A company’s financial statements can be a valuable source of information when considering where to invest, with these documents containing a lot of useful qualitative and quantitative factors that will inform your analysis. But making sense of financial statements can be tough, and they often contain a lot of dense information and statistics. Here are some tips on how to analyse a company’s financial statements to help you get the most out of your analysis.
How financial statements work
As mentioned in our fundamental analysis blog post, there are a number of factors you should consider in your assessment of a company. These include quantitative factors related to information that can be shown in numbers and amounts, as well as qualitative factors that relate to the nature and standard of the asset rather than its quantities. In terms of where to look, stock investors rely on three financial statements: the income statement, the balance sheet and the cash flow statement.
The income statement summarises a company’s revenues and expenses over a period, either quarterly or annually. There are two basic forms for an income statement- multi-step, which uses four measures of profitability that are revealed at four critical junctions in a company’s operations (gross, operating, pretax, and after tax) and single-step, which does not mention the gross and operating income figures.
The balance sheet is a report of the company’s assets, liabilities and shareholders’ equity at a specific point in time. This report is a snapshot representing the state of a company’s finances at a moment in time, which means it cannot give a sense of the trends that are playing out over a longer period by itself and should be compared with those of previous periods. The balance sheet should also be compared with those of other businesses in the same industry, as different industries have different approaches to financing.
The cash flow statement provides data concerning the inflows of cash and cash equivalents a company generates and uses over a certain time period. The main components of the cash flow statement are cash from operating activities, cash from investing activities, cash from balancing activities and in some cases disclosure of noncash activities.
What to look for in a company’s financial statements
From these three documents, here are some important financial details you can find and factor into your analysis of the company’s viability:
- Assets and liabilities A company’s assets are the tangible and intangible resources that it owns, while a company’s liabilities are the tangible and intangible resources that it owes. These two figures can be used to determine a company’s net worth.
- Bottom-line/ net income This is a company’s income after all expenses have been deducted from revenues. These expenses include interest charges paid on loans, general and administrative costs, and income taxes.
- Capital expenditures Capital expenditures (capex) are funds used by a company to buy, upgrade, and maintain physical assets such as property, plants, buildings, equipment or technology. Capex can tell you how much a company is investing in existing and new fixed assets to maintain or grow the business.
- Current ratio A company’s current ratio can be used to determine how well the company handles outstanding debt, and is calculated by dividing its current assets by its current liabilities. A current ratio lower than the industry average may indicate a higher risk of distress or default, while a very high current ratio compared to the industry average suggests that the company may not be using their assets efficiently.
- Dividend payout ratio The dividend payout ratio is the percentage of earnings paid to shareholders in dividends, and is calculated by the dividends paid divided by the net income. This ratio indicated how much money a company is returning to shareholders versus how much it is keeping on hand to reinvest in growth, pay off debt, or add to cash reserves.
- Earnings per share (EPS) The earnings per share (EPS) of a company is its net profit divided by the outstanding shares of its common stock, and serves as an indicator of the company’s profitability.
- Operating profit margin A company’s operating profit margin compares the amount a company earns before interest and taxes on sales are calculated, and can be a useful indicator of profitability and efficiency. To calculate this margin, you divide the operating income by the revenue and multiply that figure by 100.
- Price-earnings (P/E) ratio The price-earnings ratio (P/E ratio) relates a company’s share price to its EPS, calculated by dividing the market value per share by the EPS, and can be used to determine the relative value of the company’s shares.
- Price to book (P/B) ratio The price to book (P/B) ratio is calculated by dividing the market price by share by the book value per share, and reveals the market’s valuation of the company in relation to its intrinsic value.