Monday, August 29, 2011

How to read financial statements for investing in shares

All shares needs to be evaluated before being purchased. There are champions available in this world who master this art of share analysis. We are common people can only aspire and try to reach to that effectiveness. Take example of likes of Warren Buffett and Peter Lynch who has almost perfected the art of share valuation. These people who are so good in share valuation and analysis that they have made stock market investment as their profession. But the question we all want to ask that, we are common people, who are not experts of stock market, what we can do to buy shares like masters. In this article we will try to list down some key points which prospective investors can use for their investment-advantage.

General Observations

The fist visible think that investors will be exposed about a share is its market price. In isolation, market price of a share speaks nothing about its value. As an intelligent investor, one must to get more meaning out of the market price of a share. We must not how the market price of share has behaved in last one year (52 weeks). Try asking this question, Whether the current price is towards 52W high or 52W low? If the market price is towards 52W high it means there is price appreciation. It is possible that due to this price appreciation the share may be already over-valued. So this needs to be analyzed that whether the share is overvalued or still it has opportunity for some appreciation. The objective is to establish a trend (a pattern) of market price of share.

Once you get an idea of the trend of market price of share (rising, falling) your next step is to compare the market price with the ‘book value’ per share. If the market price is less than the book value it is a first visible sign that this share may be undervalued. Ideally speaking if share is equal to or less than its book value then it gives a small hint towards profitable investment. But of course we need to see other parameters as well. As a rule of thumb a share whose price to book value ratio is above 1.5 may be hinting towards overvaluation.

Price Earning Ratio (P/E) is another readily visible indicator that is very helpful in share evaluation. But again P/E ratio in isolation (like market price of share) will speak a lot about share valuation. But if you will compare the P/E ratio of this company with average P/E of all companies of its sector, you will get an idea that whether this share is trading at undervalued rates or overvalued rates.

Another visible indicator (but the most powerful) that talks a lot about the performance and psychology of company is its dividend yield. If a companies’ dividend yield is higher than current risk free rate, then it automatically becomes a favored stock. But you will hardly find shares with such high dividend yield. If at all you find those will be only one time payments. So it is important to check that if a company has paid high dividend then whether they have been paying it consistently over a period of time or it is one-off case.

Balance Sheet

A lot of information is contained in the Balance sheet of the company related to the financial health of a company. If we call a person as wealthy, then it is obvious that this wealth has not come to him in a short time. After years and years of wealth accumulation and persons becomes rich now. The same is applicable for a company/organization. The wealth accumulated by a company over a period of time is reflected in its balance sheet. In financial terms the accumulated wealth of a company is called as net worth. It is equal to accumulated reserves plus shareholders equity.

Generally the Shareholders Equity remains constant for a period of time (it not varying frequently). But the ‘reserves’ of a company should ideally increase year after year. From the profit made by the company, a portion of it is transferred to the companies’ balance sheet as ‘reserves’. This happens every year. The faster the company reserves are growing (means net worth) the stronger the company gets financially. A company which is paying good dividends and simultaneously increasing its reserves very fast provides ideal investment opportunity for investors. (in addition to dividend yield & reserves, EPS shall also grow fast, we will see this is income statements).

Cash & Bank Balance positions of companies are also reflected in Balance sheet of a company as current assets. For a company to run its day-to-day operations they need sufficient liquid cash to pay all their immediate dues (called as current liability). If cash and bank balance positions are showing positive values over a period of time (say last 5 years) it means that the company has been managing its cash flow well (more about cash positions will be discussed in cash flow statements).

It is also important to note how companies fixed assets  has increased over a period of time. In order to make a meaning of the fixed asset figures, we will have to compare it the sales turnover (available in income statements) of the company (sales/fixed asset). The fixed assets of the company should ideally increase year after year. This means that the company is expanding its capacity. With capacity expansion the sales volume will also grow. With increasing sales/fixed asset over a period of time, it means that the company is effectively using its fixed assets to produce more goods and services.

Similarly like fixed assets, we must also track variation in sales/inventory ratio over a period of time. Ideally this ratio should be increasing.

We have already noted the book value of the company in our general observations. But it is also important to see how the book value has increase over a period of say 5 years. Book value has direct effect on the market price of share. Generally all good shares maintain a constant price/book value ratio. So with increase of book value, the market price will also rise. If book value is increasing fast, it means you have a chance of fast market price appreciation. But some companies, issue additional shares to raise fund. In this case the book value per share gets reduced and this in turn will affect the market price of share (it will be reduced in same proportion in a course of time).

Book Value Per Share = "Common" Equity / Common Shares Outstanding

Profit and loss accounts

Like Balance sheet tells us about the accumulated wealth of the company, Profit and loss accounts tells us about only last year’s performance (income, expenses & profits) of a company.

The first thing that is worth noting in the income statement is the rate of increase of sales volume & operating profit of the company over a period of say last 5 years. Note the annual growth rate (CAGR) of sales and operating profit over a period of 5 years. A healthy growth in sales and operating profit is a good sign that the company is capturing wider market and also its is increasing its capacity to match the increased demand. Bettering its operating profit means that the manufacturing process if becoming more efficient.

The second thing which is important worth noting in income statements is number of shares outstanding in the market. Ideally the number of shares issued for public trading shall be constant. But often companies issues additional shares for more fund generated to do business. But increase of number of outstanding shares also reduces three important share characteristics which directly effects the market value of share. (1) Book Value per share, (2) Earning per share & (3) Dividend payment per share. In short term issuing additional shares decreases the intrinsic value of share. For existing investors, increase in number of outstanding shares is never good (at least in short term).

Basic EPS may be thought of as a fraction with income in the numerator and the number of common shares in the denominator. Expanding this thought, consider that income is for a period of time (e.g., a quarter or year), and during that period of time, the number of shares might have changed because of share issuances or treasury stock transactions. Therefore, a more correct characterization is income divided by the weighted-average number of common shares outstanding.

Further, consider that some companies have both common and preferred shares. Dividends on common and preferred stock are not expenses and do not reduce income. However, preferred dividends do lay claim to a portion of the corporate income stream. Therefore, one more modification is needed to correctly portray the Basic EPS fraction:

Basic EPS = Income Available to Common / Weighted-Average Number of Common Shares Outstanding

The Basic EPS calculation entails a reduction of income by the amount of preferred dividends for the period. To illustrate, assume that Kooyul Corporation began 20X4 with 1,000,000 shares of common stock outstanding. On April 1, 20X4, Kooyul issued 200,000 additional shares of common stock, and 120,000 shares of common stock were reacquired on November 1. Kooyul reported net income of $2,760,000 for the year ending December 31, 20X4. Kooyul also had 50,000 shares of preferred stock on which $500,000 in dividends were rightfully declared and paid during 20X4. Kooyul paid $270,000 in dividends to common shareholders. Therefore, Kooyul’s Basic EPS is $2 per share ($2,260,000/1,130,000), as discussed in the following paragraph.
Income available to Kooyul’s common shareholders is $2,260,000. This amount is calculated as the net income ($2,760,000) minus the preferred dividends ($500,000). Dividends on common stock do not impact the EPS calculation. Weighted-average common shares outstanding during 20X4 are 1,130,000. The following table illustrates this calculation:

The most important value of income statement is Earning per share (EPS). Yes I will not suggest you to see the net profit after tax (PAT) instead see the EPS figures. Even if company’s PAT is increasing but if company has issued new shares then EPS will come down. This has direct negative impact not only on the market valuation of share but also on dividend income. So if a share’s EPS is only growing it is better. Note down the CAGR of EPS. The faster the EPS is growing the faster the market price and dividend disbursement will increase.

Many companies do not pay dividends. One explanation is that the company is not making any money. Hopefully, the better explanation is that the company needs the cash it is generating from operations to reinvest in expanding a successful concept. On the other hand, some profitable and mature businesses can easily manage their growth and still have plenty of cash left to pay a reasonable dividend to shareholders. In evaluating the dividends of a company, analysts calculate the dividend rate (also known as yield).

The dividend rate is the annual dividend divided by the stock price:

Dividend Rate = Annual Cash Dividend / Market Price Per Share

If Pustejovsky Company pays dividends of $1 per share each year, and its stock is selling at $20 per share, it is yielding 5% ($1/$20). Analysts may be interested in evaluating whether a company is capable of sustaining its dividends and will compare the dividends to the earnings:

Dividend Payout Ratio = Annual Cash Dividend / Earnings Per Share

If Pustejovsky earned $3 per share, its payout ratio is .333 ($1/$3). On the other hand, if the earnings were only $0.50, giving rise to a dividend payout ratio of 2 ($1/$0.50), one would begin to question the “safety” of the dividend.
Dividend payment (total value) made to the shareholders are also appearing in the financial statements of a company. An investors must note down the percentage of dividend paid as compared to the net profit figures. Suppose a company has a policy of dividend disbursement policy of say 30% of reported net profit, so if EPS is growing at 10% per year then dividend payment will also increase in the same proportion (10% p.a.).

Cash Flow Statements

Not many investors use cash flow statements to evaluate shares value. But cash flow statements gives immense realization about short term health of the company.

The first thing that is evident in cash flow statements is called ‘Net increase/decrease in cash and cash equivalents’. Observe this value for a period of last five years. Ideally speaking this must always be positive. A company which has enough short term liquidity to pay all its current liabilities are the companies which can sustain its position in the market.

Negative cash flow for few years in succession (or lack of liquid cash availability) will eventually force the company to shut-down. It may be possible that the company is making good profits but if they are not able to maintain continuous positive cash flow (not collecting money fast) then it will not be able to run its day to day operations. Ultimately lack of positive cash will affect its sales.

As an investors you must know that whether the company is buying or selling its own shares. This will be known to you if you see ‘Net cash increase/decrease from financing activity’. If this value is negative then it means that the company is buying its own shares. A company will buy its own shares only when they think that in times to come (say 5 years) its value is going to appreciate drastically.
It is also worth noting the ‘Net cash increase/decrease from investing activities’.

We have seen in our balance sheet a parameter called ‘cash and bank balance’. A company should never have a negative bank balance and neither shall have too high cash sitting idle in bank. So what company does in either to invest in other companies shares, or do some acquisitions. So if ‘net cash in investing’ activity is showing negative it means that the company is investing.

This is a good sign, provided the ‘net cash’ is not negative. In times of crisis (to manage cash flow) companies operations cannot generate enough cash to manage the expenses. In this case company sell their investments (it will appear as positive cash flow in ‘investing activity’) to generate enough funds. This shows that companies operations are not as profitable. Other possibility is also there, that the company has sold their holdings in one of the non-profitable companies. In this case the overall profitability of the company will rise.


As a new investor, it is very important to see all indicators both technical and fundamental in order to arrive to a decision that a particular share is worth buying or not. You will get small-small hints by referring to balance sheet, income statements and cash flow statements. These small hints in total will give you a good feeling about the fundamental health of a company. A company which is fundamentally healthy and is available at undervalued price levels are worth buying.

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