Financial statements

Fundamental analysis is a method used to understand how financially healthy a company is by closely examining its financial statements. These statements reveal important details about how much profit a company earns, how much money flows in and out of the business, and whether the company is stable enough to handle its operations smoothly. For beginners who want to understand how companies function, learning how to read these financial statements is an essential first step. It helps them build a clear picture of a company’s overall condition rather than relying on short-term price movements. This chapter focuses on the major financial statements and the warning signs that may indicate potential issues within a company. A company’s financial information is mainly captured in three key statements. The first is the balance sheet, which presents a snapshot of the company’s position at a specific point in time. It lists what the company owns, known as assets, and what it owes, known as liabilities. The difference between these two is called shareholders’ equity. When a beginner looks at a balance sheet, they get a basic understanding of whether the company has enough resources to pay its debts and continue operating. For example, if Company A has significantly more assets than liabilities, it may suggest that the company is in a relatively stable financial position. If the liabilities are extremely high, it may indicate financial strain. The second major statement is the income statement, also called the Profit and Loss statement. It shows the company’s revenues, expenses, and profits over a specific period, such as a quarter or a year. This statement helps readers understand how well the company is performing in its day-to-day operations. If Company A shows an increase in revenue over several years while maintaining stable or controlled expenses, it may indicate a growing business. On the other hand, if expenses rise faster than revenue, the company may be struggling to manage its costs. The income statement also shows net profit, which is the amount left after all expenses are subtracted from revenue. Positive profit figures may reflect strong operations, while repeated losses may raise concern. The third important statement is the cash flow statement. Unlike the income statement, which can include non-cash items such as depreciation, the cash flow statement focuses purely on the actual money moving in and out of the company. It is divided into operating, investing, and financing activities. Operating cash flow shows how much cash the company generates from its core business activities. Investing cash flow shows money spent on assets like equipment or earned from selling them. Financing cash flow reflects activities such as borrowing money or paying dividends. A company may show profits on its income statement but still face cash difficulties if its cash flow from operations is negative. For example, Company A might appear profitable, but if it struggles to collect payments from customers, it may still have trouble meeting short-term expenses. While financial statements help build a deeper understanding of a company, it is equally important to be aware of certain warning signs that may indicate underlying concerns. One such sign is unusual or sudden jumps in revenue that do not match the company’s normal pattern or are not supported by similar growth in other areas like production or sales volume. These inconsistencies could signal aggressive accounting practices. Another potential red flag is when a company carries a very high level of debt compared to its assets. This can make it difficult for the company to pay interest or repay loans if its earnings decline. Frequent changes in accounting policies can also raise questions. If a company regularly changes how it records its earnings or expenses, it may be attempting to make its financial results appear more favorable than they actually are. Additionally, a company that reports profits but consistently shows negative cash flow may be at risk. This situation may indicate that although the company is earning money on paper, it is not generating enough real cash to sustain its operations. By learning how to interpret these financial statements and recognizing early warning signs, individuals can gain a clearer understanding of a company’s financial condition. This knowledge empowers them to make thoughtful and informed decisions at their own pace. The goal of understanding fundamental analysis is not to push individuals toward investing but to help them build confidence in reading financial information so they can decide for themselves whether a company aligns with their comfort level and financial thinking.