Financial statements 

are important to investors because they can

provide enormous information about a company's revenue, expenses,
profitability, debt load, and the ability to meet its short-term and long-
term financial obligations.
Understanding the Need for Financial Statements
Financial statements are the financial records that show a company's
business activity and financial performance. Companies are required to
report their financial statements on a quarterly and annual basis by the U.S.
Securities and Exchange Commission (SEC). The SEC monitors the
markets and companies to ensure that everyone is playing by the same
rules and that markets function efficiently. There are specific guidelines that
are required by the SEC when issuing financial reports so that investors
can analyze and compare one company with another easily. 

Financial statements are important to investors because they can provide

enormous information about a company's revenue, expenses, profitability,
debt load, and the ability to meet its short-term and long-term financial
obligations. There are three major financial statements.

Balance Sheet
The balance sheet shows a company's assets (what they own), liabilities
(what they owe), and stockholders' equity (or ownership) at a given
moment. 

Income Statement
The income statement reports the revenue generated from sales, the
operating expenses involved in creating that revenue as well as other
costs, such as taxes and interest expense on any debt on the balance
sheet. The net amount or the bottom line of the income statement is the net
income or the profit for the period. Net income is revenue minus all of the
costs of doing business. 

Cash Flow Statement

The cash flow statement (CFS) measures the cash generated for a period,
including all of the transactions that added to or subtracted from
cash. Cash flow is important because it shows how much cash is available
to meet short-term obligations, invest in the company, or to
pay dividends to shareholders. Dividends are typically cash payments to
shareholders as a perk for investing the company. 

Financial Ratios
Financial ratios help investors break down the enormous amount of
financial data that's reported by companies. A ratio is merely a metric to
help analyze the data and make useful comparisons with other companies
and other reporting periods.

Financial ratio analysis analyzes specific financial line-items within a

company's financial statements to provide insight as to how well the
company is performing. Ratios determine profitability, a company's
indebtedness, the effectiveness of management, and operational efficiency.

It's important to consider that the results from financial ratios are often
interpreted differently by investors. Although financial ratio analysis
provides insight into a company, they should be used in tandem with other
metrics and evaluated against the overall economic backdrop. Below are
some of the most common financial ratios that investors use to interpret a
company's financial statements.

Profitability Ratios
Profitability ratios are a group of financial metrics that show how well a
company generates earnings compared to its associated expenses.
However, investors should take care not to make a general comparison.
Instead, they will get a better sense of how well a company is doing by
comparing ratios of a similar period. For example, comparing the fourth
quarter of this year with the same quarter from last year will net a better
result.

Return on Equity
Return on equity, or ROE, is a common profitability ratio used by many
investors to calculate a company's ability to generate income
from shareholders' equity or investments. Companies issue shares of stock
to raise capital and use the money to invest in the company. Shareholders'
equity is the amount that would be returned to shareholders if a company's
assets were liquidated, and all debts were paid off. The higher the return or
ROE, the better the company's performance since it generated more
money per each dollar of investment in the company.

Operating Margin
Operating profit margin evaluates the efficiency of a company's core
financial performance. Operating income is the revenue generated from a
company's core business operations. Although operating margin is the
profit from core operations, it doesn't include expenses such as taxes and
interest on debt.
As a result, operating margin provides insight as to how well a company's
management is running the company since it excludes any earnings due to
ancillary or exogenous events. For example, a company might sell an asset
or a division and generate revenue, which would inflate earnings. Operating
margin would exclude that sale. Ultimately, the operating profit is the
portion of revenue that can be used to pay shareholders, creditors, and
taxes.

Liquidity Ratios
Liquidity ratios help shareholders determine how well a company handles
its cash flow and short-term debts without needing to raise any extra capital
from external sources, such as a debt offering.

Current Ratio
The most commonly used liquidity ratio is the current ratio, which
reflects current assets divided by liabilities, giving shareholders an idea of
the company's efficiency in using short-term assets to cover short-term
liabilities. Short-term assets would include cash and accounts receivables,
which is money owed to the company by customers. Conversely, current
liabilities would include inventory and accounts payables, which are short-
term debts owed by the company to suppliers.

Higher current ratios are a good indication the company manages its short-
term liabilities well and generates enough cash to run its operation
smoothly. The current ratio generally measures if a company can pay its
debts within a 12-month period. It can also be useful in providing
shareholders with an idea of the ability a company possesses to generate
cash when needed.

Debt Ratios
Debt ratios indicate a company’s debt situation and whether they can
manage their outstanding debt as well as the debt servicing costs, such
as interest. Debt includes borrowed funds from banks but also bonds
issued by the company.

Bonds are purchased by investors where companies receive the money

from the bonds upfront. When the bonds come due–called the maturity
date–the company must pay back the amount borrowed. If a company has
too many bonds coming due in a specific period or time of the year, there
may not be enough cash being generated to pay the investors. In other
words, it's important to know that a company can pay its interest due on
their debt, but also it must be able to meet its bond maturity date
obligations.

Debt-to-Equity Ratio
The debt-to-equity ratio measures how much financial leverage a company
has, which is calculated by dividing total liabilities by stockholders' equity. A
high debt-to-equity ratio indicates a company has vigorously funded its
growth with debt. However, it's important to compare the debt-to-equity
ratios of companies within the same industry. Some industries are more
debt-intensive since they need to buy equipment or expensive assets such
as manufacturing companies. On the other hand, other industries might
have little debt, such as software or marketing companies.

Interest-Coverage Ratio
The interest coverage ratio measures the ease with which a company
handles interest on its outstanding debt. A lower interest coverage ratio is
an indication the company is heavily burdened by debt expenses.

Efficiency Ratios
Efficiency ratios show how well companies manage assets and liabilities
internally. They measure the short-term performance of a company and
whether it can generate income using its assets.

Inventory Turnover
The inventory or asset turnover ratio reveals the number of times a
company sells and replaces its inventory in a given period. The results from
this ratio should be used in comparison to industry averages. Low ratio
values indicate low sales and excessive inventory, and therefore,
overstocking. High ratio values commonly indicate strong sales and good
inventory management.

Valuation Ratios
Price ratios focus specifically on a company's stock price and its perceived
value in the market. The price/earnings (or P/E) ratio is an evaluation
metric comparing the current share price of a company’s stock with its per-
share earnings. Higher P/E values indicate investors expect continued
future growth in earnings. However, a P/E that's too high could indicate that
the stock price is too high relative to the earnings or profit being generated.
Investors use the P/E ratio to evaluate whether the stock price is fairly
valued, overvalued, or undervalued.

The P/E ratio is most helpful when compared to historical P/Es of the same
company and companies within the same industry.

Dividend Yield
The dividend yield ratio shows the amount in dividends a company pays
out yearly in relation to its share price. The dividend yield provides
investors with the return on investment from dividends alone. Dividends are
important because many investors, including retirees, look for investments
that provide steady income. Dividend income can help offset, at least in
part, losses that might occur from owning the stock. Essentially, the
dividend yield ratio is a measurement for the amount of cash flow received
for each dollar invested in equity.

The Bottom Line

There is no one indicator that can adequately assess a company's financial
position and potential growth. That is why financial statements are so
important for shareholders and market analysts alike. These metrics (along
with many others) can be calculated using the figures released by a
company on its financial statements.