Financial Statements Analysis Tips
One of the dilemma facing most individual investors is how to quickly analyze company’s financial statements. With so many financial ratios, it could get confusing. Moreover, understanding ratios requires an in dept analysis and some financial background. The fact of the matter is most of us don’t have the time or knowledge to go through financial statements. Here three things one should at least consider when going through the balance sheet and income statement.
The balance sheet shows what asset or resources the firm controls and how it is has financed these assets. What it indicates is the current and fixed assets that are available to the firm at a point in time. A high quality balance sheet will typically have limited use of debt or leverage. Little use of debt implies the firm has unused borrowing capacity, which means the firm can draw upon that capacity for future investments. It is not necessarily a bad thing if the firm debt is high, but it is important to be aware the degree in which the firm is leveraged. Low debt tells the potential for financial distress is low. Another indication of a quality balance sheet is it will contain assets with market value greater than their book value. For example, having tangible assets such as goodwill, trademarks or patents make the firm market value exceed their book value.
When looking at the income statement, we typically look for earnings that are repeatable. If the earnings arise from sales to customers who are expected to do repeat business, the firm’s revenue stream is considered to be in good shape. Look at the growth rate of their revenue (year over year). Is it consistent? Does the firm blow away their numbers in one quarter and disappoint the next? A solid company will consistently deliver. However, it’s important to keep in mind some industry revenue could fluctuate and the inconsistency could be normal. One time and non-recurring items such as accounting changes, mergers, and asset sales should be ignored when examining earnings. Another important factor to consider is the use of conservative accounting principles. Firms should use Generally Accepted Accounting Principles (GAAP). Conservative accounting principles will reduce the chances of inflated earnings and understated costs.
Finally, read the footnotes. The footnotes will provide information on how the firm handles balance sheet and income items. Although the footnote won’t reveal everything you should know (e.g., Enron), if you skip the footnotes you won’t ever know. In fact, we recommend reading the footnotes first, then balance sheet, followed by the income statement. Obviously, there is more to stock analysis than this, but if you consistently do this over time, it will become second nature and you’ll reduce the chances of losing your hard earned money.
Best of luck!
