Importance of financial statements to investors
Financial Statements, also known as (FS), are comprehensive reports that are prepared and published by a company to inform different stakeholders of their financial performance and position.
They play a very important role and provide vital tools for investors to evaluate the potential and health of companies they consider investing in.
Three major financial statement reports:
- Income statement
Function: This statement shows a company’s profitability by presenting its revenues, expenses and net income over a specific period. This can be quarterly or annually.
Key focus areas: By analysing the income statement, investors can understand:
Revenue growth: Is the revenue increasing or decreasing? Investors do not just look at individual statements in isolation. They analyse them together and compare them to historical data or the performance of competitors to glean valuable insights.
Financial ratios derived from these statements, such as profit margin or debt-to-equity ratio, provide further condensed indicators of a company’s financial health and performance.
Why are financial statements important to an investor?
For an investor, financial statements are like a treasure trove of information, opening doors to informed investment decisions and potentially maximising returns.
Here is why they are so crucial:
Assessing a company’s health and potential:
- Profitability
The income statement reveals a company’s revenue, expenses and net income, painting a picture of its earning potential.
Investors can gauge past performance and estimate future profitability, impacting stock valuation.
- Financial stability
The balance sheet showcases a company’s assets, liabilities and shareholder equity, providing insights into its financial foundation. Investors can assess solvency, risk of bankruptcy and the overall ability to weather economic storms.
- Liquidity and cash flow
The cash flow statement tracks how a company generates and uses cash, revealing its ability to meet short-term obligations and fund growth.
Investors can understand the company’s operational efficiency and potential for dividend payouts.
- Making informed investment decisions
- Valuation
By analysing financial statements alongside market trends and competitor performance, investors can arrive at a fair valuation for a company’s stock. This helps make informed buying and selling decisions, minimising the risk of overpaying or missing out on undervalued opportunities.
- Identifying risks and opportunities
Financial statements can reveal potential red flags, such as excessive debt, declining profitability, or inefficient operations. Conversely, they can also highlight areas of growth potential, innovative investments, or strong market positioning.
- Comparing potential investments
When considering multiple options, financial statements allow investors to compare companies side-by-side, analysing their financial metrics and performance to choose the one with the most promising future.
- Monitoring progress and managing risk
- Tracking performance
By analysing financial statements over time, investors can monitor a company’s progress toward its goals and assess the effectiveness of its strategies. This allows for adjustments to investment decisions based on evolving performance.
- Evaluating management
Strong financial results often reflect effective management decisions. Conversely, persistent financial struggles may raise concerns about leadership capabilities. Analysing financial statements helps investors understand the management team’s track record and potential impact on future performance.
- Identifying warning signs
Declining financial metrics, sudden shifts in cash flow, or unexpected changes in accounting practices can be early warning signs of potential trouble. Monitoring financial statements helps investors identify these red flags and adjust their risk exposure accordingly.
Overall, financial statements empower investors to navigate the stock market with knowledge and confidence.
By diligently analysing these documents, they can make informed investment decisions, minimise risk, and maximise their potential for long-term returns.
Bryan K Nyakabawo is an accountant and a passionate advocate for financial literacy. He combines his banking background (12 years) with expertise in Investments & Portfolio Management (UZ) and Capital Markets Analysis (CFI) to guide individual investors on the Zimbabwe Stock Exchange. He actively contributes as a trustee to RICOZ (Retail Investors Community of Zimbabwe); Email: bryan.nyakabawo@gmail.com; Cell: 0772586094-ebusinessweek
