Should we invest our savings? Learn to evaluate the financial statements of a company before you invest
Learning to evaluate the financial statements before investing is beyond the scope of a short article such as this, but we can give you some basics that will help you begin to interpret financial statements and give meaning to the numbers so that you can
Learning to evaluate the financial statements before investing is beyond the scope of a short article such as this, but we can give you some basics that will help you begin to interpret financial statements and give meaning to the numbers so that you can make better investment decisions for your family.
Before we begin, just a word of caution: stock picking is an easy way to lose your family's nest egg. Rather than investing your hard-earned savings immediately into a bunch of stocks you pick on your own — or worse, one stock—consider allocating just 10% of your total investment portfolio to the stocks you pick yourself. Because you’ll want to invest over time in at least a dozen different stocks to create the sort of diversification you get in a mutual fund, you’ll want to have quite a nest egg before you start picking your own stocks. Finally, don’t get caught trading. Buy stocks and plan to hold them for a long time (measured in years, not hours).
Now, let’s begin to look at some basic financial concepts:
The income statement or statement of operations is a financial report that describes what the company generated in revenue over a period of time (typically a year or a quarter) and the expenses associated with generating that revenue. The profit is literally reported on the “bottom line.”
The balance sheet is a report that shows what the company has and owes along with the “equity” of the company. The assets are the things the company has as of the balance sheet date and typically include cash, inventory, plant and equipment and other assets. The liabilities or debts owed by the company are also listed and may include accounts payable, accrued expenses, short and long-term debt and other liabilities. The equity is the difference between the assets and liabilities and is generally listed below the liabilities. The equity is the accounting value of the stock held by the stockholders. Note that the accounting value may not have much to do with the market value.
There are a number of basic financial ratios that are often used to help financial analysts and investors to compare one company to another to determine which to buy and which to sell.
Commonly called the P/E ratio, the price refers to the stock price and the earnings is a reference to the profit per share (the latter being simply the total profits of the company divided by the total number of shares outstanding). So a stock with a price of $20 and earnings of $1 per share would be said to have a P/E ratio of 20/1 or simply 20. The average P/E of stocks in the market varies widely depending on the economic cycle. The higher the number, the more expensive the stock is perceived to be. Fans of Apple commonly comment about how cheap the stock is despite a price well above $500 because the P/E ratio is lower than some other companies in related industries.
The debt to equity ratio is a comparison of the total liabilities of the company to its total equity. Banks, which are highly regulated and explicitly backed by Federal Deposit Insurance have very high ratios of debt to equity. Many high margin, technology businesses with virtually no debt have very low ratios of debt to equity. By comparing one company’s debt to equity ratio to other companies in the same industry, you can get a sense of the health of the company.
The profit margin is equal to the net profit of the company divided by its total sales or revenue, yielding an answer that is usually quoted as a percentage. Margins vary greatly from one industry to another and from one point in an economic cycle to another. Comparing a company’s profit margin to its past profit margin and to other companies in the industry will help you understand more about the performance of a company.
There are countless sources of this information on the internet. Most stock brokerages that have online trading platforms also provide this kind of information in easy to use formats. In fact, they provide much, much more. You can read about companies that interest you to your heart’s content. One independent site that is popular is MSN Money.
Keep in mind that understanding how to read and understand financial statements is essential, but it is only a part of learning to pick stocks.
Devin Thorpe, husband, father, author of Your Mark On The World and a popular guest speaker, is a Forbes Contributor. Building on a twenty-five year career in finance and entrepreneurship that included $500 million in completed transactions, he now champions social good full time, seeking to help others succeed in their efforts to make the world a better place.