Financial statements give a snapshot of a company’s operations and its financial health. A study of the four main statements – the balance sheet, income or earnings statement, the cash flow and statement of shareholder’s equity – reveals significant trends to figure out if a company is worth investing in. For the purpose of this post, we will focus on the balance sheet and the income statement. Financial statements analysis is a powerful tool when investigating companies for the purpose of investment.
The balance sheet is the core of the financial statements and all other statements feed into it. It depicts the health of a company at a point in time and shows how it has changed over the reporting period, be it a quarter or a year. Do not overlook the footnotes where there is often important information that doesn’t fit in the regular financial statements.
Balance sheets are best compared with the year-ago period, and useful things to look out for are:
- Significant changes in debt. Is the company paying down its debt or increasing debt levels? Manageable debt can be viewed positively.
- Inventory levels. Ballooning inventory might indicate poor sales and sends out a red flag
- Quick ratio. This shows how much cash is readily available to cover current obligations.
The income statement summarizes changes in sales and profits over a period of time and most income statements are presented with year-ago figures for comparison.
The key figure is the earnings per share or EPS. During the reporting period, analysts spotlight the EPS and how they match up against street estimates. Frequently, the market rewards a company which earns significantly more than analyst estimates by bidding up the share price the next day as a higher than expected EPS means that the company is doing far better than thought.
An EPS which just matches or is slightly below estimates can lead to selling the next day. As they say, buy on the rumor and sell on the news.
However, just as important are the gross and operating margins that reveal the profitability of the company’s main businesses. Increasing margins indicate improved efficiencies, higher sales prices or lower costs.
Compare these figures to those of a company’s competitors to determine which is the more profitable and efficient. Just remember that margins vary from industry to industry, and a thin margin does not mean a company is not vastly profitable. Look at Wal Mart which makes up for slim margins with phenomenal sales.
Why should I care about financial statements analysis?
The detailed information available on financial statements is only of interest to someone who is doing some extensive research on individual stocks. If you invest in mutual funds, index funds or ETFs then you don’t need to know the details but it is useful to know the terminology since fund managers and other investing types will often talk about details from the financial statements in the business section of the news.