Many investors shy away from digging into the financial statements that a company releases each quarter, preferring to accept the distilled earnings summaries that most companies include. Knowing how to get into the numbers can give you a lot more insight into exactly how a company makes money, and in some cases, it can reveal things you wouldn't get from a basic summary. For instance, being able to cross-check net income as reported on the income statement with figures on the balance sheet is a useful way to gauge a company's long-term growth in book value and shareholders' equity.
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Understanding shareholders' equity and net income
Shareholders' equity is what's left after you take the assets of a company and subtract its liabilities. If the company's assets rise in value while liabilities remain stable, then shareholders' equity will go up.
There are generally two ways that a company can boost its shareholders' equity. First, the business can earn a profit, which typically increases either a company's cash balance, or other line items like accounts receivable.
Alternatively, the business can sell new shares of stock to shareholders. The proceeds of the offering, whether cash, some other asset, or an agreement to reduce debt outstanding, will either raise assets or lower liabilities, resulting in higher shareholders' equity.
Doing the math
Therefore, if you know the beginning and ending figures for shareholders' equity, you should be able to calculate net income. To do the calculation correctly, you also have to be aware of any efforts either to raise capital through issuing shares, or to return capital to shareholders by buying back shares or paying dividends.
First, start by figuring out the change in shareholders' equity. To do this, take the shareholders' equity figure at the end of the period, and subtract the corresponding figure from the previous period.
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Then, account for movements of capital between the company and its shareholders. If the company issued new stock, then you'll want to add the proceeds from the offering. If the company bought back shares of stock, then subtract the amount spent. Finally, subtract any dividends that the company paid.
The final result is the change in shareholders' equity that's not due to capital movements. That should match up with net income.
Again, being able to do this calculation is generally unnecessary because companies release income statements that include net income. Nevertheless, following not just earnings, but also capital flows, can give you more insight into a company's capital strategy.
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