How to analyze company financial statements
Beginner Stock Market Investing, Stock Market Investing Strategies
If you have to establish an accurate evaluation for a company, you have to look at its financial statements to understand its financial position. If you understand what you are doing, this is not a particularly difficult proposition. Your starting point is the balance sheet which lists all the assets and liabilities of the company as well as the shareholders equity or net worth. The assets and liabilities are used to establish the strength [or weakness] of the financial position of the company.
We start with the current assets and the current liabilities. Current assets are those assets such as inventories and receivables which are expected to be liquidated for cash within a period of 12 months. Similarly current liabilities are those liabilities such as dues to suppliers or short-term loans that are expected to be paid within a period of 12 months. For many companies, inventories account for a large proportion of their current assets and thus represent substantial cash investments. Companies will generally try and maintain a balance between the level of sales and inventories because too little inventory can cause a stock out whereas too much inventory is a waste of capital. If you find that a company manages a 20 percent increase in sales with a 20 percent reduction in inventory, it is a sign of good management because the effect is to increase the generation of operating cash.
On the other hand, current liabilities represent the short-term obligations of the company and will include such items as payments to suppliers, salaries and wages, expenses such as utility bills and so on. The company should aim to ensure that it has enough cash on hand to meet these obligations as and when they fall due. Failure to meet these obligations in a timely fashion is often the first sign that the company is facing a liquidity crisis. The Current Ratio, which is defined as current assets divided by current liabilities, is used by analysts to assess the liquidity position. The acceptability of a current ratio depends on the industry but many experts use a benchmark of 2:1. The ratio should not be too low because this would imply liquidity problems and not too high because this would indicate an unnecessarily high level of current assets. Another measure of liquidity is the Quick Ratio which uses cash and near cash items of current assets divided by current liabilities. This ratio which evaluates the ability of the company to meet its obligations without liquidating inventories or receivables should ideally be 1:1.
Another figure that you can deduce from the balance sheet is the Book Value which is defined as the difference between total assets and total liabilities. This is the value of the funds that belong to shareholders and is also called the shareholders equity or net worth. By calculating the ratio of the company’s market capitalization to the book value, you can establish a multiple that will identify whether the company is undervalued or overvalued in relation to its peers. The market price to book multiple provides a basis for comparison with competitors or similar sized companies in similar lines of business.
Tags: assets, finance, financial statements, liabilities, Stock Market Investing, stock research