Understanding financial statements


April 7, 2011

Tell a journalist that understanding how to read a financial statement could lead to some story ideas, and they’ll likely run as far away as possible. He or she got into writing for a living to avoid numbers.

While many journalists focus on companies’ press releases about their performance, financial statements — which can be found in a company’s 10-Q and 10-K filings with the SEC — are the no-spin zone of business reporting. Firms’ income statement, balance sheet and cash-flow statement contain numbers that are stories to be had for the taking. And any journalism student would be wise to take a class to learn how to decipher them because that skill is likely to come in handy on any beat, not just business.

Here are the five stories to look for when reading the numbers.

Compare change in revenue to change in cost of goods sold

This is in the income statement. If a company’s revenue — commonly known as sales — increased by 10% in a year, but the cost to produce those goods only increased by 5%, it could mean that the company raised the price of its products. Or it could mean that the company was able to get lower prices for the raw materials that it uses to make its product.

The opposite holds true if the cost of goods sold is rising faster than revenue. That could mean that the company’s suppliers of raw materials might have raised prices and it has not yet been able to raise its prices to customers.

Compare change in revenue to change in net income

Again on the income statement, you’re basically comparing the change in sales to the change in profits. If net income is rising faster than revenue, that means that the company has done a good job of cutting its costs, or maybe that it had lower costs in the quarter or the year, like lower spending for a new ad campaign. If net income is not rising as fast as revenue, then that means that the company has been watching its costs closely and may have cut an expense.

Compare change in earnings per share to change in net income

This is where one of the accounting games that companies play can come into notice. Let’s say a company’s net income rose by 15% for the quarter or the year, but its earnings per share — a key barometer that is simply net income divided by the number of shares outstanding — rose by 17%.

The company will promote the higher number in its news releases. But the only reason EPS is rising faster than net income is because the company bought back some of its shares in the stock market during the quarter. It’s a strategy companies use to make their growth look stronger than it actually is.

Always use the change in net income because that is more reflective of the actual growth.

Look at accounts receivable and inventory on the balance sheet

Accounts receivable is money that is owed the company by customers. If this number has increased dramatically, ask why. It could mean that the company has some customers that are having trouble paying their bills.

The same thing goes for inventory — if the number has increased dramatically, ask why. It could mean that the company is having trouble selling its products. Or it could mean that the company is getting ready to expand its locations and has taken on some inventory to stock those stores.

A one-quarter increase in these numbers may not be a story, unless they have risen astronomically. But if you see these numbers continue to increase during several consecutive quarters, then it’s time to write.

Examine cash flow

Compare the cash flow at the end of the year to the end of the previous year. If the cash flow has increased, this means that the company is healthy. If cash flow is decreasing, it may not indicate a sick company. But it may indicate that there is a problem with the company’s performance. Negative cash flow in any year should cause a red flag.

Look at specific line items in the cash flow statement. Did the company boost its cash flow by decreasing spending on its operations, such as plant, property and equipment? Did the company issue a ton of new stock to make its cash flow look better? Companies can only employ these strategies so often before investors get nervous.

Don’t forget to look at the footnotes related to the income statement, balance sheet and cash flow statement. This sometimes could be where the company is hiding the real story, such as Enron’s use of off-balance sheet transactions.

Chris Roush is the Walter E. Hussman Sr. Distinguished Scholar in business journalism at UNC-Chapel Hill. He can be reached at croush@email.unc.edu. Tags: economy, law, training.


We welcome feedback. Please contact us here.