One of the keys to responsible investing is understanding how the companies you put money into operate. Businesses compile and release financial statements on a regular basis as a means of tracking their behavior and making it known to shareholders, analysts and investors. Investors must know what to look for in a financial statement in order to put the information to use.
The biggest thing investors tend to look for in a financial statement is any indication of the company's ability to grow or anything that might prevent it from growing. Since investors will buy stock and become partial owners, they want to know the likelihood that the business will grow in value, allowing them to sell their shares in the future for a higher price. Income statements show how much the company is currently making, so investors look for an income that is sufficient but not so high that it will be impossible to increase in the future.
Investors need to know how much a company owes, which they can determine from analyzing the right financial statements. A balance sheet, which is one of the basic types of financial statements, lists liabilities that the company is responsible for paying. A company with a strong business plan and stable income will have difficulty growing if its debts cancel out much of its profits. Companies with excessive debt are the most likely to need bankruptcy protection, which usually means losses for investors. At the same time, a certain level of debt can be healthy since it indicates that the company has the ability to pay it back and build a stronger credit rating.
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Cash flow refers to the rates at which a business takes in revenue and pays out cash. Investors will examine financial statements, known as cash flow statements, to learn about a company's cash blow balance, or lack thereof. Cash flow statements also include information about the business' investments and how much they pay in interest. This is useful for predicting the future cash flow, which will affect how fast the company can grow.
Because potential investors are interested in buying stock, they will examine financial statements to determine what the company is worth to its shareholders. This is known as shareholder equity, and it refers to the value of the company, including all of its assets, when its liabilities and debts are subtracted and its cash flow is frozen in time for purposes of analysis. Shareholder equity can vary greatly from one company to another, and investors can calculate it from the information on a balance sheet.