Ploughing through financial statements can be a daunting task. Annual and quarterly reports contain such a huge amount of data it is difficult to know what is relevant. To make matters worse, when looking at historical data there usually isn’t much the markets haven’t already taken into account. Does this mean analysis of financial statements is pointless? Far from it! Fundamental analysis is great, but only if you approach it from the right mindset.
To explain what we mean let’s look at a correlation between investing and traveling. This might sound strange, but there is a striking similarity. The financial statements of a company could be compared to a destination guide for a resort. They both give us a general idea of what the place is like and also what we can expect. How many of us would tell our travel agent to send us anywhere without doing a bit of research? By investing without looking at the financial statements this is exactly what you are doing. This “planning for the trip” is what separates the successful investors from the pack.
At the same time, travel guides and financial statements are both historical representations. A company’s earnings aren’t guaranteed to continue, and the quality of a resort can go downhill. Just as a resort can make itself seem great with a full color glossy brochure, a company can distort its financial results. Finally, while travel guides are good, they only tell us so much. Nothing replaces actually going to the destination and exploring firsthand. This is why we need the right mindset with financial statements. As with travel brochures, they are good, but only to a certain point. Before making an investment make sure you look, but don’t base your entire “investing trip” on the financial statements.
We want a good appearance when looking for at a travel destination. This usually entails finding a place with a warm climate, nice beaches, good restaurants and shopping, etc. To look for good appearance in a company we use different metrics: consistent revenue, earnings growth, record level of debt relative to equity, etc. This is where the statements come in, they can give us the information to determine if the appearance is ok. Here are three rock solid metrics to “test” a company with:
Revenue Growth – Finding out how much a company’s sales have increased over the past year is the base for increases in earnings. Don’t just look at the number, dig deeper. Discover if the 15% increase in revenue meant that net income increased close to 15% too? If not there could be problems, for example did a substantial increase in accounts receivable create the rise in sales? Increases in sales are good, but only if the company is collecting the money.
PEG Ratio – Short for Price-Earnings to Growth Ratio, this relatively new ratio takes the perennial favorite price to earnings ratio and relates it to the earnings growth rate for the company. By combining the P/E with growth we get a much more useful indicator of a stock’s potential value.
Acid Test – A stringent liquidity test that indicates if a firm has enough short-term assets (without selling inventory) to cover its immediate liabilities. This ratio is used to determine risk that is not detected by the Working Capital ratio. Companies with ratios of less than 1 can not pay their current liabilities and should be looked at with extreme care. Furthermore if the acid ratio is much lower than the working capital ratio it means that current assets are highly dependent on inventory – retail stores are examples of this type of business.