How to Evaluate Financial Statements

Entering into an investment without sufficient research can spell financial doom. When contemplating an investment, evaluate the company's financial statements to attain an understanding of its fiscal stability. Each of the three major financial statements -- balance sheet, income statement and cash flow statement -- paint a picture of the company's position. The balance sheet exhibits the company's equity, the income statement denotes profitability and the cash flow statement shows how well it manages its money. Deficiencies in one or more of these statements should make you think twice about investing in that particular business.

Instructions

Balance Sheet

1. Add up the total assets and total liabilities. Subtract the liabilities from the assets. The resulting figure is the company's equity. The higher the equity, the stronger the company.

2. Divide the total assets by the total liabilities to get the current ratio. The greater the number, the better the company. A company with $200,000 in assets but only $50,000 in liabilities has a quick ratio of four to one, meaning the company has four times as many assets as liabilities.

3. Divide the total liabilities by the equity. The resulting figure is the debt-to-equity ratio. A lower number means the company has less debt in relation to its equity.

4. Perform an acid test. Subtract inventory from total assets. Divide that figure by total liabilities. A higher number makes the investment more desirable. This ratio denotes the company's ability to satisfy its debts in the immediacy.

Income Statement

1. Locate the company's net income at the bottom of the page. This figure is the company's profit after deducting cost of goods sold and operating expenses. If the company showed a loss, it may be a risky investment.

2. Add interest expense to net income. Interest is located on line 18 on the federal tax return. It represents finance charges paid on a company's outstanding loans.

3. Add depreciation to the sum of net income and interest expense. Depreciation is the decline in value of fixed assets. It is line 20 on the federal tax return. The resulting figure represents the money available for the company to service its debt.

4. Locate "mortgages, notes and bonds payable in less than 1 year" on the balance sheet. Add this figure to any proposed debt, such as a new loan. This is the company's current debt.

5. Divide the income figure by the debt figure. The resulting ratio is the debt-service coverage ratio. It exhibits the company's capacity to pay its debt. A company with a one-to-one debt ratio is only breaking even. A company with a two-to-one debt ratio has twice the income to satisfy its debt.

Cash Flow Statement

1. Analyze two to three years of cash flow from operating activity. Verify that net income has increased over that time. Compare the cash flow to the net income on the income statement. If the figures are not comparable, the company may be engaging in unscrupulous bookkeeping.

2. Analyze the cash flow from investing activity. Look for a trend of reinvesting profits in the company. If net income is high, but investments remain stagnant, the company may be unable to sustain growth and maintain its profit levels.

3. Evaluate the cash flow from investing activities. Loans should show a trend of repayment. If the amount financed increases each year without any existing debts being satisfied, the company is likely overleveraging itself.

References

• U.S. Securities and Exchange Commission: Beginners' Guide to Financial Statements
• "Inc."; How to Evaluate Your Company's Financial Position; Darren Dahl; August 2010
• Edward Lowe Foundation; How to Analyze Your Business Using Financial Ratios; Alex Auerbach