A quarterly or annual earnings report provides the clearest picture of a company's financial health. By learning how to read and understand the different financial statements in an earnings report, you can decide if an investment is worth the risk. No single financial statement tells the whole story. You need to take all of the numbers into account to get an accurate picture of the company's current health and future prospects. Here are the most important statements:
A balance sheet presents a picture of the total assets and liabilities held by a company at a specific moment in time. Assets include everything a company owns, from factories to trucks to unsold inventory. Liabilities are everything it owes, including loan payments, salaries and rent.
By subtracting liabilities from assets, you arrive at shareholder's equity, or how much investors would receive if the company liquidated its assets and paid off its debts right now. If you divide liabilities by shareholder's equity, you get the debt-to-equity ratio, a measure of how quickly a company is taking on debt compared to attracting investor money [source: Securities and Exchange Commission].
An income statement shows how much a company earned in a given period and the expense of doing business. The bottom line, after all expenses are subtracted from gross revenue, is net profit or net losses. Remember that profits or losses for a single quarter or year aren't a clear indication of the risk of the investment. They are merely factors in a larger financial picture.
The cash flow statement offers more details about how money is actually received and spent at the company. A company might report high earnings, but what if half of those earnings are IOUs for cash that has yet to arrive? This could limit the company's ability to invest in growth or even pay its expenses [source: SEC].
Don't forget the footnotes of any financial report, because they often contain important information about the company's accounting policies and methods. Another particularly helpful section is the five- or ten-year summary provided at the back of many earnings' reports [source: Merrill Lynch]. This helps you compare the information from the current report with past performance to identify trends that affect the risk of the investment.