Have you been eyeing a stock for a long time but not sure if you should invest in it or not? You are not alone – this also happens to most of us.
Investing in the stock market might seem exciting, especially for beginners, but there are many challenges. So, before investing in any stock, even if it seems tempting, a background check of the company’s financial statements is essential in order to be on the safer side and make better investment decisions.
But what are the things you need to check when it comes to a company’s financial statements? Well, in this post, we provide you with a checklist to help you analyze if a company is financially sound or not. Consider this before investing in stocks that are released by a company.
Beginners Checklist for Analyzing Stocks Before Buying
#1: Understanding the Basics
Financial statements are a set of reports that provide an overview of a company’s financial performance and its position over a specific period of time. The three primary financial statements are the income statement, balance sheet, and cash flow statement. Let’s quickly see what each of these entails.
Income Statement
The income statement is also known as the profit and loss statement. It gives you a good idea of what the company’s revenues, expenses, and profits looks like over a specific period of time.
Key elements that you need to examine include the revenue and net income. Check if the company’s revenue is growing consistently over the years and whether profits are increasing or decreasing. If increasing, are they sustainable?
Balance Sheet
The balance sheet outlines a company’s assets, liabilities, and shareholders’ equity at a specific point in time. Important factors to check:
- Assets: Are they growing, and is the composition healthy?
- Liabilities: Is the company managing its debt responsibly?
- Shareholders’ Equity: What portion of the company is owned by shareholders?
Cash Flow Statement
This statement tracks how changes in balance sheet accounts affect cash and cash equivalents. It is divided into three categories:
- Operating Activities: Is the company generating cash from its core operations?
- Investing Activities: How is the company investing its money?
- Financing Activities: How is the company financing its operations and growth?
#2: Ratios and Metrics
Once you’ve reviewed the financial statements, it’s time to understand the financial ratios and metrics. These help you get a better idea of the company’s performance and financial health.
Liquidity Ratios
When we talk about liquidity ratios, then we will be talking basically about two types. The first is the Current Ratio. This is what helps you assess a company’s ability to cover its short-term liabilities with its short-term assets. It’s calculated by dividing current assets by current liabilities. If the ratio is above 1, it indicates good short-term financial health.
The second is the Quick Ratio. This is quite similar to the current ratio but excludes inventory. It actually provides a more conservative measure of liquidity.
Profitability Ratio
- Gross Margin: It indicates the company’s profit after accounting for the cost of goods sold. A higher gross margin often indicates a competitive advantage.
- Net Profit Margin: Reveals the percentage of profit a company retains from its revenue after all the expenses. Remember, positive net income is a good indicator of profitability, but consistent growth is even better.
Debt and Solvency Ratios
- Debt-to-Equity Ratio: It calculates the amount of debt a company uses to finance its operations. A lower ratio is generally better, as it means less dependence on borrowed funds.
- Interest Coverage Ratio: It assesses a company’s ability to meet its interest obligations with its operating income.
Efficiency Ratios
This shows how quickly a company is selling its inventory. At the same time, it is also a measure of how efficiently a company collects its receivables from customers.
Analytical Ratios
- Price-to-Earnings (P/E) Ratio: This ratio compares the current market price of a stock to its earnings per share. A lower P/E ratio might indicate a potential undervalued stock.
- Return on Equity (ROE): ROE measures how efficiently a company uses shareholders’ equity to generate profits. Consistent, high ROE can be a sign of a well-managed company.
#3: Industry and Market Comparison
Compare a company’s financials with industry averages to identify outliers or areas where the company excels or underperforms. Keep yourself updated about overall economic conditions and market trends. These external factors can have a greater impact on a company’s performance. Incorporating firmographic data into your stock analysis toolkit can significantly enhance your ability to evaluate a company’s market position and growth potential within its industry.
#4: Analyze Trends Over Time
Examine financial statements over several years to identify trends. Consistent growth in revenue, earnings, and cash flow can be positive signals. Also, make sure the company maintains consistency in its accounting policies. Sudden changes can obscure the true financial picture.
#5: Risks and Red Flags
Check if there are any possible red flags present, such as declining revenues, rising debt levels, or erratic earnings. A thorough analysis should include an investigation into negative trends.
Do not forget to read the MD&A section of the annual report, where management discusses the company’s financial performance and future prospects.
Final Note
Analyzing a company’s financial performance is important to understand if you are making the right decision while investing in its stock. A thorough analysis of all the important financial factors, as mentioned above, will help you make a checklist whenever you plan to invest in a company.
Explore the stock market and do your research to gain knowledge so that you can make investment decisions with confidence. Just make sure it aligns with your financial goals.
