Stocks 404 – Reading Financial Statements
Being able to read and understand a company’s financial statements is the key to evaluating its performance and risks. The three financial statements for every company is: balance sheet, income statement, and cash flow statement. Quarterly, and then annually each statement is released to the public. Every company operates on a different fiscal year schedule, so the quarter and year will end on varies days. On your brokerage’s site, you can find when a company will release their next statement.
A balance sheet shows the assets, liabilities, and shareholder’s equity for a company for a particular period of time. This is one of the most important reports for analyzing the financial health of the business. The assets are what items the company owns, while liabilities are how those items were paid for or, simply what is owed. The shareholder’s equity commonly contains the company’s stock and retained earnings (income to be used for further growth opportunities). The balance sheet will balance as follows: assets = liabilities + shareholder’s equity.
Identifying a Strong Balance Sheet
There are several metrics of a company’s financials that can shift it from having a strong balance sheet to a weak one. The major keys to look for are: cash, investments, and debt. Companies who are flushed with cash and have solid short and long-term investment positions usually fair well over time. An abundance of cash can easily turn into dividends for shareholders. When coming across a balance sheet stuffed with long-term debt, it can represent an issue that management is operating heavily on borrowed money and potentially cannot repay it in full. High debt-to-equity ratios can be one of the first signs towards having a weak balance sheet.
The income statement is your go to when looking to assess the revenue, operating margin, and profitability of a company. In order for a business to remain solvent, it has to continue to return a profit. The statement is represented as: revenue – expenses = net income. Revenue is equivalent to sales, for most companies. The revenue and income for companies have a strong effect on its stock price. If a company has a loss, opposed to a profit, then investors surely will steer clear of it, causing its price to drop.
A Strong Income Statement Is Unique
Not every income statement is alike. Since every public company is identified by a specific industry and have a wide range in sales, having a strong income statement is only relative to that company and its competitors. The income statement will unveil the company’s revenue, gross profit, and net income, which is used to calculate the important earning per share ratio (EPS) – Net Income / Shares Outstanding. It’s vital for the revenue and earnings to be on a positive trajectory over the long-term. Having little or no increases to its operating expenses and taxes is imperative as well, to prevent slow or negative growth of profit. When a company sees consistent growth in its EPS, it typically correlates to its stock price rising.
Cash Flow Statement
Cash flow statements are essentially what they are called – cash flowing in and out of a company. This occurs when cash and cash equivalents are moving throughout the balance sheet. Common terms for this are financing, investing, and operating activities. Financing activities are situations when the company is looking to raise funding, by issuing stock or bonds. Investing activities would be the necessary reinvesting of funds to improve the business, or some companies actually buy stock in other companies. The operating portion displays the cash inflows and outflows pertaining to any operational matters.
The Importance of Cash Flow
The continuous operations of a company must at some point return those efforts into cash or tangible assets to be considered positive cash flow. Just because there are reinvestments in the business operations doesn’t make it the right strategic direction. Having low cash flow is a representation of how effective management is on the company’s operations. Poor acquisitions can hurt the cash position, as the return on that investment could fall painfully short of expectations. The amount of cash available to distribute to shareholders, after paying its financing dues, is called the free cash flow.
Reading and understanding a company’s financial statements is the most important piece to determining whether it is a good or bad stock. There are many factors to consider when evaluating the current and long-term strength, as well as its growth. Be mindful that just because a company has a strong income statement, it doesn’t make it a great business. Excellent companies have outstanding financials within all three financial statements.