Analyzing Financial Statements
Publicly traded U.S. corporations disclose financial statements four times a year, giving investors and analysts a view inside the company. Financial statements are crucial for understanding the health and future viability and therefore analysis is an important tool for investors of all kinds. From the statements, key metrics can be determined that make comparison between corporations much more simple.
Other People Are Reading
Instructions
-
-
1
Determine profit and loss. The income statement of the financial report is probably the easiest to read because it is a straightforward rendering of a company's profit or loss over a period of time. These figures can be useful for judging past performance and predicting future earnings, but is also limited because not all items can be calculated reliably. The income statement also does not provide the same insight into a company that other metrics can.
-
2
Determine the liquidity ratio. While different methodologies are used for different purposes, the liquidity ratio is simply the company's cash and assets divided by its debt and is used to determine a business' viability. By using only the most liquid assets, like cash and cash equivalents, versus short term debt, a more immediate metric is produced. A bankruptcy court, on the other hand, might include all assets including essential operating equipment in determining the ability of a company to pay all its outstanding debt.
-
-
3
Determine the activity ratio. The precise data going into the activity ratio will vary from company to company, but it essentially measures the pace of a company's business. In retail, same-store sales is a key activity metric. Inventory level is important to a company with manufacturing operations. However it is determined, the activity ratio is intended to calculate how quickly a company can convert production into sales and cash, a key factor for predicting a company's future revenue and earnings.
-
4
Determine the profitability ratio. Also known as margins, profitability ratios indicate how much each unit of business contributes to overall profits. It can also be viewed in aggregate, showing how much the whole company earned over a period of time compared to costs and other expenses. Profitability is calculated on numerous time frames, particularly quarterly and annually, and is used to compare to a company's past performance as well as to other companies in similar or dissimilar sectors of the economy.
-
5
Calculate earnings per share and share price per earning value. Using the earnings reported in the financial statement and the estimate for future earnings, the earnings per share can be calculated and from that, the share price per earning value. This is a useful metric for stock investors attempting to determine the relative value of a stock.
-
1
Tips & Warnings
Financial statements are usually embedded within quarterly and annual reports that may contain important information regarding interpretation of the financials. Generally, thoroughly understanding a company's operations, risks, and debt structure goes hand in hand with interpreting financial reports.
Frequently, analysts look for "red flags" in a balance as often as they look for hidden gems. The early identification of potential problems in a company's financials can prevent significant losses. See the Resources below for more on spotting red flags.
The string of corporate scandals since Enron show just how easily some companies can manipulate their financial statements. Even without manipulation, analysts can vary widely in how their interpretations predict future earnings. For this reason, consensus estimates are calculated. Substantial outliers should be regarded with caution.
Resources
- Photo Credit Best Ways to Invest
