If you have started new to invest in stocks, you might have already know that how important it is do your own research and find best companies to invest in. If not then very soon you are going to strike this realization. So better will be to become aware now and develop your own tools of stocks research. In the world of stocks market, hundreds and thousands of companies are listed and picking best companies to invest among the lot is not easy, particularly if you do not have the know-how of reading their financial statements.
This is the first step of wise investing, one must learn to read financial statement of companies. I know it is easier said than done but this is the only way-out to wise investing. In a day you will not learn to read financial statements but it is my personal advice, that spend at least 15 minutes each day with Balance Sheets, Income statements and Cash flow statements. May yourself familiar with those pages and terminologies. In parallel you can read online contents about these financial statements. In short time you will be surprised to see that you have actually picking the words like assets, liabilities, debts, book value, PAT, earning per share, price earnings ratio, cash generated from operation etc.
Warren Buffett was asked once that what makes him such a successful investor, he said “when other are reading playboy, I spend my time reading financial statements of companies”. In order to find best companies to invest its secret code is hidden in their financial statements.
This article is written with the objective of making its readers familiar with the most important terms of financial statements and how to make a conclusion of the its values. But as I told you earlier, there are hundreds and thousands of companies listed in stock market, we cannot research each and every stocks for our purpose.
Warren Buffett would always like to invest in the companies who are market leader. These companies are market leaders because they have some distinguishable qualities that make them a long-term winners. So my personal advice will be make a short list of say 15-20 companies who are market leaders in their sectors. Once you have this list you can then move ahead to do your research to identifies best companies to invest among this list of top 15-20.
Let us see what these financial statements have for investors. In general the total annual report of company can be divided into:
(1) Balance Sheet
(2) Income Statement
(3) Cash Flow Statements
Research shall start from Balance Sheet statements – How strong in company financially?
- Level of ‘debt’ owed by the company: Ideally speaking a company with zero debt is best. But it is difficult to find companies with zero debt. In order to maintain a positive cash flow, companies are forced to avail debts (not because they are not making loss). But a big company will need more debt (cash) to run its operations as compared to small companies, so how to compare two companies?
This is the reason why experts has devised a financial tool called debt-equity ratio to evaluate companies. Divide the level of debts by shareholders equity and you will get debt equity ratio. Debt equity ratio of less than two is reasonable. The lower the better.
- Level ‘reserves’ accumulated by the company: A reasonably good companies will strive to increase their reserves year after year. From the net profits, companies usually holds a part of income and transfer it to balance sheet as reserves. The objective of doing this is to increase the ‘Net worth’ of company (shareholders equity + Reserves). Increasing net worth is a good indicator for investors.
- Improving return on equity: This you can calculate by referring to both balance sheet (shareholders equity) and income statement (net income after tax). Return on equity is expressed in % and you can calculate this by dividing net profit by share holders equity. Observe the pattern of return on equity of last five years. In return on equity is increasing year after year is a good sign. If the rate of increase is more than 10% it means companies growth is phenomenal.
- Decreasing Inventory Levels: In a company if the level of inventory is growing then it is a bad sign that company is not able to sell its finished products. So keeping a track of last five years levels of inventor with respect to reported sales is important. Let us an example of a hypothetical company X here:
| Mar’07 | Mar’08 | Mar’09 | Mar’10 | Mar’11 | |
| Sales ($) | 1864 | 2196 | 2057 | 1856 | 2947 |
| Inventory ($) | 302 | 338 | 364 | 394 | 468 |
| Inv./Sales % | 16% | 15% | 18% | 21% | 16% |
On an average you can see that with increasing level of sales, the company has more or less have been able to maintain an average inventory level of 17% over a span of five years. Note: The sales figures are not available in balance sheet, you must turn to income statements for these figures.
- How company is managing is current cash flows: This is very clearly visible in balance sheet statements. If the company has reported higher current assets as compared to current liabilities it means they are able to pay to its vendors, employee salary etc. Divide reported level of current assets by current liabilities. This ratio is called is current ratio. The higher this ratio it means the more comfortable it is for the companies to manage cash-outflows. Managing short-term cash flows is a heart-beat for a company, if this stops the company will crease to exist soon.
Analyze Income statements – How strong in the future growth prospects of the company?
- How fast is sales turnover of company is increasing: Open the income statement of a company and note down its last five years sales turnover. A consistent growth in sales is a good indicator. Just market if the sales fives are increasing at a rate better than rate of inflation. If answer is Yes, it means company is performing great.
- How fast is net profit of company is increasing: This is important. Look at the Earning Per Share (EPS) figures of balance sheet for last five years. If there is a consistent growth in EPS at a rate (CAGR of 5 years) more than inflation then it means the company is doing great.
- Number of shares outstanding in the market: Always keep a note of number of shares outstanding in the market. In order to raise capital, companies often issue additional shares in the market. Issuing additional shares will decrease the EPS figures. Or in other words you can say with increased shares outstanding in the market, the dividend will be divided in more number of shareholders, which means less dividends per head. On the positive side, companies issuing new shares to raise capital for some expansion project, which will increase earnings of companies in times to come (higher EPS, more dividends).
Analyze cash flow statements – How well the company is placed to pay its current payables?
- Net (decrease)/increase In Cash and Cash Equivalents: This may sound very simple but cash flow management is the heart of companies top managers job. In cash flow statement “Net (decrease)/increase In Cash and Cash Equivalents” indicates net free cash in hand (net of collection and payments made) at the end of the financial year. If net cash in hand is positive (for continuously in last 5 years) it means company is managing its liabilities well. Don’t take this lightly, in day to day business it is very important and difficult thing to manage.
Conclusion
Once you have these calculation in the palm of your hand with objective to find best companies to invest in, you can then take final decisions on investment. It is important to remember that market price of stock reflects nothing the actual worth of a company. A company which is trading at a price of $20 per share may prove more economical that share trading at $1 per share.
In order to understand this we shall use and compare the market price of share with the above listed parameters visible in financial reports. Important parameter to be observed by investors before buying shares are visible only in their balance sheet, income statements and cash flow statements. If one tries to depend on advice of other to buy shares then it is a crime. Please try to read more frequently the financial reports and you will observe that it will not take lot of time when you yourself start comprehending these values.
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