Reading a Financial Statement - Part 1

Introduction

You may think you need a Master's degree in finance when reading a financial statement, but it simply isn't true. Not every data point that is included is needed to understand good companies from bad ones. The data points that are the most needed are all that you should focus on. Other data points that are included will give more insight into a company but are not necessary to determine good companies that are candidates for your portfolio. This article will focus on the important data points and where you can find them.

Reading a Financial Statement

Current Market Conditions - Why Bother?

It could be argued that this is a lesson in futility based on the current market conditions and credit crisis. It may seem like not too many people are investing in stocks and there may be some truth to that. But these conditions will not last forever. There will be a time when people will seek out stocks again. Therefore, it's necessary to be ready for when that happens. When you learn about reading a financial statement you will be one step ahead of the game when that time comes.

Here are the most important factors when reading a financial statement:

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Earnings Per Share Trend

Reading a financial statement requires that you look to see if a company has a steadily rising earnings per share trend.  The earnings data point can be found in the income statement.  What you want to beware of is an erratic record of up/down earnings fluctuation historically.  Earnings per share is often the single most data item that the media focuses on and it leads to a price getting hammered (or even exploding).

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P/E Ratio (Price/Earnings Ratio)

The P/E Ratio is computed by taking the price of the company's stock price (obtained from any financial website) and dividing it by it's earnings. The earnings are found on the income statement. It's important to grab the net income per share because the stock price represents the price of one share.

P/E has been rather controversial as a measure and should be taken in the context that it is intended. It gives a very quick snapshot of whether a company is overvalued or not. The number on its own means very little. You can have companies that have a P/E of 30 that are undervalued and companies with P/E ratios of 14 that are overvalued. You have to look at the industry that the company is in and what kind of growth rate a company is experience. It's also a good idea to look at past financial statements to see if there are trends. A solid company with an increasing P/E on a trend basis can be a good value.

Debt/Equity Ratio

Another important factor when reading a financial statement is to see how much debt a company has in relation to its overall equity.  It's calculated by taking the total liabilities divided by shareholder equity.   Both of these data points are contained in a company's balance sheet.  These numbers do not have to be adjusted for per share because they are both totals.  Again, this data point is relative to the company itself and to its industry.  A company could have a lot of debt but if they are able to put that debt to use to generate profits, the debt will not be problematic.  You must compare it historically and within the company's industry.

Cash and Cash Flow

If a company has no cash this could be a sign that they are in a big heap of trouble. Hopefully, the situation will correct itself on the next sales cycle. But if you see that a company is struggling to generate cash and keep it, this could be a warning sign. Even more importantly is the company should show a history of steady net cash flows. If not then they are relying on other forms to finance the business. This may be an okay situation in good times but during bad times, financing from debt can really take a company out.

Part 2 of this series will focus on the more subtle, qualitative aspects of reading a financial statement.

For detailed discussions on the subject of the stock market, head on over to Shareholder Helper and join in.

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