If you want to be a successful investor, there’s one absolutely critical skill you need to acquire, and that is the ability to read a financial statement. This is particularly important if you trade individuals stocks.
No matter how many experts recommend a given stock, you still need to read the company’s financial statements before investing any money.
The financial statements could reveal a hidden landmine or two, that might make you less optimistic than people recommending the company.
When we talk about reading financial statements, what we really meaning is analyzing them. What we’re most interested in knowing are certain ratios and financial correlations that the financial statements reveal.
Those relationships don’t jump out at you from the statements – you have to find the relevant numbers and do the calculations yourself.
Let’s look at the two most important types of financial statements. The statements should be taken from the company’s most recent 10K report, since these are filed with the Securities and Exchange Commission (SEC).
How to Analyze an Income Statement
The income statement is the financial reporting document that shows the company’s revenues, expenses and net profit.
We can’t possibly cover all the nuances of an income statement in this article, so let’s look at some of the most important relationships and ratios.
Net profit margin. This is net after-tax income, divided by gross revenue. For example, if a company had total sales of $1 million, and a net after-tax profit of $150,000, the net profit margin would be 15% ($150,000 divided by $1 million).
You’ll want to compare this to other companies in the industry, to see how well they're really doing. A 15% net profit margin by anyone in an industry where 10% is the norm, means the company is more profitable than it’s competitors.
Earnings per share. This number is generally determined by dividing net after-tax income by the number of shares outstanding. In fact, the number will generally be presented to you on the income statement. But there is a secondary calculation that you want to perform in addition. This is diluted earnings per share.
It is arrived at by dividing net after-tax income by the number of outstanding shares of stock plus any potential additional shares that may be issued. This will include the number of outstanding stock options, warrants, convertible preferred stock, or any other open equity offers. This number gives a more accurate picture of the company’s actual earnings per share.
You will want to compare diluted earnings per share to industry averages, but you’ll also have to compare them to the stock dividend yield. This number will indicate that the company has sufficient net income to continue paying dividends at the current rate, if there is room to increase them, or even if a cut might be in store in the future.
Return on equity. This is calculated by dividing net profit by average shareholder equity. A $100,000 net profit by a company with average shareholder equity of $1 million produces a 10% return on equity (ROE). This percentage should be compared to industry averages.
If it is higher than the norm, it means the company is making better use of company assets. It may also mean that the company can generate cash internally — without borrowing or selling more stock — which are all very good signs.
Return on assets (ROA). ROA is determined by dividing net income by average assets for the reporting period. If a company has a net income of $200,000 and average assets of $2 million, the ROA is 10% ($200,000 divided by $2 million).
This number is especially important in asset-intense companies, such as manufacturing concerns. It’s an indication of how well the company is utilizing its assets to generate profit. Once again, it should be compared to industry standards.
How to Read a Balance Sheet
The balance sheet is the financial reporting document that discloses the company’s assets, liabilities and net equity.
Here are some of the ratios you’ll want to investigate on the balance sheet.
Quick test ratio. This is a balance sheet test of the company’s liquidity, the ability of the company to come up with cash on short notice. This is a strong indication of the company’s management of its cash.
It is derived by taking current assets, less inventories and dividing the result by the amount of current liabilities. This should be a positive number (greater than 1).
Inventory turnover ratio. This is calculated by dividing cost of goods sold (from the income statement) by the average amount of inventory for the reporting period. If a company has a cost of goods of $5 million, and an average inventory of $1 million, the inventory turnover ratio is 5 ($5 million divided by $1 million).
If the industry average for this number is 4, then the company is turning it’s inventory faster than it’s competitors. If the industry average turnover ratio is 10, then the company is turning it’s inventory much more slowly than its competitors.
This can indicate a problem, especially if inventory comprises a majority of the company’s current asset total. Slow turnover of inventory can be an indication that certain inventory isn’t moving, and may be subject to a write-down that would weaken the company’s financial standing.
Current ratio. This ratio indicates the value of assets that are likely to be converted to cash within one year to pay company debts. It is determined by dividing current assets by current liabilities.
Three million dollars in current assets and $2 million in current liabilities results in a current ratio of 3:2, which in most industries is solid (but check for the average in the sector as it can vary).
This ratio could be a problem if it varies from the norm by any significant amount and in either direction. If the number is low, and especially if it is negative, it could mean that the company won’t be able to pay its debts. But if the number is too high, say 3:1, it could mean that the company is being too conservative and not investing assets efficiently.
Book value (net tangible assets). Book value addresses the question how much does the company earn on its investment in physical assets. It is calculated by taking the total assets of the company, less any intangible assets (like goodwill).
That leaves the company’s net physical assets. A company that generates a net profit of $5 million on net tangible assets of $10 million will be able to expand its profits with far less capital investment than a company that has a net profit of $5 million on $20 million in net tangible assets.
This will indicate how easily and efficiently a company can expand its operations compared to its competitors.
These are just a few of the analyses that can be performed on a company’s financial statements. But it highlights the value of learning how to read financial statements, and the often less obvious information doing so can reveal.
How strong is your ability to read financial statement?