How to Read Financial Statements

by Joe Chapin

Why is it that so many people rely on the advice of friends or upon rumors on the Internet when deciding upon their investments? Sure, everyone can point out a stock that they own that has done extremely well, but how many of those same people will tell you about the losers that they picked? Similarly, most of the postings in the newsgroups and on message boards touting stock picks are posted after the gains have been made. Anyone can tell you what you should have done last week or last year. Don't fall victim to that garbage.

In order to be a successful investor, you need to make successful investments. If you want to make successful investments you will need to do substantial research. Why is it that people will spend hours surfing the web trying to save $10 on an airline ticket but will quickly take a stranger's advice on which stocks they should fund their retirement account with? Investment decisions are some of the most important decisions that you will make in your lifetime and they should be treated as such.

Any publicly traded company produces several financial statements every year that are readily available to the public. Although these balance sheets, income statements and the like seem like something only a CPA could understand, they are filled with information that anyone can understand if they know what they are looking for. What follows are some general observations on what to look for and what to look out for in most any company's financial reports.

  • Debt: Ideally, you want to invest in companies with little or no long-term debt. This is generally a sign that a company has a healthy cash flow. Furthermore, the return on equity is substantially improved when a company is not burdened with interest payments on long-term debt.
  • Return on Equity (ROE) Ratio: Return on Equity can be determined by taking net income and dividing it by total shareholder equity. This simple formula will measure the amount of profit a company generates relative to the amount of money shareholders have put into it. You will want to focus on stocks with a minimum if .15 (15%) ROE. Achieving a high ROE while incurring little or no debt is a sure sign of financial success. Be wary or companies that increase their ROE by increasing their debt which should be seen as a red flag.
  • Profit Margins: It is an absolute must that a company's profit margin is on the rise. The ability to increase sales without a corresponding increase in expenses is characteristic of a solid company. Typically, the larger the profit margin, the safer the investment. Obviously, a company that operates with a 5% profit margin will operate at a loss if sales decline by 5%.
  • Current Ratio: This ratio is determined by dividing the current assets by the current liabilities. This ratio will show you how well equipped a company will be at handling adversity. You should focus on companies with a current ratio of at least 2:1, preferably higher.
  • Earnings: Quarterly earnings should show meaningful growth when compared to the same quarter from a prior year, not a prior quarter. This will insure that you are comparing apples to apples. Keep a keen eye out for one time extraordinary gains when looking at annual earnings. You will want to focus on companies with annual earnings growth of 20% or more.

These are just a handful of items that you may want to consider when looking at a company's financial statements. Hopefully, this will come in handy in helping you decipher these statements when you are researching your investment options. While you should not rely solely on financial statements in your decision making process, they are a vital part of that process.

So take the hot tips and rumors with a grain of salt and do your own research. There is no substitute for knowledge. Also, remember not to rush your investment decisions. If a stock is a good buy today, it will probably still be a good buy next week.

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