By Ambrose Omordion
Please hold on before writing that cheque or taking that investment decision to buy into that company. Even if it is a “brand name” with seemingly predictable growth prospects, a solid understanding of its financials always is very necessary for any investor. Irrespective of the fact that past performance is not a guarantee for the future, since every investment is made against expectation, present performance or happening in any company, which are presented through its quarterly earnings reports in addition to its history gives an insight into what should be expected of the company in the nearest future. This will enable you decide to enter the stock and whether your stay is for the short, medium or long-term.
You don’t have to be an expert anyway; just as such decisions are not rocket science. However, if you want to be a knowledgeable stock investor, you should understand the importance of crucial financial concepts, such as Return on Equity and free cash flow.
This is particularly important, if you’re considering investment in a company that may become involved in future uncertainties.
Think of financial statements as a company’s medical charts/reports, and you the doctor who’s using these charts to determine a diagnosis as to the company’s financial health.
Here are the “Big Three” pointers of where a company is coming from and headed in any financial statement:
• The balance sheet of a company gives a snapshot of its financial health condition. The majority of public companies publish an interim balance sheet each quarter and a comprehensive one at the end of their fiscal year.
Typically, the end of the calendar year is defined as the end of a reporting year. The balance sheet reveals a firm’s financial resources and obligations at a given moment in time.
• The income statement summarizes a firm’s financial transactions over a defined period of time. The balance sheet and income statement match money coming in (revenues) with the expenses tied to generating those revenues.
• The cash flow statement reflects a company’s liquidity. Generally expressed, a healthy company will spend and hang onto less money than it takes in. The difference is the profit distributed to the shareholders and owners. This is called a “positive cash flow.”
Let’s take a closer look at all three elements.
The Balance Sheet
The balance sheet will give you an indication as to the sensitivity of a company’s bottom line to market ups and downs, which is especially important for cyclical firms whose fortunes are tied to economic conditions. The balance sheet will reveal the company’s risks during hard times and its upside during good times.
What follows is a breakdown of the most important lessons that you can learn from a balance sheet—the meaning of key terms, and how to extract and interpret information that are of most benefit to investors.
The balance sheet is broken into two sides. Assets are on the left side, while on the right is the company’s liabilities and shareholders’ equity.
The balance sheet is said to be “balanced” when the value of the assets equals the combined value of the liabilities and shareholders’ equity.
The balance sheet is therefore: Assets equal Liabilities, plus Shareholders’ Equity.
In other words, it is sectioned into two and according to the assets (the inherent means necessary to keep the company operating). It is “balanced” by: 1) the company’s financial obligations, and 2) equity investment and retained earnings.
Scrutinize these aspects:
• Current assets
Current assets can be easily turned into cash, because they have a lifespan of 12 months or less. These assets include accounts receivable, and inventory cash and cash equivalents. Cash includes non-restricted cheques and bank account balances. Cash equivalents include extremely safe assets, such as Treasury Bills that can be easily transformed into cash.
• Non-current assets
Non-current assets are those that can’t be easily converted into cash; they have a lifespan of more than a year. This class of asset includes buildings, land, machines, computers, etc. Non-current assets also can be intangible assets, such as patents, copyrights, goodwill, brand equity or other intellectual property.
• Liabilities
Liabilities include a company’s financial obligations to outside parties. As with assets, they are classified as either current or long-term.
• Long-term liabilities are debts as well as non-debts, due after a period of at least one year from the balance sheet’s date.
• Current liabilities, these are the company’s liabilities that must be paid within 12 months. These include both short-term borrowings, such as accounts payables, and the current payment on long-term borrowing.
• Shareholders’ equity, this is the initial amount of money invested into a business. If, at the end of the fiscal year, a company (after taxes) decides to reinvest its net earnings or profit after tax into its operations. This retained earnings will be transferred from the income statement onto the balance sheet and therefrom into it shareholder’s equity or funds account. This shareholders’ fund account represents a company’s total net worth.
The Income Statement
With a greater understanding of the balance sheet and how it is constructed, we can now look at the income statement.
Here’s a breakdown of the important aspects for investors:
• Gross profit
Gross profit is the basic difference between the cost of production/sales and/or rendering services and the revenues generated in the process.
• Operating profit
The selling, marketing and administrative expenses category entails administrative and marketing cost and overhead involved in operating the business. Another category is expenses for research and development (R&D).
In simple terms, this is calculated as: Operating Profit = Gross Profit – Operating Expenses
Operating profits are earned from a company’s everyday core business operations. This figure doesn’t account for any profit earned from the company’s investments and the effects of interest and taxes. Operating profits also are called “Earnings Before Interest and Tax” (EBIT).
The Cash Flow Statement
A cash flow statement shows how changes—the continual ebb and flow, if you like—in balance statement. Simply put, the cash flow statement reflects the flow of cash in and out of the company.
The cash flow statement is an important barometer for investors, because it reveals the short-term viability of a company. Most importantly, it can show you the ability of a company to pay its bills or meet maturing obligations.
The cash flow statement leaves out transactions that don’t directly affect cash receipts and payments. It only includes inflows and outflows of cash (or cash equivalents).
The cash flow statement directly applies to activities related to these three areas: financing, operating and investing. As an investment tool, it is the best way for you to determine a company’s liquidity and solvency.
• Free cash flow, this indicator is crucial. Here’s the formula for determining free cash flow:
Net Income
Add Amortization/Depreciation
Minus Changes in Working Capital
and Capital Expenditures
= Free Cash Flow
Essentially, free cash flow is operating cash flow minus capital expenditures. It represents the cash that a company is capable of generating after spending all of the money necessary to maintain its asset base.
As an investor, think of free cash flow as “steroids” that boost the growth rate of the company. That’s because free cash flow can be used to make acquisitions, repurchase stock, or repay debt, all of which are highly positive actions that enhance Earnings Per Share.
Financial Ratio Analysis, Using the measures conveyed by these financial statements, you can perform interpretive analysis of a company’s finances and its operations to help your efforts to gauge its suitability as an investment option. This is known as “financial ratio analysis.”
When scrutinizing financial statements and extracting certain numbers from them, you can calculate financial ratios that provide you with a clearer understanding of the company’s financial condition, as well as the efficiency of its operations.
It’s not as complicated as it sounds. Keep in mind though; that to perform some of these ratios, you’ll need to extract information from more than one financial statement prepared by the company over a space of two financial years or more.
The main types of ratios that use information from the balance sheet are activity ratios and financial strength ratios.
Activity ratios focus on current accounts to reflect how efficiently the company manages its receivables, inventory and payables, which all come under the heading of “operating cycle.” These ratios can provide insights into the company’s operational efficiency.
Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and to what extent it is leveraged, or how much debt it is carrying compared to equity. This is why a lot of company raise equity funds via public offer or rights to de-leverage or reduce the debt/equity mix.
• Debt-to-equity ratio
The ratio is determined this way: D/E = Debt (liabilities) divided by Equity.
This ratio reveals the company’s financial leverage. Debt that has been financed with every Naira of equity would constitute a ratio of 1; scant debt compared to assets would represent a ratio of less than 1, such as 0.2. Any ratio above 1 tells you that the company owes more than it is actually making—surely, not a good sign for investors.
• Working capital (or current) Ratio, if you don’t understand what is working capital ratio here’s the formula for determining it:
Current assets = Current liabilities
The working capital ratio can give you inklings as to the company’s financial stability and the manner in which it finances itself. A declining working capital ratio over a sustained period of time is a very bad sign.
• Return on equity (ROE)
For investors, this ratio is very important and is calculated by dividing the net income by the shareholder’s equity/fund and measures a company’s Rate of Return on the money provided by its owners. An ROE of about 12% is roughly the average for public companies.
Conclusion
Now that you’re armed with the basics of financial statement analysis, sharpen your pencil and put on your green eyeshades. You’re ready to do some financial tracking—if not for fun, then certainly for profit. Do have profitable investing.
