Stock market investors can learn a lot from analyzing a company’s financial statements. A company’s income statement, balance sheet, and cash flow statement are particularly useful for understanding how a business operates, its stability, and the value of its shares.
Open the most recent financial statements for the business. Publicly traded stocks provide quarterly financial statements to the Securities and Exchange Commission in the form of 10-Q and 10-K filings. These documents are available on the SEC’s website and can be searched using a stock ticker symbol. These records are also available in the “Investors” or “Investor Relations” section of the Company’s website.
Locate the income statement on file and check trends in sales, major expenses, and net income. The growth in sales and profits is excellent, but the decline in sales, the decline in profits and the increase in expenses suggest that the company is in trouble. Examine the footnotes for non-recurring items and determine for yourself if similar losses or gains are likely in the future.
Analyze the balance sheet. Notice if the business has paid down or increased its debt, or if the value of certain items has decreased significantly. You should also note the carrying amount assigned to intangible assets and goodwill. If these are large numbers, check the footnotes to make sure they might be of use to the business in the future.
Analyze the cash flow statement. For operating cash flow, determine whether each past source or use of cash could be repeated in the future. Unsustainable sources and uses of cash should not be used to project future cash flows. Calculate free cash flow to investors by adding operating cash flow and capital expenditure (a component of investing cash flow). Investors should be drawn to companies with the potential to generate positive free cash flow. Also consider investing and financing cash flow. Find out if the business needed to cover investing and operating cash flow by borrowing or issuing stocks, and try to determine if it will start over in the future.
Adjust historical book values to reflect today’s economic reality. Items listed as non-recurring or likely to continue should be added to net income. Adjust balance sheet items to reflect their economic values if they are different from their book values.
Calculate or research valuation ratios. Valuation ratios reveal how expensive a stock is to investors and include price-to-book ratio, price-to-earnings ratio, and price-to-sell ratio. These ratios divide a company’s market capitalization by book value (equity on the balance sheet), profits (net income on income) and sales (the top line on the income statement).
Calculate other financial ratios. Liquidity ratios reveal whether a business is able to pay its creditors. The current ratio is calculated by dividing current assets by current liabilities. The quick ratio is calculated by dividing current assets minus inventory by current liabilities. Current ratios below 1.5 and rapid ratios below 1 are cause for concern and could indicate that a company may be having difficulty paying its creditors.
Make comparisons. Financial ratios can be compared between comparable companies that use the same accounting policies and operate in the same industry. They can also be used to compare a stock’s current valuation and performance against its historical valuation and performance.