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Value Investment and Mindset

How to Analyze Financial Statements? Before Investing In A Company

We discuss how, while picking a good stock, we need to evaluate the financial statement in the topic “How to Pick Good Stocks as a Value Investor?”

Now let’s figure out how to analyze those 3 financial statements so that we have a better understanding of how to analyze them.

We will be elaborating more about the analysis of these three:

Income Statement Analysis
Balance Sheet Analysis
Cash Flow Statement Analysis

🟠 Income Statement Analysis

There are some key indicators in income statement analysis, these are as follows:

Business Income
Gross Profit Margin
Operating Expenses
Net Profit Margin
Earnings Per Share

1. Business Income:

Ensure that revenue is constantly improving over a period of 5 years and more. Revenue growth indicates that businesses are getting more sales and clients.
Lots of revenue doesn’t mean that company is earning a profit

2. Gross Profit Margin:

🔸It is the profit a company makes after deducting the costs associated with making and selling its products, or the cost associated with providing its services.

GPM = Gross Profit / Total Revenue

[GGPM > 40% ✅ ]

🔸A good company will have at least 40% Companies with long term economic working in their favor tend to have a consistently right gross profit margin compared to those that don’t.

A higher GPM means lower expenses.

3. Operating Expenses:

Expenses needed to run a business include three main parts:

General and Administrative
Research and Development
Sales and Marketing

🔶 General and Administrative

General and Administrative, or G&A, must be less than 30% of the revenue to ensure that the company doesn’t go into heavy debt. If G&A increases without an increase in revenue, it means the company is paying more but receiving less.

🔶 Research and Development

Higher Research and development (R&D) spending has an inherent flaw in companies competitive advantage that will always put their long-term economics at risk (which means they are not sure thing)

For non-tech companies, high R&D costs will put their long-term economics at risk.
Strong technology company will usually have high R&D expenses to stay competitive.

So higher R&D is a risk? Well, not exactly (in the case of non-tech, we know it affects economics).

Just keep track of the quality report to ensure companies have increased R&D spending and improved revenue for tech companies.

🔶Sales and Marketing

Normally, companies spend a good amount to gain more sales or clients and grow their business.

Ensure S&M expenses are in line with revenue growth.

Example: If a company spends 500 rupees in marketing and the sale is 250 rupees, then that is bad.

4. Net Profit Margin

Net profit margin, or NPM, is the ratio of profits to the revenue of a company.

NPM = Net Profit / Total Revenue

[ NPM > 20% ✅ ]

Some growing companies' NPM falls between 10% and 20%, but that doesn't mean the company is bad, as new growing companies have less NPM initially.

5. Earnings Per Share

Earnings per share, or EPS, is the net earnings of the company on a per-share basis for a time period.

EPS = Net Profit / Total Outstanding Shares

Example: 10,00,000 / 800,000 = 1.25 for particular period

If EPS is showing a consistent and upward trend with a total constant share in the market, improving EPS means improving net earnings.

🟠 Balance Sheet Analysis

A balance sheet consists of assets and liabilities. In a good financial statement analysis, looking through some of these important things in the balance sheet is necessary.

Current Ratio
Cash or Cash Equivalent
Debt to Shareholders Equity Ratio
Return on Equity

🔶 Current Ratio: The current ratio is derived by dividing current assets by current liabilities. The higher the ratio, the more liquid the company is.

Current Ratio = Current Assets / Current Liabilities

👉🏻Current Ratio > 1 ✅

👉🏻Current Ratio < 1 ❌

We always want to make sure that a good company has a larger amount of assets compared to liabilities. But the current ratio is not a certain ratio. A good company can also have a current ratio < 0 in exceptional cases.

🔶 Cash or Cash Equivalent: It is suggested to have consistently high or improving cash or each equivalent to improve the liquidity of the company.

CASH IS KING

Make sure it is not a one-time event that causes high cash assets.

🔶 Debt to Shareholders Equity Ratio (D/E): D/E is the opposite of the current ratio and is derived by dividing total liabilities by shareholder’s equity. The lower the ratio, the lesser the debt per share of equity.

Debt to Equity Ratio (D/E) = Total Liabilities / Shareholders Equity

👉🏻D/E < 0.5 ✅

👉🏻D/E > 0.5 ❌

(Do more research)

🔶 Return on Equity (ROE): ROE is the net earnings divided by the total equity.

ROE = Net Earning / Total Equity

[ Total Equity = Total Assets - Total Liabilities ]

ROE >= 14% ✅

ROE <10% ❌

(Do more research)

Another factor in balance sheet analysis is “retained earnings.”

It is the earnings that are retained in the business.
Negative retained earnings mean that the company loses more money than it has accumulated.

Retained earnings are not that important compared to other indicators. It seems like a good indicator whether or not it is benefiting from having a durable competitive advantage, but still, it is exceptional.

Example: Microsoft has negative RE, but its economic engine is so strong that it does not need to retain the massive amount of capital it has collected over the years and has instead chosen to spend its retained earnings on R&D or even “share buybacks.”

Some strong companies do not have retained earnings, and that is why this factor is not such an important indicator.

🟠 Cash Flow Statement Analysis

There are 3 sectors in value investing for cash flow statement analysis

Capital Expenditure
Company Share Buyback
Free Cash Flow

🔶 Capital Expenditure

Cash Flow from operating activities
Not having any or minimum capital expenditure in terms of earnings.
Capital expenditure is the amount of money spent on maintaining or acquiring any fixed assets, such as lands or equipments

Capital Expenditure < 50% of Annual Earnings ✅ (Good)

Capital Expenditure < 25% of Annual Earnings ☑️ (Better)

Cash Flow from Investing Operations (There is not much to discuss for value investors POV)
Cash Flow from financing Activities (There is not much to discuss for value investors POV.)

🔶 Company Share Buyback

Share buyback reduces the number of outstanding shares, which increase the earnings per share (EPs) of the company (which eventually makes the stock price go up)
Check “Insurance of preferred stock” in the company’s annual report to search for the company’s share buyback.
It indicates that management takes good care of their business.

The management team buying back its own shares is quite important because it is an indication that the management team will continue to take good care of their business.

There is no difference between a management team and us as investors holding the shares. Investors hold shares because we believe that the company has long-term growth.

If the management team and company don’t buy their own shares, that means company management is not confident in the company's growth. Therefore, it is good to have a look at the share buyback.

There is not a certain percentage that the founder or CEO should hold. The percentage (%) is additional information; it is not a certain indicator.

🔶 Free Cash Flow

As we all know, in the business world, CASH IS KING. Positive or improving free cash flow is a strong indicator of a strong business.

But negative free cash flow doesn’t mean it is bad. High-growth companies need to invest their cash to grow further, as young companies tend to spend more cash to invest in their products or services to improve their businesses.

Think about whether the company is using cash for further good or just wasting money.

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Last Updated: Sep 05, 2024

Tags: #analyzefinance #finance #investing #investor #researching #financeanalysis #financialstatement #beforeinvesting #investment #rules Category: Finance & Investment Learning Lifestyle