How to Read Financial Statements: A Beginner's Step-by-Step Guide

Gather the Essential Financial Statements

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Start by obtaining copies of the three main financial statements: income statement, balance sheet, and cash flow statement. For public companies, these can be found in their annual reports (Form 10-K) or quarterly reports (Form 10-Q) through the SEC's EDGAR database. For private companies, these documents may be provided by management or accounting departments.

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Start with the Income Statement

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The income statement shows revenue, expenses, and profit over a specific period. Begin at the top with revenue (or sales) and work your way down. Subtract the cost of goods sold (COGS) from revenue to find gross profit. Continue down to operating expenses, which includes items like salaries and rent. Finally, look at the bottom line

• net income
• which shows the company's profit after all expenses and taxes.

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Analyze the Balance Sheet

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The balance sheet shows assets, liabilities, and shareholders' equity at a specific point in time. Remember the fundamental equation: Assets = Liabilities + Shareholders' Equity. Review current assets (like cash and inventory) and current liabilities (like accounts payable) to assess short-term financial health. Then examine long-term assets and liabilities to understand the company's long-term position.

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Examine the Cash Flow Statement

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The cash flow statement shows how much cash is moving in and out of the business. Review operating activities first, as these represent core business operations. Then look at investing activities (like equipment purchases) and financing activities (like loans or stock issuance). The net change in cash should explain how the company's cash position changed over the period.

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Calculate Key Financial Ratios

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Use financial ratios to dig deeper into the company's performance. Start with liquidity ratios like the current ratio (current assets/current liabilities). Calculate profitability ratios like profit margin and return on equity. Look at efficiency ratios like inventory turnover and accounts receivable turnover.

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