How should I analyze a company's financial statements?
Investors should take advantage of the wealth of information provided in a company's financial statements to help them evaluate the company as a potential investment.
In terms of overall profitability, the net income is the obvious place to start when analyzing a company’s financial statements. This bottom line dollar amount on a company's income statement is a good indicator of profitability because it puts a value on the amount a company takes in once all costs of production, depreciation, tax, interest and other expenses have been deducted. However, it should not be used exclusively when evaluating a company.
Operating profit margin is another important indicator of profitability and efficiency. The operating profit margin compares the amount a company earns before interest and taxes to the amount it generates in sales. The margin helps analysts and potential investors understand how successful a company's managers are at controlling expenses and generating profitable revenue from the company's business operation. A high operating profit margin is a strong indication that a company is managing its costs well and that it is generating sales at a faster rate than costs are rising.
A company's financial statements can be used to assess the company's stock price and profitability for shareholders. A variety of metrics are useful in this process. Earnings per share (EPS) is an indicator of return on investment, showing a company's per share profitability. The
price-earnings (P/E) ratio uses a stock's EPS compared to its present share price for evaluation purposes. The price to book (P/B) ratio is considered a foundational value metric for investors, as it reveals the market's valuation of the company in relation to its intrinsic value.
The dividend payout ratio is another useful metric, one that provides a measure of a company's growth, financial stability and returns paid to stockholders. The dividend payout ratio calculates the percentage of company earnings that is being paid out to equity investors in the form of dividends. The higher the ratio value, the more reliably a company’s earnings can manage to sustain dividend payouts and the more stable a company is considered to be. Retained earnings, the amount of profits not paid out to shareholders as dividends, shows what portion of profits a company is reinvesting in expanding its business.
The breakdown of assets and liabilities contained on a company's balance sheet provides investors with a good snapshot view of the company's overall financial health, as well as a picture of the company's debt situation. Debt ratios, such as the current ratio, that can be calculated from the information provided in financial statements enable analysts to assess a company's ability to handle its outstanding debt. Major capital expenditures are shown and can be used in evaluating a company's current financial condition and its potential for growth.Source: www.investopedia.com