How to Analyze Income Statements & Balance Sheets for Stock Picking
Public companies usually post financial statements on their investor relations websites. The income statement shows the revenues, expenses and profits. The balance sheet shows the assets, liabilities and shareholders' equity. Stock picking involves analyzing the financial statements of several companies and selecting those that demonstrate consistent profitability. Gather the financial statements of recent accounting periods to start the analysis.
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Instructions
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Income Statement Analysis
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Look for positive sales trends across a company's operating segments. Read the management discussion section of the quarterly report to determine the reason for a declining sales trend. If the decline is due to deteriorating business fundamentals, do not buy the stock.
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2
Find the operating and net income margins. The operating margin equals operating profit divided by sales, and the net income margin equals net income divided by sales, both expressed as percentages. The operating profit equals sales minus operating expenses, and the net income equals operating profit minus interest, taxes and unusual items. Assess the company's ability to control costs. For example, if the revenue rises by 5 percent, the expenses should not grow by more than 5 percent to maintain margins.
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Compare the price-to-earnings ratio to the industry average or the company's historical average. The price-to-earnings ratio is the current market price divided by the earnings per share, which equal net income divided by average shares outstanding. Companies that consistently grow earnings usually have higher price-to-earnings multiples. When comparing the P/E ratio to other companies, keep in mind that start-ups and other growth stocks tend to have higher-than-average P/E ratios.
Balance Sheet Analysis
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Evaluate the current ratio, which is the ratio of current assets to current liabilities. If the ratio is 1 or better, it means the company can meet its short-term obligations. Avoid stocks with a current ratio of less than 1. A more stringent measure is the quick ratio, which removes inventory from the current assets calculation. The current assets include cash and other assets that the company plans to use within a year, and the current liabilities include accounts payable and other debt that matures in less than a year.
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Compute the inventory turnover, which is the cost of goods sold divided by the average inventory during an accounting period. A high ratio indicates management efficiency in converting inventory to sales, which means fewer obsolete items in stock, lower cost of goods sold and higher profitability and cash flow. Note that cost of goods sold is an income-statement item, which is equal to the beginning inventory plus purchases during the accounting period minus the ending inventory.
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Look for a consistent accounts receivable balance. A growing accounts receivable balance could mean that the company is having difficulty collecting on its outstanding invoices, which could lead to cash flow problems and loss of operational flexibility.
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Tips & Warnings
A common-size financial statement expresses all values as percentages of some base value, which is usually revenue for the income statement and cash for the balance sheet. Percentages make it easier to evaluate a company's financial performance over time and compare it against industry peers.
Financial statements have certain limitations. First, they use historical data, which have limited predictive value. Second, the accounting procedures may vary across companies. Third, the statements do not provide qualitative information, such as why sales or profits are down. Finally, companies may have fiscal years that start on different months.
