When you are considering investing in a company’s stock, you want to know what you are buying. That is, you need financial information about the company to decide if your investment is likely to grow in value or provide good income. Publicly traded companies must publish the financial information you need each year and update it periodically during the year.
Most of the financial information an investor needs about a publicly traded company is continued in four annual financial statements required by the Securities and Exchange Commission. The balance sheet provides a summary of a company’s financial condition. The income statement details revenue and expenses for the year and how much net income the company earned. A statement of shareholders’ equity summarizes changes in equity due to net income and equity transactions like the sale of new shares. The cash flow statement describes changes in cash the company has on hand and the effect on the amount of cash available resulting from earnings, borrowing and investments.
Financial information for different companies can be difficult to compare directly, so, investors use a variety of financial ratios to make comparison. For example, a quick ratio is the ratio of cash plus receivables divided by current liabilities. The quick ratio tells you how many dollars of cash a company has for each dollar of short-term debt. Since the quick ratio is a proportion, not a dollar figure, you can easily compare different companies. Other financial ratios serve the same purpose; that is, they allow you to quickly compare one company to another.
The four major financial statements are included in each publicly traded company’s annual report, which is usually available for downloading from the company’s investor relations website. A company’s SEC document filings, financial statements and quarterly reports are often posted on the company website. If not, you can obtain them by accessing the SEC’s EDGAR database online. Financial ratios are often included with these documents or are available on finance websites. However, if you can’t find a particular ratio, you can find the required information in the four financial statements and calculate the ratio yourself.
Financial Analysis -- An Example
Understanding a company’s financial circumstances doesn’t end with reading financial statements and calculating ratios. Bringing these pieces of information together is essential to getting a good picture of a company’s prospects. For example, suppose you want to know about a firm’s long-term growth prospects, so you look at a company’s return on equity. ROE is the percentage of the company’s net worth it earned in profit. If the company earned 12 percent of its equity, that’s considered good. You might think the company is likely to grow. But then you look at the company’s dividend yield, which is the percentage of a company’s net worth paid out in dividends. If a firm’s dividend yield is 10 percent, subtract that from the ROE and you see that in this example, the company only reinvests at a rate of 2 percent of its net worth. You might have a stock that provides good income from dividends, but it probably will grow slowly.