A company's financial statement gives you insight into its business operations and financial performance. There are four main financial statements: Income statements, balance sheets, cash flow statements, and statements of shareholders' equity. Each one tells you something different about a business, but they give a great overall picture of a company's financial health when used together. Let's look at three of the top numbers you should know on financial statements and what they mean.
1. Net income
Net income (or net earnings) is calculated by taking a company's sales and subtracting the cost of goods sold (COGS), taxes, interest, operating expenses, administrative expenses, depreciation, and any other expenses. Ideally, you want this number to be positive because that means the company is bringing in more revenue than it's paying out in expenses.
Net income is sometimes referred to as a company's bottom line because it's found at the bottom of its income statement. It's important to know a company's net income because it shows profitability, but it's also important to calculate other figures, such as earnings per share (EPS). A company's EPS shows how much profit it made per outstanding share. If their net income is $1 million and they have 100,000 outstanding shares, their EPS is $10.
2. Cash flow
Although cash flow looks similar to profit, there are some key differences. Cash flow measures how much money is coming into a business versus going out. If there's more money coming in than going out, it's cash flow positive; if there's more money going out than coming in, it's cash flow negative. For investors, it's important to know a company's cash flow because that's money the company can use to pay out dividends, buy back shares, repay debts, invest in growing its business, and make acquisitions.
It's especially important for investors interested in investing in dividend-paying companies. You should, ideally, look for companies that generate greater cash flow than they pay out in dividends. If a company is paying out more in dividends than it has in cash flow, you should be cautious. In addition to showing short-term struggles or misguided priorities, it's a sign that there's a higher chance the company could cut off the dividend in the future.
You can find cash flows at the bottom of the operating activities section of the cash flow statement.
3. Gross margin
A company's gross margin tells you how much money it has after accounting for the direct cost of producing whatever goods or services it sells. You can find a company's gross margin by taking its sales and subtracting COGS. The higher the gross margins, the better because it means a company is profiting more and can use that money for other financial obligations. When using COGS, labor costs and the costs of any particular materials used to manufacture the products should be included.
If a company brings in $500,000 in revenue by selling products that cost $300,000 to make, its gross margin would be 40%. When looking at a company's margins, it's best to compare it to a company within its industry because margins vary widely by sector. Airline and grocery store businesses are notoriously low margin, for example. It would be misleading to compare those margins with a software company, which typically has higher margins because of its low COGS.
Just because a company has higher margins doesn't make it a better investment either. A company could have 80% margins, but if it only has sales every now and then, it may not be a better investment than a company with 10% margins and a steady stream of sales.