US earnings season can have a significant impact on the global stock market.
Final thoughts
Having a well-defined strategy is a crucial aspect of investing and achieving your financial aims. Fundamental analysis serves as a very useful tool in this endeavour, enabling you to identify promising trading opportunities and gain the confidence to hold them until they reach their target price.
Combining a company’s financial reports with an earnings call — a meeting between a company’s management team, investors and other interested parties — can really help investors to determine whether they want to become a shareholder or not.
The eToro Academy can teach you how to identify investment opportunities.
Quiz
FAQs
- What is an “earnings beat”?
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In the lead-up to an earnings announcement, financial brokers and analysts at investment firms provide their estimates of what they believe the report will reveal. These individual views are aggregated by market data agencies to create a consensus forecast. If the actual earnings number surpasses this forecast, it is referred to as an “earnings beat.”
- How many firms “beat” earnings forecasts?
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Historical data indicates that approximately 66% of US firms tend to post earnings beats. This is partly because earnings forecasts are often biased to the downside, which suggests that a “beat” may not always be as positive as it initially appears.
- What are the risks of using financial statements to help you invest?
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Financial statements are considered lagging indicators because they provide a retrospective view of what occurred in the previous quarter. While they offer crucial insights into an individual firm’s performance, they do not account for wider macroeconomic factors.
Investment decisions can, therefore, be improved by factoring in a wider range of macro data and incorporating more subjective analysis, taking the time to consider things such as the quality of a company’s management team.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.