What is a company financial statement? How can it help you spot good or bad investments?

Every February and August, business news sites are full of headlines about company reports and “earnings season”.

That’s because in Australia, most companies have a reporting period ending June 30 – the end of the financial year – meaning they will release their full-year results in August and half-year results in February.

Share prices can move dramatically depending on the company’s performance or its comments about the outlook.

If you’re new to investing and want to understand some of those results by reading company financial statements, here’s where to start.

What is a company financial statement?

Company financial statements show what a business owns, owes, earns and spends. It is like an annual health check-up for a business, written in numbers.

Company financial statements are prepared in accordance with Australian Accounting Standards.

Most listed companies publish their financial statements on their company website, usually in an investor or annual reports section. They are free to access. They are also published on the Australian Securities Exchange (ASX) website.

What to read first

If you’re new to financial statements, start with the big picture before diving into the numbers.

First, look for the trading update in the half-year report or chief executive’s letter at the beginning of the full-year report. This explains the company’s performance in plain language and will discuss the results for different segments of the business.

You can then look at the statement of profit or loss, which shows the profit or loss for the period.

Revenue is what they have earned – but that’s not counting any costs.

Net profit after tax (known as NPAT) shows total income minus expenses and how much profit is available to shareholders after tax is paid. This is the key measure used in reporting season news stories.

Another term you might run into is EBIT (earnings before interest and tax). EBIT shows profit from core operations before financing costs and tax are taken out. So it is considered a measure of underlying profitability.

Earnings per share (EPS) shows the portion of a company’s profit attributed to each ordinary share in the company.

A closer look at the numbers

After getting a sense of the big picture, the statement of financial position tells you what the company owns and owes.

What percentage of the total assets of the company is made up of liabilities – what the company owes?

Note that “current” assets and liabilities are expected to be converted to cash, or due for payment within 12 months. A company should have enough current assets to pay for its current liabilities.

Total assets less total liabilities equals the total equity: the shareholders’ stake in the company. A negative figure means the company owes more than what the assets are worth. That’s why this statement is often called the balance sheet.

What’s the difference between cash and profit?

Cash and profit are not the same thing. Revenue and expenses are recorded in the reporting period they occur, not when the cash is actually paid or received.

It is possible for a company to show a healthy profit, but have poor cash flow – or the other way around.

For example, a company sells to thousands of new customers in June on credit. Sales are recorded in June, boosting profit. But if the customers don’t pay quickly, there’s no increase in cash.

The cash flow statement shows the cash inflows and outflows of a company, including how much is paid to investors as dividends.

Expectations are the key

Financial markets always look to price in the future, today.

If a company’s profit result is close to market expectations, there may not be a large share price reaction. If it beats expectations, the shares may jump. Likewise, a profit miss will see the share price punished.

But what the company says about its outlook for the coming period is where the greatest chance lies for a surprise that is above or below market expectations. And that can have a big impact on the share price.

To understand a company’s results, context is important. It’s worth reading media coverage from reputable outlets such as The Australian Financial Review (if you don’t have a subscription, try for free access via your local library) and ASX updates.

What are some positive signs to look for?

Look for:

• consistent growth in revenue, profit, cash flow

• more assets than liabilities, with debt at a manageable level

• positive operating cash flow.

You should also consider industry and market trends, management quality, and competitive pressures.

What are some warning signs to watch for?

In its day-to-day operations, keep an eye out for falling revenues and low profit or an outright loss. Sometimes a one-off gain, such as from an asset sale, can prop up results.

Look out for current liabilities higher than current assets, or frequent changes in auditors or senior management.

Following these steps for reading financial statements can help investors to make more informed decisions. A registered financial adviser can provide you with investment advice.

This article is part of The Conversation’s “Business Basics” series, where we ask experts to discuss key concepts in business, economics and finance.

Disclaimer: This article provides general information only and does not take into account your personal objectives, financial situation, or needs. It is not intended as financial advice. All investments carry risk.