In our last article, we have discussed what are the financial statements and what it contains. In this article, we will tell you what you should look for in the financial statements before investing in stocks.
We have four sections to a company’s financial statements;
- The balance sheet
- The income statement
- The cash flow statement
- Notes to accounts or explanatory notes
If you are new to stock investing, then in order to start with financial statement analysis, you need to first acquire all essential skills to understand different components of financial statements.
We have key performance indicators in the financial statements which will let you know how the company is performing and what rate of return it’s offering. Investors want to see these key indicators before investing in the company.
Income Statement – Part of financial statements which shows revenue against expenses
Income statements get more priority when investors try to find out the rate of return the company can offer. It’s also referred to as a company’s profit and loss account.
Profit and loss account tells you from where the company is getting money and how effectively the management is managing cost to derive profit.
Two most important among all others are: sales and earnings. Also known as the top and bottom line of a company.
Sales – Top Line of the company
Are people buying the company’s products or services? Sales figures in the company’s income statement will answer this question.
You can compare yearly and quarterly sales to know how the company has grown over the years or quarters.
If sales are down year after year, then people are not taking interest in the company’s products or services. If it’s showing an uptrend, people are taking interest in the company’s products and/or services.
A horizontal and vertical analysis of income statements will tell you how the company has performed over the year or during the year.
Sales are meaningless if the company is not making money. Therefore, the most important thing value investors look for is the profit margin.
Net income on a company’s income statement is an excellent indicator of a company’s overall profitability. It tells you what the company has retained by selling products and/or services.
Net income or profit is calculated in an income statement by deducting all business expenses from the company’s gross receipts or turnover. Which means it’s the money that the business has left over after paying all expenses.
Another profitability indicator is operating profit margin. In it, the company deducts only operating expenses from its gross receipt or turnover to tell you how much money the company has got before paying interest and taxes.
You can also use a variety of tools to assess a company’s profitability. Here are few important metrics;
- Earnings per share – EPS
- Price to earnings – P/E ratio
- Return on investment – ROI
- Dividend payout ratio
- Dividend yield
You can use horizontal and vertical analysis to compare a company’s performance year on year or during the year and against industry standards.
If the company is working on a higher margin, it means it will generate more money for the shareholders. If the margin is low, then the business is not generating money and any adverse impact will create problems for the company.
Balance Sheet – Part of financial Statements showing assets and liabilities of the company
Balance sheet gives you an overview of what company owns (assets), what company owes (liabilities) and the networth, also known as book value. Investors use balance sheets to have a comprehensive overview of the company’s assets, liabilities and shareholders equity.
As an investor you need to understand how the company has financed its assets and how the cost of financing will impact the profitability.
Asset details can be found in the company’s balance sheet.
You need to look for the liquid assets the company has in its balance sheet. Liquid assets are cash, money in bank accounts, deposits, bonds and other assets that can be quickly converted into cash without losing any value.
You can use asset turnover ratio to know how efficiently the company’s management is using assets to generate revenue.
High asset turnover ratio indicates that the company is generating more revenue per rupee spent on the asset. If it’s low, then management is not effectively using its asset to generate revenue. Therefore, the higher the asset turnover ratio, the better.
The best way to analyse is by comparing with other company’s asset turnover ratios within the industry. It’s used as a measure for those companies which are into asset savvy industries such as power, telecom and infrastructure.
Accounts receivables turnover shows you how long the company takes to collect money from customers.
Inventory turnover is another factor you need to calculate to know how effectively the management is managing the inventory.
Main part of the liability section is Debt.
In case of high debt, if the company goes out of business, debt holders will get preference over equity shareholders to get their money back. Therefore, value investors always try to avoid high debt companies.
We have companies in infrastructure and other sectors, where high debt is part of their business as investment is huge in these sectors. Therefore, investors always try to analyse the impact of business on profitability in case of any adverse impact.
Debt repayments also eat up company’s earnings. Which affects a company’s dividend payments and ability to meet other expenses.
Apart from debt, you also have current liabilities which tells you company’s short term obligations to outsiders. You can also use your analysis to know how the company will fund its short term requirements.
Here are a few important financial tools you can use to analyse the liability side of the balance sheet.
Cash flow Statements
Investors and analysts say cash is king.
In addition to net profit of the company you should also look at the cash flow statement of the business to know how cash comes in and goes out of the business.
Cash flow statements will reveal the cash that company has received and spent under investing, financing and operating heads.
You also need to understand the cash figure in the company’s balance sheet. Which will reveal how much hard cash is in a company’s bank account to fund its growth and to take care in difficult circumstances.
Notes to accounts
At the end of the balance sheet and income statements, you will find notes to the accounts section. You need to read it carefully as it will give you more clarity on the numbers you are seeing in the financial statements and income statement.
Remember, notes to account change based on the type of company and industry. Here are certain most important things you should not miss;
- Accounting policies used for revenue recognition.
- Recognition of assets including intangible assets.
- How foreign currency transactions are accounted for.
- How asset impairment is recorded in the financial statements.
- How derivative transactions are accounted.
- How foregin currency exposure of the company is hedged.
- Mix of secured and unsecured borrowings.
Auditor’s report on Financial statements
Auditors are appointed as agents of the shareholders.
A company auditor shall make a report to the members of the company, which is published in the annual report.
It tells you following two important things;
- Content of the financial statements of the company represent the true state of affairs.
- Whether the company’s financial statements comply with the generally accepted accounting principles of the country.
A clean opinion gives a green signal on the company’s financial statements.
Qualifying remarks need to be looked at very carefully.
Remember, the auditor’s clean opinion on the financial statement does not certify that the stock is a good investment for you. You need to do your own research before investing.
Management discussion and analysis
In the annual report of the company you can find a section titled “Management discussion and analysis”. It contains a detailed explanation of the current situation and expectation for the future.
By reading management discussion and analysis, you can understand the future guidance and expected revenue growth of the company. They will also share their views on economic outlook.
You can also read the management discussion and analysis section of a competitor to have more clarity on the sector and industry. Better to refer to the annual report of the company who is considered to be the leader of the industry.
Things a financial statements don’t reveal
Financial statements have their own advantages and disadvantages.
Here are a few things that the company’s financial statements may not tell you.
- Fraudulent activities by the management to deliberately distort the numbers.
- Will the business continue to operate in future?
- Comparative analysis with the financial statements of company’s competitors.
- The actual market value of the company’s assets.
- Impact of non-financial information
Remember, in addition to financial statements, as a value investor you must review non-financial information which can impact the company’s business, such as quality of management, impact of the economy and industry, government decisions, political impact and company’s competitors.
If you are new to the financial market and planning to invest in stocks, we suggest you to choose the mutual fund route instead of investing directly in stock. If you have decided to invest directly in stocks, then learn all investing skills and each and everything of the stock market before getting into it.