How important it is to read financial statements and then invest in stocks?

I was wondering how good it is to know to read financial statements to make investments. People say that reading financial statements is the key to profitable investment. I know this question troubles majority of people who likes to invest but are not sure about it. It is even more interesting for those investors who are already investing but without any idea about reading and analyzing financial statements. In this article we will see what actually we miss if we are investing in stocks without reading financial statements of companies.

We have all heard that stock market investments are risky. The risk comes due to short term stock market volatility. In short term the variation in market price of stocks can be very annoying. But in long term (5 to 7 years min) there will always be slow and steady appreciation in market price of stocks. But it is possible to make a slow and steady appreciation a faster one. Fast appreciation is possible if (1) we are buying shares of fundamentally strong companies, (2) we are buying shares of companies at undervalued levels & (3) we are buying shares of companies paying high dividends.

As a rule of thumb we can say that following parameters tell us that a company is fundamentally strong:

(a) ever increasing balance sheet reserves of company
(b) ever increasing book value per share of company
(c) ever increasing earnings per share (EPS) of company
(d) ever increasing dividend payments (with high dividend yield if possible) to shareholders
(e) company able to maintain its short term cash flow (current liability management) always positive since at least last 5 years.

An investor who is buying a share in considerations to points list above has opportunity to keep the investment risk (which is a inherent characteristic of stocks) to bare minimum.

So coming back to our question that what an investor can lose if he is not reading financial statements and investing in stocks. The investor will never know that the company, whose shares he/she is buying, is fundamentally strong or weak. A fundamentally weak company will have less probability of price appreciation in future and moreover they will have less chance of high dividend disbursements.

When a long term investor buys shares, he does so with an objective of (1) earning periodic dividends & (2) market price appreciation. Market price of shares will appreciate if company is upgrading its fundamentals year after year. If profits of company is increasing then companies will be more likely to pay higher dividends to its shareholders. As value investors say ‘the true value of a share is dependent on its ability to generate future income for its shareholders’. For share market investor future income comes in two ways, market price appreciation and dividend income.

Conclusion
If our focus, as share market investor, is investing in shares which has strong possibilities of market price appreciation and high dividend income then we must learn to read financial statements of companies. Reports like balance sheets, profit and loss accounts and cash flow statements talks a lot about how well the company is managed. A company run by strong managers are bound to make good money for its shareholders.

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